Q:  What is the investment philosophy of the fund?

A: While being value based, we look at value quite differently than most investors. Our investment philosophy is based on evaluating and valuing economic performance as opposed to accounting performance. Everything that we do revolves around cash flow generated by a firm’s gross asset base and the company’s ability to generate and return cash to the investors or owners of the business.

Q:  What is your definition of cash flow?

A: Our definition of cash flow is something we call net cash receipts. We try to take out those accounting distortions which are the end result of net income. We start with the company’s net income and backwardly adjust for all the various non-cash accounting items and build our way back into net cash receipts.

Once we start with net income, we’re making adjustments for depreciation, amortization, and net interest expense. We’re also subtracting out gross capital expenditures and net change in working capital. We eliminate cash from sources such as investing and financing. What we’re interested in from an operating standpoint is how much cash the company generates.

Q:  Could you highlight your research process?

A: The first step is to determine what companies are undervalued versus those that are overvalued in the marketplace. We use consensus earnings estimate, and normalized growth rate in assets for a company to build a projected future cash flow stream, then we apply a discount rate to those future- projected cash flows. The discount rate is calculated beginning with a market implied discount rate and then adjusting for company specific risks such as size and leverage. We discount those future expected cash flows to arrive at a present value and then net out the debt. We compare this intrinsic value to what the market is currently implying. If the present value of the future expected cash flow is greater than where the stock is trading, we would deem the company to be undervalued.

The second step is to distinguish those undervalued companies where management understand the dynamics of creating shareholder value. We again use an economic measure. It’s what we call cash flow return on investment, or the internal rate of return on all the company’s operating assets. The higher that return, the higher the market valuation. The market does pay for economic performance. Things like earnings surprises have no correlation to the long term performance of the stock.

We screen a universe of roughly 5,000 to 6,000 names on a weekly basis for new data based on a number of value criteria, one of which is cash flow return on investment. We typically cut the universe down to 400 to 500 names. From there, we look at what industries and what companies may be undervalued by looking at the industries that predominate the list. We look at the industry dynamics and drill down to the company level as far as generating investment ideas.

Q:  Generally, what kind of risks do you perceive and how do you monitor them?

A: We’re an advocate of broad diversification as a means of reducing volatility to that of the broad market. Within that broad diversification we’re constructing a portfolio of a strict value discipline on conventional measures of PE, price to book, price to sales and dividend yield. We don’t take huge positions in any one stock. When we buy a stock it’s usually about a 1.5% to 2.5% position. The maximum position size is 5%, but that would occur only through price appreciation.

At the screening level and at the fundamental analysis level, we look at accounting exceptions: things like net income as a percentage of gross cash or if its intangibles are a large portion of the value. The average company in the portfolio has about 18% or 19% debt-to-capital ratio, so we look for less levered companies. Traditionally we invest in companies with above-average dividend yields and/or the ability to grow those dividends. The dividend yield in the portfolio now is about 2.3%. About 90% or 95% of the companies in the portfolio pay a dividend.

Q:  Do you benchmark yourself against any index?

A: Our portfolio is measured against the Russell 1000 Value Index but differs in the sense that we’re more broadly diversified. We don’t maintain a heavy concentration in financial services or utilities and telecom, which combined constitute roughly 45% of the Russell 1000 Value Index.

Q:  How would you define your buy and sell discipline?

A: Our sell discipline is solely based upon the discounted cash flow model. When the present value of the future expected cash flows net of debt of a company reaches parity with where it’s trading in the marketplace, the stock is sold.

We tend to buy and sell stocks earlier in the investment cycle. We tend to sell stocks as they transition from value stocks to more momentum type stocks.

Our screening process is done on a weekly basis and we constantly update our analysis of a particular industry or company. It a company or industry demonstrates improving valuation we perform fundamental analysis focusing on things like asset utilization. If companies that have traditionally just earned their cost of capital are now starting to contract their asset base by selling off or pairing down underperforming segments of their businesses in an effort to increase returns they will likely appear attractive to us. Companies that hold back on the growth so they can become more profitable may not be initially well received by the market. However, these are the companies that tend to see the greatest increases in profitability in the long run as management understands the concept of wealth creation.

Q:  What are the key elements of your portfolio construction?