I believe that a real advantage of a quantitative process is that we don’t have target prices and we are never accused of falling in love with our stocks. We’re constantly evaluating alternative choices and we have the ability to come up with an opinion on a weekly basis for every stock that we track.

Q:  What are the main elements of your research process?

A: A crucial part of our research process is our belief that the key for long-term success in a quantitative process, is keeping a proper balance of discipline and improvement. Our research gives us the framework to adhere to a discipline, but also helps to recognize how the factor effectiveness changes over time and to adjust our model to those changes.

We look at the macro picture, the significance of the factors that we are tracking before we move on with our investments decisions. Our five-person quantitative strategy team meets monthly to review the portfolio. This team is responsible for reviewing the portfolio construction discipline and for evaluating any other quantitative research that we’ve done.

Q:  Could you give us some specific examples that illustrate your research process?

A: The energy sector has been the source for many standout performers. Since we adopted the quantitative process in 2003, our factors have picked up on the fact that many energy stocks possess the characteristics that we find attractive in our model, namely, strong earnings momentum and attractive valuation. As a result, we have had a consistent overweight in energy for the past four years, which has been rewarded. For example, Global Santa Fe and Tidewater have been recent winners for us, while Superior Energy is currently our highest-ranking stock.

Also, the fund has participated in the strong performance of the cyclical growth companies, such as Cummins, which is our largest holding, MEMC Electronic Materials, and US Steel. The current posi tions in the portfolio still reflect the view in our model that cyclical stocks are still attractive.

Q:  What are the characteristics that made Cummins and U.S. Steel attractive in your process?

A: Both in the idea-generation and stockselection process, there is very little qualitative or subjective elements. Removing the subjectivity from the process was the reason for establishing the model, and all of our buy and sell decisions are determined by the calculated quantitative scores.

Cummins was evaluated in the context of the ten broad factors. The company had similar characteristics to many of the cyclical growth companies; it was a company with attractive valuation compared both to its industry and to other sectors. It had strong fundamental momentum, including earnings growth, accelerating sales, profitability trends, positive analyst revisions, and price momentum. Our multi-factor model requires a stock to be attractive on many different metrics to achieve a high weighted average score. The investors’ enthusiasm and the company’s execution have to come together to attract our attention.

The example of U.S. Steel probably best illustrates how a quantitative process allows you to put aside some biases. From a fundamental perspective, we probably wouldn’t give the company much consideration at the time we bought it. Its industry seemed to be in a decline and there were no signs of commodity inflation. But the evaluation of the company through our quantitative model helped us to appreciate some of its attractive characteristics, such as low valuation and signs of improving earnings momentum. That enabled us to buy the stock before the story was well recognized.

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

A: The fund typically holds between 100 and 150 securities. The initial positions are restricted to 1% or less, while the maximum position size is 3%. Typically, our top ten holdings account for just 10% to 15% of the portfolio. The maximum sector weight is 30%.

The sector and industry weights are the result of the stock selection; there’s no top-down overlay. But we feel that by limiting our exposure to sectors and by holding many different positions, we can emphasize the factor characteristics that we seek, instead of having them clouded by sector definitions or single stock events.

For example, in the last four-year market cycle, the traditional definitions of growth and value haven’t held up. Growth stocks were not found in healthcare and technology, but in energy, materials, and industrials. Being completely bottom-up allows us to find the important characteristics that we seek without having to restrict ourselves to a particular sector. We also avoid market-cap drift by requiring that the holdings are members of the Russell Midcap Index. Currently, we hold stocks with market cap from $1.6 billion to $25 billion. The weighted average capitalization size is $7.3 billion.

Q:  What is your view on risk and how do you mitigate it?

A: We define risk primarily as the volatility of return, both in absolute and relative terms. Diversification is our main risk control and is related to the constraints on position and sector exposure. We use several tools to monitor the risk attributes of the fund, such as the Zephyr Style Advisor for analyzing standard deviation, beta, R-squared, tracking error, Sharpe ratio, information ratio, as well as RiskGrades, which is a measure of the price volatility.

We don’t use cash for controlling risk and we don’t time the market. We think that the investors in our fund are willing to participate in the asset class risk and, therefore, our objective is to maximize the return. In our process, the stock selection is the primary focus of the fund and that’s where the alpha is added.