Q:  What’s your investment philosophy?

A: There are three things we consider very important: valuation, long-term time horizon, and concentrating a portfolio. Our firm uses the same philosophy and applies it to different universes. For this fund, we use a growth universe.

First, we believe valuation is critical to our investment decision. We look for ideas with a margin of safety. For a growth oriented fund, we do not want to write a blank check for growth, Second, we think about investment opportunities over the long-term. We are seeking companies that can sustain or improve over a three to five year time horizon. This requires patience. Third, we develop a concentrated portfolio and are willing to take sizeable positions if the opportunities warrant. For Security Select 25 fund, generally we own 20-30 names. As we perceive we own businesses rather than stocks, we have a fairly low idea turnover rate.

We define growth ideas differently than the market. We are looking for companies that generate a pre-tax return on invested capital (ROIC) greater than the market median. The market’s median ROIC is just under 14% today, and any company that’s able to generate higher than the market pre-tax ROIC is considered a potential growth idea.

Occasionally we will own companies in the growth portfolio that have less than the market’s pre-tax ROIC. For these we must believe they are capable of improving their returns above the market’s median ROIC within our three to five year time horizon. Federal Express is an example. We bought it in 2004 in the high $60s when they were generating less than 7% in pre-tax ROIC. Today the stock price is over $110 and its pre-tax ROIC is greater than 11%. The Kinko’s acquisition, although it lowered the pretax ROIC in the short-term, allowed them to reposition the business and get margin improvements long-term. Even though it’s not as compelling as it was in early 2004, we still believe they can improve their results above the median market rate.

Q:  How do you estimate future growth? Do you consider historic growth to come up with the estimates?

A: That’s the challenge in the growth universe. It is important to be aware not only of where the historical pre-tax ROICs were, but also a company’s reinvestment opportunities. For example large-cap pharmaceutical companies appear to be generating ROICs in excess of the market. The question is what are their reinvestment opportunities? Many pharmaceutical companies may be generating 25% pre-tax ROIC, well in excess of its cost of capital, but have limited reinvestment opportunities. Other growth investment approaches reward a company that can grow fast. Companies who either are putting capital to work at lower than current pre-tax ROIC levels or growing without regard to their cost of capital employed on this expansion will eventually be figured out by the market. As they generate lower levels of pre-tax ROIC, valuation levels typically drop to reflect this over time.

Managing both value and growth portfolios, we find the difference between them is that it’s difficult to find a large margin of safety for growth ideas. This can cause volatility in fund performance. An example would be Zimmer Holdings. It is a company with a pre-tax ROIC in excess of the market but when something goes wrong, such as it falls short of quarterly earnings forecasts, the stock responds with a sharp sell-off because of the absolute p/e multiple it carries. This is what makes growth investing more difficult.

Another example we own is ADC Telecom, which fell about 25% in two days. While it didn’t have a high P/E multiple, we believed the firm was capable of earning a pre-tax ROIC greater than the market. Recently ADC Telecom had not been generating a pre-tax ROIC in excess of its cost of capital and we believed they had a vision and resources to get there. All of a sudden, the management decided to acquire a company with lower returns and slower growth prospects. The market reaction was swift and stock lost 25% of its value.

Because we do not employ an earnings or price momentum approach, we tend to under perform a growth peer group when momentum approaches work. When valuation matters, we tend to outperform other growth strategies.

Q:  How would you regard Black- Berry-maker Research in Motion and flash memory-maker SanDisk?

A: We really struggle with names like these. We are good at recognizing what we know and what we do not know. I am not able to guess what Research in Motion will look like in three years even though they have been able grow signifi- cantly in the past. We have trouble focusing on hyper-growth companies. We prefer to focus on quality companies that generate or will generate pre-tax ROICs greater than the market median and have good reinvestment opportunities.

We usually buy when there is something weighing on the stock in the short term. We buy when the discount is caused by what we view as a transitory event, not a terminal problem. If the company is able to fix the situation or the perception changes, we’re going to make money.

Q:  Would you describe your investment process?

A: We have a long list of companies that we watch and know. We review this list every day and hope that transitory events happen. Unfortunately, these types of opportunities are not always bountiful, so we continue to search for them and remain patient.

Our process employs a bottom-up, fundamental stock-picking approach. We focus on finding the best 20 to 30 opportunities in which to invest. We do not spend much time thinking about the economy and sectors. Names stay in the portfolio unless a significantly better opportunity appears or we believe the company’s ability to impact pre-tax ROIC has been impaired.

Our analyst team focuses on evaluating a company’s competitive advantage including analyzing management, resources and industry opportunities. For growth companies, we need to believe a company has a sustainable competitive advantage. For value ideas, you may get opportunities with something just being cheap enough, but that’s not the case on the growth side.

We try to understand management’s vision and strategy for running the business. Do they have a history of creating shareholder value? We also examine the resources used to sustain and/or grow the business, including both financial and human resources, and finally the growth potential and competitive situation in their industry.

Q:  Do you follow investment themes when selecting those 25 names?

A: No, we don’t. We screen the universe, go through the list, and some names always show up. We don’t start with a theme but we’ll often find a company that may lead us to other investment ideas.