Q:  How would you describe your investment philosophy?

A: We make money by buying companies with sustainable growth at the right price. When the market gets too excited about a stock, the price tends to over-reflect the good news. We avoid those stocks. On the other hand, the market tends to under-appreciate sustainable growth and changes in inflection points. These are the companies we want to own.

Overall, it's a growth at reasonable price (GARP) philosophy. It's a risk/reward- based philosophy of participating in good growth companies that participate in good markets. We typically look at a universe of domestic mid-cap stocks, or companies in the $1 billion to $15 billion market-cap range.

Q:  Why have you chosen this philosophy? What are the salient features that make it attractive?

A: The returns over time are compelling. If we exclude 1999, which took a life of its own and when we admittedly underperformed, this has proven to be a good philosophy to follow. The growth side now carries more volatility and risk, so we want to mitigate that risk by pursuing reasonable prices. We want to participate in the upside, but we also want to prevent capital loss by being cognizant of the risk.

Q:  How do you translate that philosophy into an investment strategy and process?

A: Initially, we run quantitative screens for the characteristics we look for. In addition to being in the right marketcap range, the stock should generate enough trading volume to enable effective transactions. These screens leave a pool of about 900 companies. We then narrow that to the top 450 companies in terms of revenue growth over the past three years.

Market cap, liquidity, and revenue growth represent the first cut and ensure that a stock falls within the right marketcap area and style box. For practical reasons, we need to be able to transact in a stock without driving it way up when we buy, or way down when we sell.

We research only those companies that pass these quantitative screens. We're looking for sustainable earnings growth in companies that are reinvesting shareholder capital at stable to higher margins than the base business. The companies should be able to grow the business in a way that enhances profitability and return on capital, rather than degrading it. For example, Dollar Tree Stores grows and grows, but it is building ever bigger stores and its return on capital is degrading every year. That’s a stock we used to own, but we sold it.

Our measure of sustainable growth includes return on capital, shareholderfriendly management, advantages in pricing power, and some type of value-added or differentiated approach to the market. The gist of the process boils down to a decent balance sheet, cash flow generation, and cash reinvestment profitably. I believe our focus on cash flow and its reinvestment, together with our valuation discipline that’s based on discretionary cash flow, differentiates us from other funds in the space.

When the companies we own degrade in their rankings, we go back and check our assumptions because that may mean there's a more attractive candidate available.

Q:  How is your research divided between the quantitative and the fundamental parts?

A: The quantitative part takes very little time, but it gives us a good pond to fish in. Once we've identified the companies with the right characteristics, we analyze them for sustainability. What are the market trends in this industry or sector? Is competition rational? Are they able to get pricing leverage? Are commodity costs in their favor, or are they a concern? If so, how would they affect their margins?

These computer screens help us select companies with characteristics that have been rewarded in the past by the market, and we then use our best judgment. We talk to management about their business plans, about using the cash that is generated by the company (but belongs to the shareholders) about balance-sheet management, and about their perspective on the industry. In our mind, it is a 10% quantitative and 90% research-driven process.

Q:  Do you use historical earnings or forward- looking earnings?

A:We definitely have a forward-looking approach, but we also look back to see what a company has done. In the case of Dollar Tree, they grew earnings well from a smaller base. But as they got bigger, their earnings growth slowed and they were degrading their returns by continuing to grow at the same rate. Return on equity, for example, fell from the 40s to the mid teens, a function of margins declining over time. This was not a recipe for outperformance.

Q:  Why do you think management believes that bigger is better, instead of focusing on profitability?

A: We always ask management how they get paid. Often, they get paid to grow sales, or they get paid for things that don’t necessarily lead to stock-market outperformance. That's why we examine the behaviors that the market has rewarded in the past.

Q:  Invariably, retail companies always go through that change in mentality.

A: Yes, they have to figure out who they are, so we tend to look for that. This is what made us buy Office Depot a year ago. Office Depot always had a poor margin, (half the margin of Staples) but a new manager came over from Auto Zone. He increased their margins to the point where they were the highest in the industry, and did a great job of getting that business focused on profitability. The whole culture has been changed to focus on profits, not just sales.