A: The moist smokeless tobacco niche is a pocket of tremendous growth, especially as smoking bans continue and cigarette makers are agog as to what is going on in this segment. UST was the leader in this arena with 60% market share. In April ’06, Reynolds American bought the number two player, a private company called Conwood and they paid $3.5 billion for it. After that deal, we went long on UST in the mid-$40 price range thinking that it would also be bought and if you put the same multiples that Reynolds paid for Conwood, one could get huge numbers for UST. Therefore, we rode UST from the mid-$40s to the low to mid-$50s, at which point we exited and we are now short.

UST operates in super premium end of the moist smokeless tobacco category hence their Copenhagen and Skoal brands are north of $4 dollars a can. However, the real growth in this sector is the discount side where Conwood operates, where growth has been off the charts. UST has been losing market share, slowly and steadily, at the expense of the discount end of the category. There is this pricing gap between the positions of UST and Conwood and more so because of the nature of the taxes that are based on price not by weight; hence UST’s can of Copenhagen is taxed higher than a can of Conwood’s Grizzly. We believe this major pricing gap has to be resolved at some point, especially as consumers are trading down in that category.

For a long time it was felt the situation could be salvaged as people thought the giant Altria would buy UST, and if they didn’t, they would come out with a Marlboro branded product at the premium end, where UST is. This would support and bring back growth to the premium end of moist smokeless tobacco, and also use the Altria political power to try and get the tax structure changed to be based on weight rather than price, which would help alleviate some of that pricing gap. Recently, Altria tobacco unit, Philip Morris USA, announced the test launch of a Marlboro branded moist smokeless tobacco product in the Atlanta market. If successful, it would be rolled out nationally at $3 a can. This also means a potential suitor has turned into a fierce competitor. They undercut where Copenhagen and Skoal are currently trading by about 40% to 50%, and so there is tremendous pricing pressure now on UST, eventually to come down and match Marlboro or risk losing more share.

Q:  How do you go about portfolio construction?

A: Generally, at any given time, the number of stocks in the portfolio on the long side, could be between 30 and 50, and on the short side, much less. So overall, we are probably below or between 50 stocks or 60 stocks. The turnover in the fund could be 44% but ultimately, our goal is to make as much money for our shareholders as we can.

Unlike other managers of other sectors, we do not have to be, and we are not, bullish on each of these four sectors all the time. Our job is to be experts in these sectors and if something warns us from a bigger picture view, causing a concern for us, we will not have exposure there. Our requirement on aggregate is that our fund has to be 80% invested into the four of them combined but we do not have to own all four of them all the time.

Q:  What is your buy and sell discipline?

A: As for buy discipline, first, based on the EBIDTA, we must believe a company currently fits within the directional move of the industry. Secondly, it must compete with existing ideas. We will not continually add more ideas to the portfolio as we feel that there is not very much value in a manager that has 200 stocks.

For instance, when we are making an investment in brewers, we find those that have the most exposure to the fastest growing beer markets in the world, and the least US exposure because of macro dynamics in the domestic market. Most of the international exposure overall in the fund, comes from this sector.

We will generally sell a company for two reasons: one is if the bigger picture industry view starts to change, which would then result in a shuffling of all of our companies, because they are currently positioned based on one industry view. Generally, however, this view changes very slowly, because these are trends we see developing over many quarters or years. Secondly, we would sell a stock if on the company-specific level it just does not live up to our expectations. A third reason is of a defensive nature - if there is something concerning us in the overall market and we are trying to raise cash.