Q:  Do you benchmark against any index?

A: Because our process is very bottom up and because of our criteria, there will be areas where we’ll be very underexposed most of the time. With that in mind, we don’t closely benchmark against index weightings although we do hold our performance up against the Russell 2000 index. We focus on absolute returns and downside protection, and we do not focus on sector weightings against the index.

Q:  How many holdings do you have in the fund?

A: We have about seventy holdings.

Q:  How do you manage against taxes?

A: We try to be tax efficient, particularly when it comes to short-term gains. We spend more time worrying about the short-term gains than the long-term gains.

Q:  How do you find ideas?

A: Ideas can come from a number of different sources - running screens, presentations, and meetings with the management teams. And the most interesting source of ideas is the intellectual database at our firm.

Since small-cap stocks tend to be less liquid than large-cap stocks, during those times of news related volatility, you tend to find that liquidity goes up a lot for a very short period of time. So when there are news items, our stocks will move a lot and trade a lot and it’s a very short window of a day or two. We are laser focused on small-cap stocks, and when there are market-moving events, we make intelligent decisions very quickly and with a great depth of knowledge, and that’s a huge competitive advantage for us.

Q:  How do ideas turn into holdings, and then how do you harvest them?

A: I’ll take Cimarex Energy (XEC) as an example of how market knowledge helps. Our firm owned oil service firm, Helmerich and Payne (HP), a drilling contractor. We believed that longterm the price for oil was rising and we knew the company. They decided at one point to divest their exploration and production business and they merged it with a company called Key Energy. I saw and met the people at Key Energy, as it was one of those companies that we had in our institutional database. After the merger Key Energy was renamed Cimarex Energy. As a result of that transaction, and our knowledge of the business, we then took a look at this newly created company. We liked its prospects and the fact that it was under followed because it was a division of one company merging with a small under followed company, so no one really knew it. We met the people, got comfortable with their strategy, their assets, their business model, and we wound up taking a big position. The company and the stock are a lot larger now than a few years back. That was an example of a company that met our financial metrics, a company that came into existence where on one side we had been impressed with the people from a distance, but on the other side of the transaction we had been invested with the people and knew the business, so all those things came together to get us interested in this new opportunity, and it still is a winning investment.

Q:  When you look at an Exploration & Production company like that, and when you look at asset to equity ratios, how do you verify the assets that are under the ground are worth what they are priced at?

A: That’s the wild card, but that’s true of any commodity company. It’s true of any financial services company, because the financial statements are all really estimates there too, and at some point anybody who tells you differently is maybe deluding themselves. Unless you are an engineer who has access to the actual raw data, then you have to believe the people and look at the track record of write-offs. Like a financial services company or an insurance company or a bank, you can never really know.

Q:  But as a strict value investor, even though the assets declaration may be in balance sheet, wouldn’t you pass on this investments even though they may be good, but in the end, you’re relying on somebody’s word and not on numbers that could be verified?

A: It can be somewhat verified by others, it can be verified by their independent outside engineering firm.

We monitor the balance sheets as we go forward and it’s the same thing with companies that we own that may do large acquisitions, but do them in such a way where the balance sheet no longer fits our criteria, in that case we may divest our holding.

Q:  How do you measure and control risk?

A: We look at risk as a function of losing money rather than a function of variation versus the index. We do that by diversifying. A big part of how we view risk gets back to the balance sheet criteria again. That helps us in a big way from having the big wipeouts, and that, combined with diversification, and good businesses is one of our risk control measures.

We are not benchmarking the index, and we are not looking at spreads versus the index, and tracking errors versus the index. We are not trying to manage tracking error and we are not using the Barra risk management tools to see how the portfolio differs from the index on size and on leverage and on valuation and all those things that you do when you are very institutionally index focused. We are more about picking stocks and not losing money. It’s a different way of looking at the world but it works.