Another example illustrating the handson type of research is a company called Valmont Industries that manufactures street light poles; the kind one sees around airports that light up a wide space. We met the management in Omaha and when we returned to Denver, we discovered that the airport’s light poles had fractures. On further probing, we found those to be Valmont poles. We photographed them and called the management to verify that they really were Valmont’s. They confirmed our findings but said that the poles were put in an area that had a very high wind velocity and they weren’t recommended for those conditions, yet Denver International Airport elected to put them up anyway.

Q: How is your portfolio constructed?

A: We may hold between 100 and 115 credits and we seek to limit the volatility. Our research process should help us identify issues that are not default candidates and we should earn at least the yield to worst at which we purchased the bonds.

Consequently, if the markets get volatile the portfolio performs exceptionally well relative to its peers. We have historically benchmarked ourselves relative to the Lehman High Yield Bond Index. Year-to-date our fund would be in and around the 5th or 6th percentile according to Lipper, and again, it is largely because the market has become volatile.

Q: What is your buy and sell discipline?

A: We describe our sell discipline before the buy discipline because we are far more sensitive to an indication to sell a bond than to buy one. For instance, the moment we see excessive volatility, it is a trigger for a sell.

Again, a breakdown in communications with a management team would be a very strong sell signal. If they fail to call us back in an appropriate amount of time or do not allow us to make a company visit, their bonds will be sold.

We also look at upside versus downside. Many times news releases will trigger bonds to trade up. If we feel there is only a limited amount of upside relative to the downside, the bonds will be sold, or at least some percentage of them.

We also closely monitor trading. If a bond trades lower we will react to sell the bond so that we don’t erode the value of the coupon. We have a formula whereby if we lose two years’ worth of coupons and, for instance, we have a 10% coupon, then 10 times 2 is 20. This means if the bond was priced at 100 and it drops to 80, it will be sold. This is again a way to limit volatility and since it is formula driven, bonds that are accruing income are not jeopardized by a minor drop in principal.

The telecom industry aptly illustrates our market perspective. In the ‘90s telecom was a big industry but we do not think the buy side understood it. Furthermore, we felt one thing that was going to be common with all these telecom companies is their insatiable need for debt. That factor alone steered us well away from telecom. We did not understand the sector, saw it as a far too volatile sector that did not have enough capital or hard cash invested in the companies and yet, it was mostly debt financed.

Q: What is your view on risk? How do you mitigate risk in your portfolio?

A: We approach every company as though it’s a potential default candidate until proven otherwise. It is the management team’s job to convince us of their honesty, solvency, ability to support the leverage and more importantly, their desire to rid themselves of leverage and willingness to use free cash flow to pay down debt. Only then we would commit capital to that security.

We try to limit very aggressive securities so that we limit the beta of the portfolio. We do allow for a basket of more aggressive high yield securities but all within our frame work, namely, debt pay down, good collateral, predictable earnings, transparent and cooperative management team etc.

We also try to limit volatility by focusing on a shorter dated portfolio. Other risk control measures include avoiding deals that are being made to finance an acquisition, a stock buyback, or to pay a dividend to an equity holder. We look for very stringent covenants in such bond deals and want them to be exceptionally debt-holder friendly and antistock holder. Ultimately, we think ours is a very balanced approach between credit risk and duration or interest rate risk, thereby leaving us with a good total return product.