Q:  What is your investment philosophy?

A: We believe that you can earn betterthan- market returns with less-than-market risks by building a portfolio of high-quality businesses selling below their intrinsic value. That translates into buying lower price to earnings, lower price to book and lower price to sales companies.

We have a strong preference towards better businesses in better industries. We’d rather buy a medical technology company growing at 15% at thirteen times earnings than an industrial steel company that’s selling at twelve times earnings but whose earnings don’t grow over time.

Q:  Some investors look at deep value, other investors look at turnaround value, and still others look at relative or absolute value. What is your version of value?

A: We fall into the core value or the relative value area rather than the deep value area. We are trying to buy leading businesses at good prices. We are looking at the company’s earnings, growth and prospects, the company’s dividends growth and prospects, their cash flows, their return on equity, and then we want to make sure that it’s a superior business with a superior franchise. Then, based on those earnings prospects, we try to figure out what that business is worth and we want to buy it at a one-third discount.

We believe it is better to focus on good businesses that have short-term issues than to focus on inferior businesses that are given away at a fire sale price.

Q:  How do you define a superior business? Are companies paying dividends a must for you to buy?

A: The company dividend rate and history of dividend are two of eight elements in our valuation models. However, some companies decide they can do better with your money than you can, and have not paid a dividend. As long as the company appears attractive on our other valuation models, we can and do buy and hold such stocks. There are several companies in the portfolio that were non-dividend paying when we originally bought them.

We like businesses that can grow over time through a business cycle. We like industries where sales are growing over time, where there’s not a great deal of operating margin pressure, where there are barriers to entry for competitors, and where the companies have superior margins.

A few years ago we owned Guidant Corp., a company whose earnings over time were growing more than 15%. They had a dominant market share in the ICD market and a solid market share in the stent technologies, and there were a handful of competitors in these markets. Originally, we bought them at under fourteen times earnings. So, we had a good growth business, barriers to entry, wonderful cash flow, all at a very attractive price.

Q:  How is your research process organized? How do you find ideas and then how does an idea turn into a holding?

A: Our research universe is the largest 1,500 companies in the Zacks company database. First, we look at the strength of the balance sheet, where we are trying to find companies that have low debt to capitalization ratio, high interest rate coverage and high current ratio. If a company violates our financial strength, it gets screened out. The first step is the balance sheet review. Thus we screen 1,500 companies down to about 1,000.

We then put every company through eight rigorous quantitative valuation models. Our models will look at a company on an absolute and relative basis. There are four absolute valuation models of earnings and earnings growth, dividends and dividend growth, return on equity to book value, and earnings rate to AAA Bond rate. We look at a ten-year operating history of the company along with the current year’s earnings, next year’s earnings, and the year after. We look at valuations based on those ten-year periods. The higher the earnings growth, the more we are willing to pay for a company, but within reason.

Then we have four relative valuation models, which will look at how the company has sold vs. its own history over the last six to ten years. We’ll look at a company on its P/ E basis, its price to book value, its price to sale and its dividend yield. We require that a company appears attractive on any two or more of those eight valuation models. So the initial 1,500 companies are winnowed down to about 75 to 100 companies that appear statistically attractive.

Q:  How do you continue your research on these 75 to 100 companies?

A: We do very detailed qualitative work. We go through the company’s financial reports and their 10-K statements. We make sure that we are comfortable with everything they are doing. We look for understated or overstated assets, contingent liabilities and check the management strategy - are they running the business for shareholders, is there a conflict of interests. We’ll then speak with Wall Street analysts, we’ll try to pick an analyst that is negative on the company to make sure we understand all the reasons they don’t like it. We’ll then try to speak with two or three analysts that we think are the most insightful and have the best record on the company or an industry. We do not rely on the analysts for buy or sell recommendations but just to get an overview of the company and industry and current trends.

At the end of that three-pronged process, we’ll try to do a catalyst assessment. Yes, the stock is cheap, we like the management, they are shareholder-oriented, it’s undervalued, but what is going to help us achieve our value? If we can identify the catalyst, that’s great. However, there are a number of cases where we can’t, but if everything else is right for the company, we will still have a high level of interest. At the end of that process, those 75 or 100 companies are winnowed down to 30 or 40 most attractive stocks that we build a portfolio from.

Q:  Are your holdings all the same size, percentage wise, or do you employ a range?

A: The latter. Generally, 2% would be a smaller position, and position at cost would be no more than 4%. So an average position for us is about 3.3%. Then, beyond the rule of not buying more than 4% at cost, we will scale back a position even if we continue to like it, so that it would definitely be no more than 8% at market value of a portfolio as a rule, but generally a position will rarely be above 5% at market value of the portfolio.

Q:  Can you give us some historical examples?