A: A dividend doesn’t strengthen the balance sheet, but it tells investors that management has enough confidence in its business to return cash to investors. Anything that comes back to shareholders as a return on investment is a positive thing for us. Second, it sends a very clear message about putting shareholders’ interests first.

Historically, when dividends were taxed at a higher rate, management could argue that this was a less efficient way to return capital than share buybacks. But when the tax rate on dividends is 15%, that’s pretty nominal and the tax-effi- ciency argument is less meaningful.

You’re right that paying out dividends doesn’t grow the business, but dividends are paid after capital expenditures. We look at the free cash flow after the company has made enough investments to maintain and grow its market position. The question is will this free cash be used for benefit of the management or for the benefit of the shareholder?

Q:  When a company increases the dividend, isn’t that a very long-term commitment?

A: Absolutely. It’s a long-term commitment as it would be very painful to cut that dividend. That’s why management must be confident to do it and we take that as a positive sign. If the company has lots of cash on its balance sheet, but is unwilling to boost the dividend even modestly, that’s also a sign.

Some companies argue that they don’t want to become a high-dividend type of stock because it would send the wrong message. For example, Microsoft wants to be perceived as a dynamic growth stock, not as a cash-cow investment. I think that Steve Ballmer’s biggest fear is that everyone will regard Microsoft as a utility. But at the end of the day, if they have good use for that cash, they should be putting it to work, not keeping it on the balance sheet.

The argument against dividends is that you’re sending a signal that you don’t have a better option for that cash. But what are the other options? Are you going to continue building a war chest that will depress your ROE, or pay out that money as dividends or repurchases? Some companies strike a good balance between those options and some don’t, but at the end of the day, they want to get that excess cash off the balance sheet.

Q:  What are the most important aspects of your research process?

A: My analysts spend their time on what we own in the portfolio, not on producing new ideas. We’re mostly a buy and hold fund with three to five-year outlook, so we’re not trying to find the next earnings pop. I basically believe that absolute performance is driven by what you own, while relative performance is driven by what you don’t own. I want to make sure that we can deliver good absolute numbers, then the relative numbers will take care of themselves.

To keep the absolute numbers up, we try to avoid the land mines, so I want my analysts to know the companies well. That helps us gauge the company risk on an ongoing basis. We take advantage of occurring shifts, such as emerging leaders moving up due to management changes or product launches, etc. The key is understanding the company and the competitive landscape.

Valuation doesn’t come in until later in the process. About 75% of our time is spent on the businesses and only about 25% on valuation because valuation is the easier part of the equation. It’s not easy to tell if a stock will go up or down, but it’s easy to tell whether a stock is cheap relative to its industry, its history, and the overall market by traditional valuation measures. It helps to understand the dynamics of the company and the industry.

Q:  Would you explain your portfolio construction process?

A: Three-fourths of our assets are in what we call core value types of names, such as Wells Fargo, FPL, Lockheed Martin, or large companies that offer traditional type of value. For these names we have an outlook of three to five years. Then we have 25% in a more opportunistic portion of the fund, where we’re looking one to three years out. These names may include a broken down growth stock, a deep cyclical turnaround story, a mid-cap name, or something that isn’t traditional value, but offers compelling value over a shorter period.

Overall, we have about 60 names that we consider the nucleus of the portfolio. At any point in time, there are about fifteen companies that we’re scaling in and out of, and this process is related to risk control. We build our positions slowly, buying 25 basis points now and 25 basis points later when we like the price. We also come out of positions gradually, so there’s an ongoing rotation rather than big position changes. Our annual turnover rate is about 20%, which means only about 12 new names a year, or one new name a month.

We have limits of 25% in any industry and 3% in any holding to ensure proper diversification and risk control. The only exception is the financial industry as it represents a huge part of the Russell 1000 Value Index, about 35% to 40%. That’s a lot of concentration and it makes us nervous, but we recognize that this is the benchmark to which we’re compared, so we’ve made an exception. We have about 30% in financials and another 3% in REITs, which are considered financials by the index, but we treat them as a separate asset class. But in general, we try to stay at less than two times the S&P weighting in most sectors.

We also use convertible bonds and convertible preferred bonds in areas where we can’t find dividends. If we find a name in biotech that we really like, we’ll look for a convertible because the common shares don’t pay dividends. That approach allows us to participate in the upside of the common stock and earn a nice yield while we wait for that upside. It also gives us exposure to areas that are not traditional value, so there’s an asset allocation component that we consider very effective. It’s another way to spread risk, increase return and differentiate ourselves.