Q:  What is the investment philosophy of Quaker Strategic Growth Fund?

A: As the name suggests, we are growth investors. We believe that the markets are quite efficient and earnings momentum and earnings surprises are crucial for stock outperformance.

The growth universe is extremely volatile, especially on the downside. In order to outperform in a market where major losses easily occur, it is important to understand its structure. If you look at 10 growth stocks over a period of 20 years, 6 stocks will underperform the index, 3 will outperform in some random fashion, and only one is the Yahoo! or Google where, if you could, you’d want to have 100% of your portfolio invested.

I believe that finding the one super performing random stock is a matter of chance or luck. That is why our philosophy focuses on avoiding the six bad stocks. If we can do that, the four outperforming stocks should end up in the portfolio on a consistent basis.

The problem with most growth managers, in my opinion, is that they tend to focus on the one super outperformer. They believe that the losers are part of their process to get that one winner. Our philosophy is just the opposite - avoid the six, bring in the four and hopefully you’ll get that one stock that really drives performance over time.

Q:  How do you implement this philosophy into an investment strategy?

A: We look at stocks on a GARP basis. We spend a lot of time making sure that our holdings are not prone to negative surprises. In that way, we try to avoid the inconsistency of returns over time.

This strategy requires diversification, adding positions gradually, and managing liquidity. Diversification is a must because no one knows where the next winners will come from. I find growth portfolios with only 20-30 names to be extremely risky because of the high downside volatility. If a stock goes down 40%, you have to be up 66.7% to break even and you will hardly be able to recover. That’s why we, on average, own between 50 to 80 stocks in the portfolio.

Another important part of our strategy is to take smaller positions initially and add more if the company meets the milestones. These milestones are based on what the company has told us or on what we’ve researched. Liquidity is another important factor in avoiding downside volatility. To manage money in this universe, you cannot be limited to a single market-cap category. We have some market-cap minimum for liquidity reasons, but that is the only constraint. We want the entire universe, again because we don’t know where the winners will come from.

In a nutshell, our strategy is to liquidity-weight the portfolio, tilt the portfolio to earnings surprise momentum, and avoid the losers. I believe it is better to tell clients that we have lots of little winners than the one big winner that most managers talk about.

Q:  Can you describe your perspective for growth investing? Do you consider the historical growth as much as the forward-looking growth?

A: We are looking at forward-looking growth. We are looking for reasonable valuations and high earnings growth. Right now, you can find such companies in the oil-drilling area, whereas the multiple of Google or Yahoo! is too high for us. Our companies have the characteristics of typical growth stocks, such as high return on equity, high cash flows, and even high price-to-book. When you compare our portfolio against the growth universe, we look very much like a growth manager, but we have very different stocks in the portfolio.

In the small and mid-cap area, valuation is not that important to us because these stocks tend to move on earnings momentum. We look for great franchise companies and alpha-generators that grow regardless of the state of the economy. In such cases, we are willing to pay a higher price-to-earnings multiple.

Q:  Would you highlight your research process?

A: We use traditional tools to identify investment opportunities. We do industry research; we travel to trade shows and investment conferences; we do one-on-one company meetings. Part of our philosophy is that we cannot invest in a small company without meeting the management. In the large cap segment,
we don’t feel that this is necessary because there is sufficient research in the public domain. I don't need to meet IBM's management to see what they are doing.

Also, we run quantitative earnings screens like the typical earnings momentum and earnings surprise models. Internally we use a very simple earnings revision/earnings surprise model for ideas. We do primary research for smallcap ideas and we use regional brokerage firms for maintenance research. Because our outlook is not out just one quarter, we don't need to visit the company every single quarter and can instead get updates either from the company or the regional analyst.

Once we decide that we have an attractive candidate, we do a thorough income statement and balance sheet analysis. Unlike other growth managers, we pay a lot of attention to the balance sheet because that’s where the problems often start. We want companies that can be financed adequately in the capital markets, because they will need capital to sustain growth rates of 20%-30% a year.

We are always looking for balance sheets that can support growth over time and we don’t like too much leverage. Also, if the company keeps issuing stocks, shareholder returns are diluted over time. Many growth managers think of topline growth without realizing that they are getting diluted on the earnings side.

We avoid companies with large institutional ownership in the large-cap space, which is a contrary view to that of most investors. We always look for companies that institutional owners don’t want to own for some reason. We feel that there is a margin of safety in those names.

Q: What are your benchmarks in terms of portfolio construction?