The research process involves in-depth fundamental work, and using that information to fine-tune the quantitative aspects of the metrics that we look for regarding each company. Initially we scrutinize growth in revenue, earnings, and cash flow on individual companies. Different industries, sectors and stocks have different metrics that can be equally important and may actually be leading indicators for earnings. Identifying and monitoring these key metrics is an important part of our process.

We also have a thematic approach to investing. We are bottom-up investors and look at one stock at a time. However, sometimes, when we capture a compelling investment theme that may be broader than just one company, we will look for other securities that might fit into that theme. It might be an overarching trend that’s affecting multiple companies or an entire industry, and therefore from a research perspective, it’s a big part of our research process, as it allows us to leverage what we believe is proprietary information across more than one investment.

Q:  Can you give some examples of stock selections that illustrate your investment process?

A: One example is NVIDIA Corporation that provides graphics processors for computers. We bought this stock several years ago in our small cap fund when we first identified an important catalyst, which ultimately lead to the stock becoming a text book case for exploiting the biases that are commonly identified in the field of behavioral finance.

After suffering through a two-year period of no real growth due to a more robust competitor and unforeseen events, a meeting we had with the management team indicated that things were going better. Subsequent to this meeting, NVIDIA had a quarter where we identified an inflection point. It was the first time in 10 quarters that it had posted a year-over-year gain in earnings and beat the high end of earnings expectations.

From a fundamental standpoint, they were shipping this new, better product and would be able to regain some market share. The stock shot up 10% to 15% subsequent to the call that day and we bought the stock because for us this was a fundamental inflection point. Of course, even our most bullish expectations did not prepare us for the fact that NVIDIA would progress to be a $19 billion company today.

We owned NVIDIA in our small cap fund, enjoyed huge returns and when it crossed the $3 billion market cap level, we bought it in our mid-cap product. NVIDIA is an example of a stock that we owned in both our small cap and mid cap funds for a period of time. When it grew to nearly $6 billion market cap, we could not justify owning it in our small cap portfolio and sold all the stock in chunks opportunistically over several months.

GameStop Corp, retailer of computer games, which is currently one of our larger holdings is another example of a stock that we owned for years in our small cap fund, generated significant return, and transitioned it into our mid-cap product. We still own it in both funds, although currently it is at that market cap level where we have had to trim our position in the small cap fund. GameStop is a retailer of video games and entertainment software. It turns out that people are still playing them, even in their 40s. So here is this big picture trend theme of an expanding demographic, with a lot of discretionary income. In addition, there is this catalyst, the continuous flow of new products like Microsoft Xbox 360, Nintendo Wii, Play Station 3, from the three major players in this industry that has been driving sales.

The factor that first attracted us to GameStop was that it was seriously into the used games business and in a monopoly position, too. GameStop was soon extremely successful with a national presence because of its ability to price the used games. It had a fantastic system behind the pricing, purchasing, and flow of inventory in the used game business segment and this unique model allowed the company to enjoy abnormal returns.

Then, its biggest competitor, Electronics Boutique, entered the used games business. Just when the competition was starting to have a meaningful impact on the pricing, GameStop bought Electronic Boutique and thus regained its monopoly position. The synergies between the two retailers provided great pricing leverage on the used games and better stature with the game publishers. It is now the largest distribution channel for Electronic Arts and all game sellers. Moreover, the price increase on the new flow of games has raised the umbrella under which it could price the used games which was basically all margin, awarding GameStop even greater profitability.

Q:  How are your portfolios constructed? What is your buy-sell discipline?

A: Currently, our small cap fund has about 120 issues and the mid cap fund has around 90 stocks. The portfolios are relatively diversified on a stock specific level, but we may have a more meaningful amount of exposure to any one theme.

Our buy and sell decisions are made on a case-by-case basis, a very bottoms up approach. The common thread among all those decisions is confirmation of both the fundamental and quantitative analysis. For each of the stocks under consideration we have our discrete investment thesis. If the stock fits into the criteria underlined by our philosophy and if there is data that confirms our investment thesis, then we will buy that stock.

Although valuation is important, sometimes growth investors like us can make the mistake of getting too involved on the valuation side and not buy what might be our favorite idea just because it seems too expensive. Especially in case of catalyst stocks, we believe that in the priceto- earnings equation, the market can underestimate the earnings part, and that, there is an inflection point where earnings are going to be accelerating and growing much faster. In such cases we will decide to buy the stock.

On the core side of the fund or stocks that have more stable business model, valuation is more important. These are more stable, predictable companies; we try to opportunistically use valuations to trade around these positions. Typically, these are stocks that we will own for a long period of time, and we know when stocks get relatively expensive or cheap.

The sell side decision is a disciplined process. Our investment thesis will stipulate the criteria, right at the onset of buying, which will compel us to sell the stock. Once we identify and buy a stock, and later, if the factors driving revenue and earnings growth have changed, the stock is not working out as we thought or we see a change in that data, then that would trigger a sell decision. Again, that is part of the daily maintenance process that we do, which is, constantly monitoring and measuring those data items and factors that might cause us to want to sell, and constantly trying to identify new ones.

We also decide to sell if it is required to maintain the style purity of the portfolio. Ironically, these decisions are sometimes a result of our success – when our stocks grow beyond our definition of small cap or mid cap and we are eventually compelled to sell just to keep the portfolio in its mandate.

Q:  How do you mitigate risk?

A: In small and mid-cap stocks company specific risk is a significant risk. So, diversification is one of the key tools that we use and limit ourselves on individual position sizes and sectors. In our smallcap fund we won’t let a stock get to be more than about 2% of total asset. In our mid-cap fund we go a little beyond that, but limited to, just the low 2% range. We also have some rules internally about sector exposure relative to our benchmark - 50% band around benchmark sector weightings.

Portfolio risks are also related to our investment themes and trends. Take for example, healthcare IT spending. Here is a theme that cuts across both technology and healthcare companies. They all benefit from this trend of healthcare organizations spending money, upgrading and adopting new technology that are of great help to patients and doctors. We might have several investments in this type of theme, so the risk is that, if something goes wrong with this theme, we would be vulnerable.