Q:  What is the investment philosophy of the fund?

A: We are value investors and we are contrarians. What makes this approach rewarding is the tendency toward mean reversion of return on investment and earnings growth. The reason for this is that high returns on investment tend to attract capital, which in turn tends to drive returns down. Low returns on investment tend to drive capital out, and as a result, return on investment rises.

In spite of those cycles, investors extrapolate the recent past and price the stocks accordingly. They assume that companies that have not been successful recently in terms of their profitability and earnings per share growth rate are not going to be successful in the future, and they assign a low P/E ratio to those companies. Yet, when this reversion to the mean occurs and profitability and earnings growth rebound, the P/E ratios rise, providing the reward for value investors.

Q:  Do you think along sector lines or along the lines of capitalization? In general, what type of stocks are you looking for?

A: We’re interested in stocks of companies with market cap of $4 billion or more, and we have some constraints that require exposure in all of the ten economic sectors.

We’re looking for stocks that are statistically cheap and undervalued and, ideally, which have a positive catalyst. ‘Statistically cheap’ means low P/Es, low price-to-cash flow, low price-to-book value, and higher yields. Undervalued means stocks that are selling for less than our estimate of their intrinsic value. By positive catalyst I mean something that’s going to get investors excited. It could be a new product, a new management, a new strategy, or simply rising Wall Street earnings estimates. For a cyclical stock, it could be our conviction that the economy will expand.

Q:  How do you determine that a stock is undervalued?

A: We use a number of valuation models, but all of them are driven by three things. The first is an estimate of normalized EPS; the second is an estimate of long-term EPS growth; and the third is an assessment of risk. Those three things are the focus of all the fundamental analysis we do - all the 10Ks we read, the numbers we crunch, the research reports we read, the conference calls we listen to.

The estimate of normalized earnings is something that we spend a lot of time on. We start by looking at history, at least ten years. We look at reported earnings and return on equity. Then we break return on equity down into net margins, asset turnover, and financial leverage. We think about what may have changed, why, and if it is a permanent or a temporary change.

We have five people on the large cap value team with an average experience of 21 years. All of us are CFAs and four out of the five have an MBA. The fifth person is a CPA, which is helpful with all the accounting issues today.

Q:  Which benchmark you measure yourself against and how would you define your perception of value? Do you look for turnaround situations, for example?

A: It’s the Russell 1000 Value Index. Certainly, we end up buying a lot of turnaround situations. I’m never entirely sure what people mean by ‘deep value’ and ‘relative value,’ but we do have some stocks that everyone would agree are deep value. We are not relative value in the sense some people mean it. If, for example, in the tech sector there are very few stocks that are cheap relative to the overall market, many investors would buy stocks that are cheap relative to other tech stocks. We don’t do that. We want statistical cheapness relative to the overall market, which means that within the tech sector there aren’t many names that are appealing to us.

Q:  Would you explain your valuation models in more detail?

A: I’ll start with the PEGY ratio, which is a little different from the wellknown PEG ratio. We’re value investors and yield is important, so we’re looking at the P/E on normalized earnings divided by our projection of long-term earnings per share growth plus yield.

Another methodology we use is implied growth rate analysis. We calculate the EPS growth rate that is implied by the P/E and yield of the stock relative to the overall market. We compare that implied growth rate with our long-term EPS growth rate. If our growth rate is higher, then the stock is considered attractive.

Another methodology is a theoretical P/E ratio. We run a regression on the P/E ratios for our universe of stocks against three variables. One is our estimated long-term growth rate; the second is the dividend payout ratio; and the third is our assessment of risk. We get a regression equation which says the P/E is some coefficient times the growth rate plus some coefficient times the payout ratio plus some coefficient times our risk measure. We plug the numbers in for each individual stock and solve for the P/E ratio. Then we compare that to the actual P/E.

The next approach is something that we call ‘normalized return analysis,’ and this is the simplest and the most subjective of our approaches. The first step is to estimate normalized earnings, which is an input to all of our valuation models. The second step is to determine an appropriate relative P/E ratio for the stock and we do that judgmentally based on our expectation of earnings growth and risk, based on where the stock has sold relative to the overall market in the past, and after making a judgment about whether or not that can persist. We multiply this relative P/E ratio times the P/E ratio for the overall market to get a target P/E. We then multiply this target P/E ratio times the normalized earnings. The result is a price target.

Our final tool is free cash flow yield. This isn’t so much a valuation model as it is simply a calculation. There are times when this works extremely well for us. For example, we were very attracted to the high free cash flow yield of Sun- Guard Data Systems. Shortly after we bought the stock, it was purchased by a consortium of private equity firms who were attracted by the same thing. We have a little bit different way of defining free cash flow yield. We take a threeyear average of capital expenditures and a three-year average of the increase in working capital to smooth out the peaks and valleys.

Q:  Do you view the dividend paying companies more positively than the others?

A: An above average yield is frequently a characteristic of a value stock and can be a function of a low price and/or a high payout ratio. Sometimes a higher payout ratio is a way of management’s endorsing the quality of its earnings. When the payout ratio is low, that’s often because the quality of the earnings is low or because there’s not a lot of truly free cash flow. So, generally, higher payout ratios are positive. And just as having a high level of debt imposes a discipline on management to make good decisions about capital investments, a high payout ratio does the same thing. There have been some studies that show that, actually, higher payout ratio companies have grown faster than lower payout ratio companies. So we are positively disposed towards yield. Fif