Q:  What are the core beliefs behind your way of money management?

A: We invest in undervalued companies that, we believe, are experiencing a positive catalyst. We believe that the companies are typically undervalued for a reason, and we expect them to remain undervalued, unless a catalyst occurs. We also believe that entire market is cyclical, so we need to be cognizant of that when we make our investment decisions.

We focus on the stocks for which the consensus view is negative because, in those cases, we believe most of the negative news is already priced into the stock and, therefore, there’s not a lot of downside risk left. If the majority of analysts have a negative view or “sell” recommendation on a particular stock that we believe has attractive value characteristics, we definitely want to take a look at that company.

Similarly, we would generally begin to sell a security when the analysts’ consensus becomes more favorable and the analysts begin to upgrade the stock. If there are positive developments in a company, sooner or later we expect the analysts will make upward revisions, and we want to be ahead of that.

Q:  How do you translate your philosophy into an investment strategy and process?

A: To find these undervalued companies with a catalyst, we rely primarily on fundamental analysis. Three members of our team have accounting and auditing backgrounds and two hold CPA licenses. That’s very important for us, because from the standpoint of fundamental analysis, we should be able to get an understanding of what’s going on within a company through its income statement, balance sheet, and cash-flow statement. That approach helps us to understand what’s going on, why the company is undervalued, and how plausible it is to turn the company around.

From a valuation standpoint, one of the critical screens is enterprise value to sales. Enterprise value is the market capitalization of a company adjusted for its debt and cash, so we believe it is a better measure of a company’s worth than the market capitalization. We prefer to use sales because sales typically represent what we consider to be the “cleanest” part of the income statement, while earnings can fluctuate over time.

The other critical valuation that we use is return on capital. We are very big proponents of return on capital because the companies that continuously exhibit low returns on capital gradually destroy value over time, and we make sure to avoid them. We’re looking for companies that have or historically had high return on capital. Even if currently they don’t have the highest return, we are looking for a trend towards improvement.

Q:  Do the companies with high return on capital fall into several industries?

A: Typically, companies with high return on capital are concentrated in specific industries; the pharmaceutical industry is a good example. There are very cyclical industries, for example commodities, which don’t exhibit high returns on capital. When we evaluate those specific areas, we do it from a relative standpoint. We look at the historical returns and focus on the companies with high returns relative to their peers and on the companies with the ability to achieve high returns.

Other valuation measures include price-to-earnings and price-to-sales ratios. But when we use the P/E ratio, we use normalized earnings to compensate for the cyclicality. We want to make sure that we strip out the times when the companies will be over or under earnings, as well as the times when anomalies occur. We usually go back at least 15 years to see what the normalized earnings have been over time. The normalized figure helps to see if the P/E is reasonable and if the company is undervalued. Based on that decision, we will determine whether or not to continue to focus on the company.

Our fundamental analysis work starts with looking at the companies’ financial statements. Once we’ve come up with a company that looks attractive, we’ll talk to Wall Street analysts. We’re not looking for their stock ideas or recommendations, but for gathering more detailed information on the company.

Meeting the management is another crucial element of our strategy. Whether at an in- person meeting, a conference call, or at an investment conference, we need to talk to the management prior to investing in the company. This is because we need to ensure that we’re comfortable with the management and are confident that it can execute and lead it in the right direction. If we can’t get that confidence, then we will not invest in the company.

But, before making the final investment within the company, we need to come up with a catalyst.

Q:  Could you describe the type of catalysts that you look for?

A: We look for three different types of catalysts, but we don’t necessarily need all three of them working at once; we’re looking for at least one catalyst.

The first type is a fundamental change within the company, which is probably the easiest one to identify. We can see it through the income statements, the earnings growth, the margin improvement, and the efforts of the company to cut costs or to come out with a new product that’s going to drive its revenues.

We look for a positive change within the company and we try to find an inflection point for that change. A company may be losing money, but if it is losing less money quarter over quarter, there is something going on. We want to make investments in such companies before everyone else on the Street jumps on the bandwagon of that company’s improvement.

The second catalyst is related to changes or consolidation within the industry. Usually, when an acquisition is announced within one industry, it creates a domino effect and other companies within that same industry start making acquisitions as well. In 2005 and 2006, for example, in the telecommunications industry there was the Sprint-Nextel merger; then Verizon and Quest Communications were battling out to take over the MCI assets. Later SBC acquired AT&T, then acquired Bell South. When there is rampant M&A activity like that, you can take advantage of the situation.

The third catalyst is a management change at the top level. We prefer outside changes, or when the company brings a CEO from the outside to move the company in a new direction or to change the company’s attitudes. Sometimes an internal management change can be positive as well, but we’re mostly trying to focus on outside changes.