Q:  What’s your investment philosophy?

A: Our core belief is that earnings and cash flow generation drive stock prices. We are looking for companies where we think the future earnings and cash flow generation is going to be above market expectations.

Our time horizon is two years. It’s not a science, but we’re looking for longerterm ideas where we think the earnings power would be above expectations.

Q:  Why do you believe that future earnings are more important than historical earnings?

A: We are trying to figure out where the stocks are going to go from today. Past earnings and cash flows are already incorporated in the stock. That is in the past and that is not very relevant to the future direction of the stock. What is important for where the stock is going to go is what happens in the future. We do study the past to learn about cycles and history, but the drivers of the stock price from today are going to be what happens in the future.

When you look at a stock price, it incorporates a consensus view about what may happen in the future. Not only does it reflect what happened in the past, but it also reflects the market expectation about what will happen going forward. The market has some sort of rate of growth built into the revenues, earnings and cash flows and that is what drives today’s stock price.

In our process we are looking for companies where we can identify upside earnings or cash flow surprises relative to market expectation. So we generally believe that the earnings in every one of our holdings will look more favorable going forward than what the market currently expects.

Q:  What do you do when you don’t have any market expectations available on certain stocks?

A: We are a fund investing in large-cap stocks, measured against the S&P500, and we would rarely run across a stock that doesn’t have Wall Street consensus expectations. This selection tool is not always absolute, because there are times when a stock overly discounts negative news and you could have consensus earnings numbers that come down and stocks still go up. We don’t want to make it sound like we only use Wall Street estimates to gauge expectations, because we don’t.

Stocks, even if they are not followed, have some expectations, based on the price. Then there are other ways to understand the expectations besides Wall Street consensus. We use valuations like discounted cash flow and we look at multiples relative to the company’s history and the industry.

Q:  How would you describe your investment process?

A: We have a process that utilizes topdown and bottom-up analysis. We try to use all of the available information, our internal research staff, our in-house economists and everybody in the investment process here at our firm, which is a quality set of resources for us. And if we can identify a top-down theme or a sector where we think the growth rate and earnings across the sector will be underappreciated, then we’ll latch onto that and overweight that in our portfolio. Similarly, if we find a sector that is going to disappoint in terms of future performance relative to expectations, then we will underweight it in our portfolio.

Then, even in these top-down themes that we identify, we are going to use bottom-up analysis to try and figure out which companies within that framework are likely to be the best ones to own and which stocks are likely to see declining performance. Even though we are looking for the top-down theme and for sectors that will outperform from an earnings standpoint, there may be times in the market where there is no dominant theme.

For example, in the last couple of years, a very prominent theme in the marketplace was energy and industrials and we identified that very early. Currently there is not such an obvious theme to us, and we are likely to be more sector neutral and focus on bottom-up stock picking to drive our performance relative to the benchmark.

We have a research process firm-wide that starts with all the investment division getting together on a daily basis to go over what’s going on in the market, and in the international markets, from a currency standpoint and economic growth standpoint. This is an effort that is supported by a process firm-wide to sort out where we are going to find underappreciated growth, either in a sector, or just from a company-specific standpoint.

Q:  Can you give an example to illustrate how an idea turns into a holding in your portfolio?

A: For example, when we bought John Deere there was growth in ethanol demand. Farmers started putting up ethanol plants to take advantage of the higher prices in energy, and the amount of corn used to feed the ethanol industry looked like it was going to double in the next few years, so we bought John Deere stocks.

We identified there was going to be growth in demand for ethanol, and that would lead to higher corn prices. When farmers see increased corn or wheat prices and they have more cash in their pockets, they are more likely to go out and buy farm equipment. So, we figured out that one very meaningful way to play ethanol is by buying a position in Deere.

Q:  How do you generally build a portfolio? How do you diversify?

A: We generally don’t go over two times the allocation in the fund in any particular S&P500 sector and won’t go much under half-weighted in any particular sector. So we manage diversification on the sector weightings. Besides just having the top-down theme finding process, the bottom-up process also adds ideas in sectors where we don’t have a powerful theme.