Q:  What is your investment philosophy?

When we started the small-cap program at U.S. Trust back in 1996, we did not have a model in place, so I had the privilege of designing an investment process based on my experience. My fundamental belief is that the path to successful portfolio management is ultimately the minimization of mistakes and the containment of errors. We try to identify opportunities where risk has been greatly diminished. One of the starting points for us is to observe stocks that have either suffered a shattering price decline, or have endured a long bout of underperformance. At that moment, we are looking to gain confidence by statistical evidence that the decline is over and all that is left is the opportunity for an uptrend. The fund does not belong strictly to the growth or value investment styles. As we have found over time ideas in both camps, my desire has been to remain agnostic to the classical definitions of growth and value. The classification of stocks into growth or value year over year is, in fact, very arbitrary based on price to book. In recent months we have had a couple of positions in our portfolio that S&P decategorized from value to growth, but I do not see this as a good enough reason to sell these stocks.

Q:  What is your approach to stocks with such dual characteristics?

If you try to identify a leader within an industry, you have to make a valuation guess about the future, based on how those companies are performing today. Conversely, I am looking in the rear-view mirror to find companies that may have been leaders before they have gone through a period of dislocation for some reason. Then, I am trying to figure out which of these players are likely to return as leaders again. The only reason for an investor to own an equity is to participate in the rising stream of earnings. I would rather invest in companies with growth characteristics to catch the stream of earnings than apply a pure value approach with the aim of benefiting from economic cycles. While I am staying away from a trading mentality, I am seeking better companies that are temporarily off their game, but I have the conviction that they can return.

Q:  How do you put your investment philosophy into practice?

A new investor is always observing performance that has already happened to somebody else. Thus, the investor who is looking for performance has to gain confidence in the repeatability of results. In other words, the investor realizes that experiences in the past could be projected into the future depending on the consistent application of the investment process. To determine that the decline of a stock is over, we look at the basic characteristics such as the price to book and price to sales ratios as well as the dividend yield, but the main determinant for the potential of a successful idea for us is the price to earnings ratio. However, we do not consider the price to earnings trailing ratio because we do not use forecast earnings. Since the price action of stocks that fall into our area of interest involves dislocation in the recent past, trailing earnings are not going to be representative either. What we are primarily paying attention to is normalization. We look at our candidate companies over periods of five to ten years of their operating history. By measuring their return on equity, return on assets, and return on sales, we develop normalized earnings so that we can judge by the historic earnings how successful a company has been. As a result, our strategy compels us to be dealing with companies that have at least five years of operating history. Because we are focusing on companies with the lowest 25% of normalized P/E, we also normalize our universe so that we can compare stocks in an adequate way. The normalization process is a major differentiation because, as investors who follow trailing earnings are driven almost entirely by value stocks, we have a broader view of what opportunities are available to us.

Q:  When does a stock become a buy?

As I mentioned earlier, we find a company attractive under circumstances when its risk has diminished dramatically through a price decline and there is statistical evidence that the decline is over. When we have located these two indicators for a dislocation in the company's recent past, we want to eliminate as many concerns as possible before we start buying our first shares in the company. We believe that good balance sheets are a core element in the analysis of the stock's quality, so we automatically disregard companies that have more than 50% debt to total cap. Typically, our average portfolio holding has only 20% debt to total cap. In addition to good balance sheet management, we are looking for companies that have been able over 10 years to generate a simple tendency to at least 12% to 15% return on equity. Bearing in mind the normalization process, we want to have at least 25% of upside potential in every portfolio holding candidate, and we want to see the statistical downside pretty close to 0%.

Q:  Could you discuss your portfolio construction process and the limits on allocation?

We realize that the investing public has a very efficient economic alternative to our approach in the form of indexing. Consequently, in order to offer value to the client, we need to outperform the index with a product which, therefore, has a different structure from the index. Regardless of the industry breakdown in indexes, we will never force any names in order to maintain a market-like exposure to sectors. Thus, our portfolio often has extremes in overweightings or underweightings relative to indexes. We have designed a fairly concentrated portfolio in which the $530 million of assets under management are currently invested in only 38 names. We believe that if we have done our work correctly, keeping the downside minimalized and the upside substantial, it will be inappropriate to dilute the handful of holdings in the portfolio with the next best names. For example, a fund manager with 100 names in the portfolio of approximately 1% positions may raise the successful positions to 2%, adding only 100 basis points to performance. When we have success with 4% to 5% positions that we are going to double, we add 400 to 500 basis points to performance. Typically, we start out with meaningful positions within the portfolio.

Q:  What are the core elements of your research process?

One of the unique features of small-cap investing is that there is not a great level of coverage. As a rule, we do not rely on calls from brokerage firms or any outside resources, but, by making all of our own judgments, we analyze companies on a one-on-one basis. With every portfolio candidate we want to see, based on the normalization process, at least 25% upside before we even get started and we want to feel confident that the statistical downside is close to 0%. The normalization process is, in fact, very conveniently driven by computer analysis. We have well-defined balance sheet criteria and we find the underperformance of a stock easy for screening too, when we observe the company's price action. As we apply our yardstick to 5,000 small-cap stocks, we get down to about 100 names of investment merit from which we select ideas for the portfolio.

Q:  How do you manage risk in the portfolio?

Risk management is a core element of the fund's philosophy since we are looking at stocks where risk has been diminished. Furthermore, if we experience a stock in the portfolio that has declined 20% relative to the Russell 2000, we review that idea with the notion that it is going to be sold. In addition, we pay attention to diversification by having exposure to the major economic sectors. The benefits from our approach to risk are that we are only dealing with stock selection rather than market predictions, and secondly, we are always fully invested. We are not interested in being defensive against market conditions, because that is implicit in the stocks that we are buying.

Q:  How do you execute your sell discipline?

In our investment process we try to define the moment when a stock returns to its normal condition with the company's earnings going back to their normal level. At that stage, our goal is to understand what the market has paid historically for that level of recovered earnings. The assessment of the historical prices based on the normalization in the stock's earnings gives us the price target. Once the stock meets the price target we review the company for an eventual fundamental change in the business, but in most cases we are going to sell the stock. When analysts and portfolio managers suggest an investment idea, they are putting their reputation and ego into the recommendation. Thus, when the market is sending them back a message for a decline, their normal human response is that they have done everything right but the market does not understand the idea. To stay away from this road to ruin, I used my experience for the development of a process in which mechanical numbers have removed the psychological impact of my ego as a portfolio manager. It is very important to utilize a non-emotional gauge instead of writing down a stock for a prolonged period of time simply because you like the name.

Q:  Perhaps your non-cyclical approach to the stock market results in a lower turnover ratio?

Yes. Two characteristics of our fund have a direct influence on the portfolio's turnover: we do not focus on the direction of the market, and secondly, we stay fully invested. While the stocks are undergoing the period of rehabilitation, we tend to wait for the turnaround with long holding periods and a low turnover in the fund. The historical turnover rate of the fund has been 33%. Typically, the life cycle of our portfolio holdings lasts about 3 years from the moment of getting involved with the stock until we exit the stock. As a result, recent evaluations in the fund industry ranked us in the top 5% of mutual funds based on tax-efficiency. Overall, we have delivered a product that is in the top 20% of peers based on 5-year performance; we have protected our clients in declining markets; and we have achieved this in a taxefficient manner.

Q:  Could you provide one specific example of a successful investment?

In the bear market of 2000 to early 2003 we identified two industries that were operating in subnormal conditions. The first of them was the brokerage industry, which was enduring the impact of the worst bear market since the 1930s. At that time we had a very high representation of capital market companies, holding positions in Knight Trading, LaBranche, Piper Jaffray and E-Trade. I will now concentrate on discussing E-Trade because it is the best example of all the characteristics that we want to find in a company. We started building our positions in E-Trade between the fourth quarter of 2002 and the first quarter of 2003 when the stock was trading in the range of $3 to $4 a share, a significant price decline from $72 a share in 1999. Going into the fundamentals on their balance sheet, E-Trade, at $3 a share in cash, was selling at the valuation of cash in the bank. At that moment when the NASDAQ was down 80%, we concluded that the downside risk of E-Trade, which was selling at cash value, was consistent with our investment philosophy. As far as the normalization process was concerned, E-Trade at that point had a book value of $4.50, so we made the assumption that they could return to earning at least 15% return on equity, which would translate into normalized earnings of above 70 cents a share. We then figured that should ETrade return to normal conditions, just like they had regularly done in the past, the market would pay about 20 times on a P/E basis for the recovery. Therefore, the price target for the company was $14 per share. With the cash value support on the downside and the upside potential at 300% based on the return to normal conditions, we saw E-Trade as an ideal risk-reward situation. As we all know, the market has recovered and when E-Trade, which has traded as high as $16 a share, met the price target of $14 we took the majority of our investment out of the stock. During the whole cycle of the stock holding, this example highlights the prerequisites for the success of our investment strategy.