So we initiated a short position in the relatively modest 1% to 2% range and then gradually saw, over the last year and a half, that the company has run into significant problems and missed Wall Street consensus earnings estimates on several occasions and as we saw that thesis play out, we have gradually increased our short position along the way. Generally, a lot of the problems we were concerned about, have come to fruition. After the acquisition of Royal Group, Georgia Gulf traded on the New York Stock Exchange in the $28 to $29 range. We initially put our short position in the $26 range. Today our position is much smaller and the stock has gone down significantly to the $12 to $13 range.

Q: How is your research process organized?

A: We are a small team of fourteen people at JC Clark. Research as a whole, is a six-step process. They are: idea generation, information gathering, analysis, company visits, portfolio construction and weighting, and lastly, trading. However, only the first four steps come under research while the last two would basically come under the portfolio construction umbrella.

The first step, idea generation, is a multipronged approach having four key tools that we use and apply consistently over a long period to identify companies. They are: a network of contacts; quantitative screens that include traditional valuation metrics to identify companies with high free cash flow yield; reading trade publications; and lastly, company visits particularly of those less covered by sell-side analysts to discover and exploit bottom up, undiscovered opportunities.

The second step, information gathering on both the company and industry, begins with talking to industry experts, reading trade publications and reviewing industry data. Analysis of individual companies involves, reading past several years’ annual reports, scrutinizing their 10- year historical financial track records focusing on free cash flow generation stability, return on invested capital, and other fundamentals.

The third step is when the research team builds, from an analytical point of view, our own financial model on a particular company. The one common factor will be our focus on a discounted cash flow analysis for we believe that having a significant free cash flow yield in a company, is a sure way to avoid a value trap. For example, if we buy a company that generates a 10% plus free cash flow yield, then, as equity holders, we are getting paid over time even if the multiple or the stock price does not immediately climb.

The fourth step would be company visits and very active interaction with management teams. We also like to develop ongoing relationships with the management teams of the companies that we’re involved in. Particularly in Canada, often in the mid-cap space we find many well managed businesses with efficient management teams but ones that are not savvy on matters like capital allocation and corporate finance. Therefore we indulge in “friendly” activism and provide management with ideas and suggestions that might help create value in their businesses.

Q: How do you go about building your portfolio? What is your buy and sell discipline?

A: We have a very focused approach to portfolio construction. We have only 30 names in our portfolio. We overweight the top ten names and often they may represent more than 50% of the overall portfolio. We are also relatively long-term investors and hold a position for anywhere from three to seven plus years. There are some positions in our fund that we have held from the time of our inception eight years ago. If a company is consistently performing and creating value, it’s much more tax efficient to have a low turnover and hold that position over the long term.

Our buy discipline involves the gradual building up of a weighting or a position in a particular company over a long period. This is not a sudden one-day action. From the long side of the portfolio we initially acquire a position with a 1% to 2% weighting and then gradually, as we gain higher conviction after seeing signs of confirmation of our initial investment thesis, we increase that position to about 5% to 10% of the portfolio.

Two reasons prompt our sell decisions. First, if something fundamentally changed in the business that had a material impact on our initial investment thesis; a related reason is if something very broad changed in that industry like the entrance of significant new competition or technology. The second reason would be a significant change in valuation.

Finally, we have trading, which is basically of three types. The first is position building. Second, would be selling a position or short covering that position, the third would be opportunistic trading. That involves adjusting the size of the weighting of our core position depending on how it is trading vis-à-vis its intrinsic value.

Q: What is your risk perception and how do you manage it?

A: We believe that the real risk in owning any business or equity is permanent loss of capital and hence we evaluate every opportunity on that basis before investing.

A key method to reduce risk is identifying businesses having a significant margin of safety, as seen from solid balance sheets, low debt to equity ratios, significant free cash flow generation and the ability to meet all future obligations. From an overall portfolio perspective we try to maintain a low net market exposure. For example, our current net exposure is in the 20% to 30% range net long.

Other risks include liquidity and exposure in different positions and sectors. Our sector exposure is typically below 30%. We limit our position level exposure from the long side at around 10% and on the short side it is 7 ½% for maximum position sizes, so that we do not take an inordinate amount of risk in one particular name.