In terms of valuation, that means that the installed base is extremely valuable and the revenue model changed so that cash flows are realized over a period of time. That gives us a more attractive and predictable business. In addition, the acquisitions provided the ability to layer on future growth.

Finally, what you end up with is a business with margins in excess of 25% to 30% and very high returns on invested capital. We bought the stock when it was trading at about 14 times earnings, which was a phenomenal opportunity for us as a value investor.

Q:  What are the guiding principles in the portfolio construction process?

A: We are typically compared to the S&P 500 from an index standpoint, but we do not construct the portfolio to mirror the index. We may have no exposure in some sectors within the index if no companies qualify as businesses able to produce predictable growing excess cash flows. For example, heavily cyclical and commodity based businesses, which have performed very well in the last couple of years, tend to not show up in our portfolio. At the same time, we don’t mind overweighting certain companies or sectors.

So the portfolio is constructed with a bottom- up approach. We’re buying individual companies and we tend to hold between 20 and 25 names, predominantly in the mid and large-cap space. We won’t buy a business unless we can get at least 30% or 35% discount to intrinsic value based on our valuation metrics.

Because we recognize that we can’t call the bottom on a name, we tend to build positions gradually. We’d buy 1% or 1.5% positions and then wait to get a better opportunity to increase that position to 3% or 4%. We usually don’t buy more than 5% in a stock unless we believe that the business is very attractive, the management has done an excellent job, the valuation is particularly compelling, and we have unique understanding of the characteristics of that particular investment.

Although most of our companies are based in the US, we do have international exposure, which is an important growth driver. On average, the companies in the portfolio generate about 40% of their revenues from non-US based businesses.

Although we build the portfolio from a bottom- up standpoint, we acknowledge that we should also have at least some top-down view for risk management. Gross over-concentration in individual industries can have an adverse effect on our ability to avoid the unanticipated or unrecognized risks, and there are always such risks in the marketplace. So we make sure to be cognizant of the interactions of individual stock risk.

Q:  When and for what reasons would you sell a stock?

A: We’d sell a stock for three reasons. First, if we reach a price target on a relative or absolute basis. The second reason would be a fundamental change in the business, which is a polite way of saying that we were wrong in predicting the future for this business. The third reason would be if we have a better idea. Assuming that we have an equally attractive business, we’d sell a 90-cent dollar to buy a 65-cent dollar. Most often a sale results from a combination of those factors.

Q:  What kind of risks do you perceive and how do you mitigate them?

A: Most importantly, we define risk as the potential for permanent loss of capital. Our responsibility is not to eliminate risk, but to identify, understand, and price risk in order to take advantage of opportunities where the risks and the related opportunities are inappropriately priced. When we look at risk, we first look at the individual businesses. Then we look at the relations across those businesses within the portfolio. While we may have some concentration in individual industries, we’re aware of the correlation between the drivers and the underlying economics.

For example, there are highly leveraged businesses, businesses dependent upon the capital markets to execute their business on a day-to-day basis, companies with regulatory or accounting issues, and companies with changing business models. Individually, none of those four components should be entirely excluded from the portfolio because, separately, those risks are manageable. However, the combination of those risks is dangerous, so we tend to look at the risks that companies share.

While most value investors would buy when a company hits their buy targets, we’re also focused on understanding the risk of that investment over the future. We don’t mind being early, but we don’t want to be too early. On the one hand, we seldom get the opportunity to buy a great business, but on the other hand, what we really think a great business is worth, may not ever come to fruition.