Q: What is the strategy behind the Diversified Equity Income portfolio?

A: The fund has two objectives – capital appreciation and income. That does a couple of things – it introduces income, which has a tendency to cushion your returns a little bit in down markets. Also, in certain environments it turns out to be a performance strategy. By that I mean that, over very long periods of time, dividend income and dividend yield turn out to be an important part of the total return. Since I have been here, I have exercised a style I describe as “deep value.”

Before I started managing the fund three years ago, the general thrust was toward cheaper names on standard metrics. The bias was more towards larger cap stocks, and some growthier stocks. It maybe had been a deep value fund in the mid-1990s, but then it became more growth-oriented and looked more blend-like at the peak of the market than it should have been. My style is deep value, which means that we not only own stocks that are cheaper than core and growth portfolios, but also cheaper than other value portfolios.

As a general principle, we believe that you can’t beat the competition by mimicking the competition. We take views that are not consensus. Thus we are constantly looking at stocks that have low ratings by Wall Street.

Q: You do not seem to have many restrictions apart from being at least 80% invested in dividend-bearing stocks. What other restrictions do you have?

A: There are a series of things related to income. If you are an equity income fund, you have to be 80% invested in income producing securities. It is also true in terms of policy that we want 65% of our assets to be invested in securities with above-market yield and that the overall portfolio on a gross basis at least should have an above-market yield, which means higher than the yield on the S&P 500. That is not by prospectus, though, that is by style. Otherwise, it is a pretty broad mandate.

I should point out that there are no restrictions with regard to market capitalization. And that is an important element, because when I came three years ago, my argument was our shareholders would benefit if we got an exposure to the small-cap and mid-cap markets. And that has proven to be the case thus far.

Q: There are times in the market when value is more difficult to find, much less “deep value.” Let’s take this year, for instance, with the serious run-up in stock prices. How do you deal with such situations?

A: If you look at the recent activity in the portfolio, we have been looking at the energy and telecommunication services areas. These are the two areas that have lagged the market. Both areas have witnessed significant free cash flow generation and they have fairly high dividend yields. These are areas that we find attractive – the telecommunication services names more tactically, short-term, and the energy names more long-term. Yes, there is still value in this market.

Q: Still, you are overweight in financials, which is the traditional value play.

A: Yes, we have a significant financial weighting. On the other hand, if you look at a common benchmark for value portfolios — the Russell 2000 Value index — the finance weighting there is much higher.

Q: Relative to the Russell 2000, you are more overweight in industrials, right?

A: That is absolutely true, and that is a key strategic thrust for us. Think of the industrials as somewhat synonymous with the cyclical stocks. Cyclical stocks underperformed consumer stocks in the Morgan Stanley indexes for 20 years in the 1980s and 1990s. Then, for two or three years they are essentially in a dead heat, and now the cyclical stocks have started to outperform.

We argue that many of these companies developed an ability to cut cost, manage process through Six Sigma, and manage disciplined capital spending, such that the outlook going forward is dramatically improved, depending on the precise industry you are looking at. In each case you have gone through a difficult period, in which demand was low. Now I think you are seeing a turn in the economy, and you have many of these companies with expenses screwed down so tightly that you are likely to see dramatic increases in margins. We think that this is an unrecognized secular shift in the markets. So, we have a weighting in industrials, which started to pay off for us in the last three months.

Q: Where, more specifically, are the turnaround stories in your largest holdings?

A: Caterpillar is a perfect example. This is a very well-run company that has also suffered from some of the things I have already outlined, and one other issue I didn’t mention – they are beneficiaries of a weaker dollar. A strong dollar created a problem in terms of competing globally for this company. For the most part, infrastructure-related companies and companies that service commodity-related businesses like Caterpillar had a very difficult time in the 1990s. But through the application of Six Sigma and intense cost control, they have positioned themselves for reasonable capacity in an economy that is growing and they also have a very tight cost control. I think people are going to be very surprised at the earnings power of this company demonstrated over the next couple of years.

True, it has moved up a lot. It certainly is not as inexpensive as it was six months ago or a year ago, but still we like Caterpillar. I believe at some point we will begin to think of this potentially as a growth stock. At that point we may not be a big holder anymore, but I think it can achieve above average growth in the next few years and attract a lot of attention.

Q: Tell me about your research. What kind of resources do you have at your disposal?

A: I work with a group — we call it the Deep Value Team. I am the portfolio manager, and we have two associate portfolio managers – Laton Spahr and Steve Schroll. We run some initial screens, looking for stocks that are inexpensive on standard measures, and then do additional fundamental research on the candidates that either fit within the theme, or are cheap on a number of measures, or both. We also have a research staff in Minneapolis that we use. They have done a lot of work on Caterpillar.

Q: And what makes a stock a “buy?”

A: It depends on the market sector. And the reason I say that is some of our holdings are considered more strategic. That is where we think there is what we call a semi-permanent shift, and where you need to be more concerned about fundamentals and the shift in the fundamentals and a little less concerned about the price. So, for example, we would like to hold on to Caterpillar, despite the fact that it has run up. There are other, more tactical areas, that we don’t have a particularly favorable bias on, but they are statistically cheap. And I would put many of the financials in that area. For the most part, we think financials have seen their best days.