Q: What is your investment philosophy?

A: Our investment philosophy consists of three core beliefs. First, we believe that companies that possess a sustainable competitive advantage in their industries in the long run will outperform their competitors and achieve superior stock price appreciation over several economic cycles. Secondly, we believe in purchasing these companies’ shares when they are trading at a discount to their fair market value. Lastly, we believe that consistent adherence to a discipline based on fundamental valuation techniques will produce superior results.

Q: How do you identify a company with a sustainable competitive advantage in its industry?

A: We are market generalists and do not focus on any particular sector. We focus on U.S. companies and evaluate them according to the five parameters explained in Michael Porter’s “Competitive Strategy”. They are: What is the company’s pricing power with its customers? What is its purchasing power with its suppliers? What are the barriers to entry to protect that competitive position that the company might enjoy? What is the degree of rivalry amongst the competitors in the industry? Lastly, how relevant are the substitute goods for the goods or services that they provide, what substitutes are out there and at what point do they become relevant? The answers to these five questions help us get a good handle on a company’s competitive position and its sustainability.

Q: Based on your investment philosophy, what is the fund investment strategy?

A: We first try and identify U.S. companies that have a sustainable competitive advantage in their industry and are undervalued. However, identification is not an easy task. Most fund managers will start off with some sort of quantitative screen and based on valuation techniques screen through say, the Russell 1000 or the Russell 1000 Value index and come up with a short list of undervalued candidates. They will then take a qualitative look at the businesses and decide if they like them or not. We reverse that process because it’s hard to be rational about a company’s business prospects if you already believe that its stock is undervalued and it has passed through your valuation screen. So we do qualitative analysis and research first.

In trying to identify investment candidates, we go through a list of qualitative concerns that includes, besides the five points of the Porter model, some key questions. They are: Is the company an industry leader? Does it dominate a certain niche market? Has management proven that they’re prudent and proactive over various economic cycles? Does the company have a strong franchise or brand loyalty and do they provide outstanding customer service within their industry? And lastly, given positive answers to all these questions, will the company still maintain its competitive edge and is financially sound enough to withstand any kind of short term problems or an economic downturn or any paradigm shift in how the industry works or any increased competitive pressures? We believe with a strong balance sheet and good cash flow a company can get through those kinds of tough times.

Any company that satisfactorily answers these questions convinces us of its sustainable competitive advantage and becomes a candidate for investment. Generally, through this process, about 100 companies fall into our investable universe of qualified candidates.

We then run valuation models on a daily basis, on all the companies in this universe. The quantitative metrics we use includes growth at a reasonable price model, a discounted cash flow model, a price-to-book model, a justified price-to-sales model and a dividend discount model. And we actually calculate five separate and distinct fair market values for each company so that there’s no interplay amongst these models. We then take the highest of these five numbers and assign that as our fair market value. Finally, we sort these companies from most undervalued to most overvalued and then pick out the 20 most undervalued stocks.

We never make top down macroeconomic decisions about how much to allocate any one sector or industry. We research one company at a time first based on competitive advantage and then on valuation. Consequently, when a company or industry is out of favor the valuation will show that and push us towards it and vice versa.

Q: Can you walk us through your research process?

A: I have been in the industry for over 20 years and experience tells me where to look and how to find information and determine who the various industry leaders are. Some are easy to identify and some come through a more stringent research process. For example, in the quick-café arena, one will easily identify Starbucks as the leader in that industry.

Another way to identify leaders is through companies you already know about that lead you to them. This is due to the concentric rings of quality that revolve around quality companies. We also collect information first hand by visiting companies as a consumer, researching their products and services and in the case of retailers, their stores.

For example, one of the retail companies in our universe is Staples, the office supplies leader. A visit to a Staples store will reveal that they’re reselling phone service such as Verizon Wireless. Thus, Staples has just led us to Verizon, a quality company in the wireless business. A look at Verizon’s wireless network reveals that its backbone is CDMA Technology the patent for which is owned by another quality company, QUALCOMM. Thus researching one market leader Staples led us to two other market leaders and if one digs further and finds out who manages their logistics, shipping and various other functions one will be led to many other companies as well as their competitors.

Ideas also come from the many contacts developed over the years, in various industries and with commercial and investment bankers whose intellect we trust.

Once we’ve identified investment candidates we have to look for sustainable competitive advantage. We therefore study the detailed financials and read various trade journals, and company filings and research reports by independent analysts and listen to management conference calls. Our experience helps us glean all the information we need from those types of reports.

Q: Can you give us examples of stocks you have purchased that illustrate your research process?

A: One example is Goodrich Corporation. A supplier to both the commercial and military sectors of the aerospace industry, the components or systems that Goodrich provides, cover many parts for an aircraft manufacturer giving them a 50% market share in the arena. They are a leader in each of the areas where they operate such as airframe systems including landing gear, wheels and brakes for 100-plus seat passenger jets. They’re global producers of various jet engine components and parts and also manufacture electrical systems.

Goodrich’s customers are industry heavyweights such as Boeing, Airbus Industries, Rolls Royce, Southwest Airlines and the U.S. Military. Being the leader gives Goodrich a strong advantage because aircraft manufacturers are loath to experiment with parts and systems suppliers, if an aircraft fails there are very severe consequences. Boeing and other aircraft users rely on Goodrich for the long term availability of parts and giving Goodrich a long term competitive advantage.

Furthermore, although aircraft manufacturing is cyclical, supplier companies like Goodrich actually have very stable revenues because there is a dynamic market for replacement parts. Aircraft parts have to be replaced more frequently than the aircraft itself creating a steady revenue stream. There is also a steady cash flow to Goodrich for servicing the parts that they manufacture as most of the components and systems are of a proprietary nature and specially designed, and cannot be replaced in the aftermarket by other manufacturers.