This analysis is also tied to our security evaluation process. This is where the business analysis meets security analysis. We use the QQ score as a substitute for Beta because we’re interested in fundamental earnings risk going forward. We develop financial models and discounted cash flow analyses, which give us an idea of what the security is worth.

This leads to the third step, which is valuation and rating. Analysts rate the securities that make it this far in the process buy, sell, or hold. We’re now down to about 400 companies and we call that our qualified investment universe. This is the universe from which the portfolio managers can select stocks.

I should add that a key element of the process is contact with management because that’s where we frequently get insight. I believe that last year we had over 850 management contacts; this year it should be over 1000. The idea is to create a mosaic of contacts, understand where the value is going in the industry, and position the portfolios accordingly.

The final fourth step is the portfolio construction. We have pretty concentrated portfolios of approximately 55 stocks and low turnover ratios of about 25%. So our average holding period is about four years.

Q: How do you construct the portfolio from this qualified universe of 400 stocks?

A: Portfolio construction is an ongoing series of judgments. We’re continually making judgments, most frequently about the expected return of various securities. We’re always communicating with our analysts, debating growth assumptions and company specific risks. We judge the expected returns of the stocks we don’t own and compare them to the stocks we own.

Portfolio construction is thus a bottom-up stock by stock process, where one stock squeezes out another one. With our turnover and number of portfolio companies, we change about 12 stocks a year, or one per month.

Correlation is another important factor in portfolio construction. When an attractively priced security is not correlated with many other securities in the portfolio, it will receive a bigger position size.

Conversely, we don’t own any Brazilian securities not because we are unaware of the opportunities, but because we aren’t comfortable with the correlation among Brazil, China, and the US. For example, Brazilian commodities are sold to Chinese manufacturers and then the goods are sold to the US consumer. If the US consumer rolls over, does that reduce the demand for Chinese exports and thus for Brazilian commodity exports? We’re really cautious about the US consumer and don’t want unintended exposure anywhere in our portfolio.

Of course, the Chinese consumption of Brazilian commodities could continue without the US consumer if the domestic Chinese market and intra-Asian trade gain real traction. And that could happen with the long anticipated de-linking.

Q: What are the most important elements of your sell discipline?

A: The sell discipline is an important part of the process, especially in the current environment, where high-quality growth has underperformed value for six years. We have taken the opportunity to tighten our discipline because we do not want to find ourselves selling stocks out of exasperation.

Before buying a stock, we have to define investment benchmarks to help us track the thesis as time goes by. Basically, we have to follow if the company is on plan or not, if it gains the market share, raises margins, introduces the new product, etc. When we experience negative volatility in the shares, we go back to those benchmarks and review them with the analyst before selling.

That process can help us avoid the behavioral traps of selling when you should be buying. A company like L’Oreal is a very good example of a high-quality global growth name, but it underperformed for quite some time. It is our benchmark analysis that prevented us from selling. 3M is another example where this sell discipline helped avoid what would have been a very poor sale.

We also sell when shares become overvalued on our analysis, or when we anticipate fundamental deterioration in the business model.

Q: What’s your view on risk control?

A: We think about risk in a couple of ways. First, there is active risk. This is the benchmark risk/ tracking error. Our portfolio weights are driven primarily by bottom-up stock selection, but we keep an eye on divergences and tracking error to make sure that we are aware of the relative bets our bottom-up views are generating.

Of course, we also consider absolute risk. We have a series of investment guidelines that steer the portfolio construction process. For example, the allocation to the US is between 35% and 75%.The emerging markets exposure is limited to 15%, and we can’t have more than 5% in one emerging market, such as China. While ensuring risk control, these guidelines still provide enough flexibility and allow us to be significantly overweight and underweight to the index, which is the MSCI All Country World Index.