Q: What is the investment philosophy of the fund?

George Fraise: Our core investment philosophy is to be long term investors in great businesses bought at a reasonable price. We are willing to be patient with our companies (on average, we hold stocks for more than five years) because they have one key element in common: sustainable above-average earnings growth.

Our experience has demonstrated over a long period of time, dating back from the 1960s, that certain characteristics increase significantly the probability that companies will be able to achieve and maintain sustainable above-average earnings growth. We look for three qualities in all the companies we invest in: first is pricing power; second is a high degree of repeat revenues; and third is global reach.

We first look for companies that control their pricing destiny. Not many companies can do this, but when they do, it puts them in a great position. They can set prices on their products and services at levels that consistently provide good profit margins and strong returns on invested capital.

A number of elements can lead to pricing power. Microsoft and Starbucks, for example, have a dominant position in their industries. Johnson & Johnson and Gillette have proprietary positions with their products. Being a low-cost producer in an industry allows you to price at a discount to your competitors while remaining more profitable than the competition. Dell and Wall-Mart are perfect examples.

Our second key characteristic is a high degree of repeat revenues. We invest in companies whose products and services are used frequently and need to be replaced regularly. If you start every year with a core constituency of loyal customers already in the habit of patronizing your products and services, you’re in a much better position to grow. Also, repeat revenues provide a higher degree of conviction that the growth will be predictable and sustainable.

Finally, we want global reach, the ability to expand a business model and take advantage of growth opportunities outside of the U.S. We like companies with no geographic or cultural limitations to their business model because the products and services they offer are used all over the world. If you think about sipping a latte in a Starbucks in Hong Kong while working on Microsoft Excel spreadsheet on your Dell laptop, you get the idea.

Q: What is your investment research process?

Rob Rohn: Our entire research process is directed at finding companies with sustainable earnings growth. We conduct first-hand fundamental analysis and support our findings with the financial models that we build using data we collect through our research. We scrutinize the drivers of earnings growth and the factors that affect the quality of those earnings for each business we invest in.

First, we are very selective with the companies we have in our universe, only allowing those few businesses that have the characteristics we described earlier to make it on the universe. Second, we are diligent in doing our research, and finally we are very disciplined about valuation.

A key step in our research process is to build financial models for companies in our universe. This action, building the income statement, balance sheet and cash flow statements for the business not only for the next year but for the next five to ten years, really helps us understand the financial dynamics of the business and its long-term prospects. It also helps us test the predictability and sustainability of the business over the long term. If we find ourselves at a loss trying to project the business out several years, then we know the business lacks the visibility we require.

The financial projections that we build in our research process help drive our valuation system. We use a number of valuation methodologies, some of which are proprietary. First we look at short-hand measures such as P/E ratios to growth rates and a Graham and Dodd formula. Second, we use a proprietary discount model which arrives at fair value by discounting the long-term earnings projections that are derived from our research work using the risk-free rate and an equity risk premium. Finally, we also take a hard look at cash flow and measure something we call Enterprise Yield. This is the measure of the true free cash flow available to shareholders as a percentage of market capitalization.

Q: How do you describe your buy discipline?

Gordon Marchand: The first step of the buy discipline is to make certain that the business has the three characteristics that make it a great business from our perspective: pricing power, repeat revenues and global reach. We then want to make sure that it has sufficient sustainable growth to qualify for our portfolio. Finally we want to ensure that we do not overpay for that earnings growth.

A company with great potential in the eyes of the investors and analysts, but no earnings yet, won’t make into our universe. Of course, future earnings and cash flow are important but current earnings and cash flows are important as well.

Ultimately, our investment universe encompasses between 30 and 40 companies. This works well for our firm as well because it allows each of us to focus on five to ten names. This focus enables us to know companies to a higher level of detail.
Our portfolio is constructed of 20 to 30 names, selected from our universe. Our portfolio position sizes are determined based on our view of the fundamentals and our view of the valuation. We will not let an individual position size rise above 8%, or an industry weighting within the portfolio exceed 25%.

Q: There are three people in the investment team, how does your management team make investment decisions?

Rob Rohn: There are actually five members of our investment team, including our Research Principals. The firm’s three founding principals, George, Gordon and myself, jointly make ultimate decisions in the portfolio. A discussion can be brought up to the committee by any of the members but the three of us must agree on every decision that takes place. Consensus is required for all buy and sell decisions.

We fundamentally feel that to be a portfolio manager you need to be an analyst as well. We also believe that a two-layer structure of analysis and investment decision-making within an investment firm can lead to imperfect communication. All of us are analysts with primary responsibilities for certain companies within our universe.

Q: Can you give us some examples that highlight your buy/sell discipline?