Q:  Would you describe the investment philosophy of your fund?

A: We (Baribeau along with coportfolio managers Richard Skaggs and Pamela Czekanski) firmly believe in owning stocks of businesses that are growing rapidly, have defensible competitive advantages, and are exploiting good market opportunities. Stocks perform best when the companies are going through a strong growth phase with barriers against competition, so that profit margins are expanding and return on invested capital is accelerating.

We’re very active investors. We don’t mind taking big bets against the benchmark or the market itself. We let the process tell us where we should focus as investors rather than picking stocks from the index components. We’re looking for profit growth no matter where we find it.

In the last three years growth stocks haven’t done that well on average, but active managers have done very well as there’s been a whole new group of companies coming along with strong fundamental leadership. These new leaders are not the ones from the 1990s, which happen to dominate most of the indexes. So it's been a very interesting time for the good stock pickers.

Q:  How do you implement that philosophy into an investment process and strategy?

A: The process involves three steps. First, we run quantitative screens looking for a minimum of 11% per year EPS growth for the next three to five years.

Second, we'll look for positive earnings revisions after a company has reported fundamental news. If analysts’ consensus has been far too conservative regarding the earnings power of a company, you’ll see that reflected in an upward revision for this year and the next year. That’s an indicator that a security may be systematically undervalued because analysts have been too conservative in their profitability estimates. We track that every month as an indicator to take a look at the stock.

Another key element is looking for strong or accelerating revenue growth. We don’t want to be weighed down by companies with sluggish sales growth that are driving their earnings up through cost cutting or financial restructuring. If strong unit demand is backing the sales growth, then the earnings estimates are more likely to be sustained over time.

Once we’ve gone through that process, we’ll take a look at the valuation to decide if it isn't too late to buy the stock. We use discounted cash flow models to determine the intrinsic value of a company and what the market is already embedding in this security. Other methods of valuation, including P/E ratios, tell you what a company is worth, but they don’t tell you why it’s worth that relative to any other competitor.

The third step in the process is risk management, which helps us determine the position size we should establish in a stock.

Q:  What are the milestones in terms of portfolio construction and risk management?

A: There are three variables that help us determine the position size we should establish in a stock. The first one is the volatility of the historical stock price that will influence the level of the allocation we make. The second is the correlation of similar risk factors embedded in that security with other stocks in our portfolio. The higher the correlation, the lower the position size we’re likely to take.

Third, we match our fundamental conviction level with the position size. Even if a stock is not very big in the market, it may come in as a large holding in the portfolio if our conviction level is very high, the stock has unique noncorrelated risk factors versus the rest of the portfolio, and a unique business model with very little competition.

The risk management part of the process is important as the last filter in terms of building the portfolio. We always stay fully invested. Cash will only go to a maximum of 5%. A single position in the portfolio can grow only to 5% of the portfolio's market value and then we’ll start selling it.

We only have 45 to 55 stocks. The turnover historically is about 175% and that’s where the active manager discipline comes in. The turnover is not due to new names; half of it is trimming from or adding to existing positions.

Q:  Since you define growth based on projected earnings, there is always the factor of guessing and hoping. At the same time, historical earnings are a fact, but they aren't necessarily reflecting the direction in which the company is going. How do you handle this situation?

A: We definitely look at historical earnings because they help to establish the execution profile of the business, whether it’s a growth business or not, how well the company executes versus its peers, whether it’s gaining or losing share. All of these are important in evaluating the investment case.

What we don’t do is top-down macro bets. We don’t get involved in economic forecasts that could disrupt or change, because the business dynamics is not forecastable. Instead, we focus on the individual business and how the company is executing in the current environment, because this is the best indicator of what could happen in the next three to 12 months. While all valuation models are based on long-term forward cash flows, the reality is that short-term stock performance is based on very short-term fundamental results.

Q:  Active management also creates some tax liability for the investors. Is that something that you manage or the tax implications are just part of the fund?