DIAMOND HILL LONG/SHORT INTERVIEW

January 3, 2006

 

Legend: We are going to ask you a basic question. Who is Diamond Hill? It looks like you are a load fund group, and it does not look like you do much marketing except through the broker-dealer community.

Ric Dillon: Yes, we are relatively young. We just completed our fifth calendar year with most of our strategies. The company came out of a different business, a different company, and that history is neither particularly interesting nor pertinent. I joined the company in May of 2000 to build what is known as Diamond Hill. My background is in the investment management business, having been with Loomis Sayles and having my own firm, as well as a few other jobs over the last 29 years. My colleagues who joined me here are people that I had either worked with in the past and/or people I knew very well over the last couple dozen years. We put this together and offered the different strategies that I and others have been involved with over our careers. The fund that started it all was actually from the previous business. It is our bank and financial fund which goes back to 1997 with the former company, then known as the Bank Stock Group. None of those people are here now, but they started that fund. It was a load fund because they were a broker-dealer. As we started our new fund, it came out of that same registered investment company and was a load fund. However, the vast majority of the money invested in our funds has come from RIAs on a no-load basis. Very little of our business has been with any kind of sales charge. I think most of it has come through the big platforms that everyone knows, such as Schwab, Fidelity and TD Waterhouse.

Those fund platforms are the ones that seem to be the three groups which represent a high percentage of our business, perhaps as much as 70%. Again, as Iíve mentioned, my background goes back to 1977. Our managing director of equity is Chuck Bath, someone Iíve known since he came into the investment business. He originally was a CPA, then received his MBA and entered into this business in 1982. Our other three equity decision-makers are people who either worked with me and/or Chuck previously. Thomas Schindler co-manages the small cap and Christopher Bingaman co-manages our new small mid-cap fund with Christopher Welch. Tom and Chris Bingaman worked with me at first, and then went to work with Chris Welch and Chuck at Nationwide. Now we are all together here at Diamond Hill.

Legend: In terms of your organizational structure and making decisions, how many analysts do you have working with you?

Ric Dillon: We have five equity decision-makers, PMs (Portfolio Managers) if you will, and a couple of younger fellows, Bhavik Kothari and Jason Downey, who are analysts who do not have investment decision-making ability but certainly work in support roles for what the five of us do. While we work as a team, we have different strategies and individual responsibilities for each of us. In all strategies we function as a team, with a lot of communication and collaboration, but ultimately we have de-centralized decision-making.

Legend: So the decisions are made as a whole? In other words, is it a voting system?

Ric Dillon: No, not at all. For instance, say that Chris Bingaman decides he likes Wells Fargo. Wherever it is appropriate, Wells Fargo will go into the portfolio. Chuck Bath, who is the managing director of equity, is the "captain" of the team, while also is the manager of Large Cap. On the Long/Short Fund and New Select Fund he is the co-manager, and yet he has been involved with some small cap names where he is the primary analyst. We could go on and on with these kinds of examples illustrating that, while we function as a team, we have individual responsibilities and work in that fashion.

Legend: Have all the decision-makers been with the firm since the inception of the fund?

Ric Dillon: No, I was the first, followed shortly thereafter by Tom Schindler and Chris Bingaman, then Chuck Bath and, most recently, Chris Welch.

Legend: If something were to happen to you Ric, who would take over the Small Cap and Long/Short Funds?

Ric Dillon: Tom is already the co-manager of the Small Cap Fund, but I do not know that I have a good answer. I guess it depends on when this would happen. If it were today, maybe it would be Chris Bingaman. If it were four years from today, maybe we would not necessarily assign anybody to it with Tom, and he would just become the sole manager. I guess it would depend on the circumstances. We have toyed with the idea of calling all of them team-managed, but we have not done that and probably will not do that. That at least expresses a sentiment of how we look at ourselves truly working as a team. For instance, every day at ten oíclock we meet and discuss ideas regarding the Large Cap, Small Cap, Long/Short Funds or anything in general.

Legend: How many total funds are there for Diamond Hill on the public side and on the private side? Are you running any private money?

Ric Dillon: Yes, we have started two new funds, bringing the total now to seven mutual funds. Five funds you could find information on, and the two new funds started on December 30, 2005. The five mutual funds then would be our Large Cap and our Small Cap, our Long/Short, the original bank fund which is called the Bank and Financial Fund, and then a fixed income fund called Strategic Income. The first new funds would be a Small-Mid Fund, because we closed our small fund, and the new fund does not include any of the small cap stocks under $500 million and then goes up into the mid category. The second new fund is what we call Select, which is our fund for our favorite ideas, again with a $500 million minimum market cap so that it does not encroach on the capacity of the micro-cap portion of the Small Cap Fund. Select is a strategy for which we had separate accounts for more than five years. It is actually our original strategy which we started in 2000, five and a half years ago. We are just making it into a mutual fund as well, but most of our separate account assets are in that strategy. It is a concentrated strategy and, as I said, It is an all cap strategy.

Legend: How much money do you have in separate accounts?

Ric Dillon: Separate accounts would total about $500 million, $900 million in mutual funds, and another $100 million in a private investment partnership. So $1.5 billion would have been the December 31, 2005 assets under our management.

Legend: We have Morningstar reports for the Focus Long/Short Fund and the Small Cap Fund. It seems like you have had a tremendous run-up in assets this year.

Ric Dillon: Yes, at the end of 2004 we finished the year around $524 million total. Of course, this year there was appreciation, but the vast majority was new assets.

Legend: What do you attribute that to?

Ric Dillon: On the small cap side, people with good small cap records, a number of the funds closed. Ours was one of the few that was still open and had an excellent record. That drove a lot of assets, approximately $300 million in new assets, to the Small Cap Fund. That is why we closed it. As for our long/short strategy, in addition to a good record, there are not many long/short mutual funds out there, especially with good track records. Probably $250 million came into that fund. Our Large Cap Fund also has an excellent record. When Chuck Bath joined us, Morningstar said that he was one of the best large cap managers in the United States for the past two decades, and yet he joined our little firm. I think that is starting to get some traction in our large cap strategy.

Legend: Ric, you had mentioned that the separate accounts were managed in one style. What style was that?

Ric Dillon: I said that most of them would have been in our Select Strategy. We had formerly called it our All Cap Concentrated Strategy, but that was a little wordy so when we started the mutual fund version, we decided to just call it the Select Fund. It is our favorite ideas from large cap and small cap with the caveat that we do not buy names under $500 million, because we do not want to encroach on the micro-cap end of our small cap capacity. So it is an all cap fund with the exception of the sub-$500 million portion of the Stock Market.

Legend: Did you start the institutional funds at the same time as the A shares?

Ric Dillon: No, those were started in 2005.

Legend: Morningstar information dates back to January 1, 2001.

Ric Dillon: I think they do that, but the asset class did not exist. They take the A shares and they adjust for lack of the load and the lower expense ratio. The other thing I know they do now, which just started last month, is that on the A shares they now give their star ratings, both with and without the load. Almost all of ours sold are load waived.

Legend: You mentioned that the Small Cap Fund was currently under a soft close. Do you anticipate that going to a hard close?

Ric Dillon: Probably not in 2006. Whether it will ever happen, I do not know. We originally thought $500 million in total assets was the number that we could handle, and when we got to $350 million we decided to do the soft close earlier rather than doing a hard close at all. I am hoping that we can avoid doing the hard close forever, but I canít really say.

Legend: So you do not have a set asset range at which to close?

Ric Dillon: When people started asking the question two years ago, we said $500 million was what we thought we could manage, not drawing a distinction between hard and soft because back then we did not have that much. As we got closer to that number, we decided to start thinking about this issue pretty seriously. We chose to do a soft close far in advance of reaching $500 million so we would not have to cut off our business relationships. We understood that over time that number would be met at a certain point and grow higher. My guess is we did the soft close early enough that we will not have to do a hard close in 2006, and hopefully wonít ever have to do one. But it is hard to say because you get into some of these 401(k) plans and you just do not know what is going to happen.

Legend: Could some of that new money been attracted by the 50% return in 2003?

Ric Dillon: Yes, 2003 was a good year for small cap and we participated fully. I think the Russell was up nearly 40%. It was a big year all the way across, but yes, the 50% return was way above average so I am sure that helped a lot.

Legend: Is there anything special that you can point to that helped your performance?

Ric Dillon: In 2003, and it seems like it is always this way, there were just a few holdings that drove our results. We had a couple of big winners, actually a couple of holdings where Chuck Bath was the analyst, Pacificare and Greenbriar. Everything was up in 2003, but those two were up 200% to 300%. Since we run relatively concentrated portfolios, they were both 2% or 3% positions at the beginning of the year. When you have that kind of performance on positions that size, you can add five to ten percentage points to the return. In 2005, the markets were not that good and neither was our fund, but again if you look at the oil stocks that we had you would see that they did especially well last year, as well as the airline stocks. Brinks was also a big winner for us last year. Probably the top five performers were responsible for 60% to 70% of the performance.

Legend: Do you have any foreign exposure in your Small Cap Fund?

Ric Dillon: Not probably in the sense that you mean the question. We do not have ADRs or off-shore companies. Even some of our small cap names have international business, but I assume that is not what you meant.

Legend: Correct.

Ric Dillon: Again, with that caveat in mind, we really do not manage non-U.S. or purchase non-U.S. companies. There is the occasional exception once every three years where we might have a small position in an ADR, but it is close enough to zero to think of it as zero.

Legend: We would like to shift the focus to more of a broad view on what you expect from the markets, what sectors you think are performing better now, and what you expect from them going forward.

Ric Dillon: We are very long-term investors, and probably a lot of people make that claim, but our annual turnover is 20% to 30% or less. The reason I start with that is because five years ago we had a big emphasis in the small cap area, so in our Select strategy where most of our separate account business is, and even in our large cap where we used the Russell 1000 instead of the S&P 500, if you look at the holdings five years ago or four years ago they tended to be more on the lower end of that. We had this view that the attractive valuations were at the small end and so those were the companies we wanted to own. In the first three of the past five years, that is what we did. Fortunately, that worked out very well. The theme of the past two years might be called inflation-sensitive or commodity-related, since energy in particular would fit into that theme. For the last two years, commodity or inflation-sensitive, including some transportation/industrial, might represent half of our portfolios. That was last year. As we enter 2006, we have the same emphasis and the same strong conviction. Chuck was talking about a conversation he had with someone just the other day, and he told them that this could be a theme for a very long period of time. We do not know, of course, because it depends partly on how the stocks do. If tomorrow we woke up and they all doubled, we would sell them and move to something else, but that probably is not going to happen. Most likely it just sort of develops and evolves and we continue to have that emphasis into 2006, maybe 2007 or 2008. It is hard to say. We are always asking what the fundamentals are and what those fundamentals are worth. For instance, the fundamentals in energy are still especially attractive to us. Those fundamentals are causing growth in worldwide demand, difficulty in meeting that worldwide demand from existing supply, and new finds having a hard time off-setting supply declines. Then you ask what is that worth, what are the valuations? When we look at the valuations in the companies, they are still very compelling. It is the only area, generally, where we are seeing expected returns over the next five years in the double digits. Almost every other sector has expected returns in the single digits, some cases high single digits, some cases low single digits. That is why we have the emphasis in our long strategies or alongside our long/short strategies on the inflation-sensitive, commodity-related areas, energy in particular.

Legend: What kind of system do you have in place for selecting candidates for your portfolio? Do you run models and then generate buy signals off those?

Ric Dillon: We do have a valuation model that is proprietary, and you can read about it on our website. But I always like to emphasize that it is just a tool and a framework to think about things because it is forward-looking and therefore requires judgment input. While we have first approximations on over 3,000 companies, we never evaluate them solely based on those first approximations. What we have to do is to go into each companyís valuation model and ask what do we think about it, make judgments and estimates, and then those result in valuations that we take into consideration. After that is done, it is pretty easy to say that a stock looks like it is worth ten dollars and is selling at seven, so it is a good buy. Or that this stock is worth ten and is selling at fifteen, so that is not an attractive stock. But the tough part is the fundamentals that go into determining that "ten" in the example.

Legend: Can you tell us about any hedging strategies that you are using on any of your funds?

Ric Dillon: Yes, we do have the Long/Short Fund, and when people see "long/short" they call it a hedge fund. I say it that way because we do not think of it that way at all, and that is important. A lot of people will not want to invest in our long/short strategy after they hear how we do it. We are not market-neutral, and we likely never will be market-neutral. We are not even sector-neutral. For instance, currently we do not have any shorts on the energy side. We are long with things we think can make money on the long side, and we are short the things we think can make money on the short side. It is probably a rare occurrence, where you would have long and short in the same industry when that is what you are trying to do. We are not trying to minimize volatility like many long/short strategies, we are trying to maximize return. Yes, we have less volatility than our long-only strategies, and naturally that is going to normally be the case, but that is not what we are trying to do. We are really just trying to make money, and so we realize we are not going to appeal to everybody with that kind of approach to a long/short strategy, having a long bias and not approaching anything close to sector-neutrality or hedging.

Legend: We believe in long/short like you do. Many people look at market-neutral and long/short as being the same strategy. We do not! On the other hand, if you are long-biased, what happens if you view there is nothing to buy on the value side of the ledger? Would you go more short than long?

Ric Dillon: No, we want to have a range of 30% to 70% net long. I do not know what we would do if we could not find anything. That is a great question, but I do not have an answer.

Legend: Where would you be in January of 2000?

Ric Dillon: Our long/short partnership started in December of 2000. That was our first long/short strategy. We had no problems finding small cap names and we had no problems finding stocks to short, which tended to be mega-cap names and tech names. For instance, in our long/short partnership, and again the mutual fund was long-only back then, the years 2001 and 2002 were especially good on the short side, so we made money both years. This would be a tougher time because, with the exception of energy, it is awfully tough to find, in our view, attractive long positions. One of the things that happens is our total invested position tends to be lower, because if you want to have that net long I described and you have limitations on how much you can short, the result is you are going to have less on the long side. We might be 80% long and 35% short for a net 45 today, whereas back then, had the mutual fund been long/short, we could have been 100% on the long side and 40% on the short side because we were so positive about small cap and yet so negative about other things, the dichotomy could not have been greater. Well, it is not like that now, and it is harder to have that kind of conviction. The only place on the long side, as I have said a few times now, is in energy where we have that kind of conviction.

Legend: Your asset levels do not seem to be a problem in terms of performance. In terms of the Long/Short Fund, is there an upper limit that you would put on shorts such as 20% to 30% of the total 100% of assets?

Ric Dillon: The mutual fund actually, by prospectus, limits it to 40%. So 40% is the most we would have on the short side.

Legend: When you go out five years, according to Morningstar, your standard deviation is much higher for the Long/Short Fund at 17, whereas over the last three years it has been closer to nine.

Ric Dillon: For the first couple years it was long only, so that is the reason. We changed it a couple years ago to a long/short fund, mainly because as a new firm we were not getting any traction. No one cared about it so we said, this is not working. Our Long/Short Partnership had performed well. We decided to change the fund into a long/short mutual fund because there did not seem to be many of those. There seemed to be less competition there than in the long-only mutual fund world. It was a business decision to go long/short. Now that we have more traction, we are going back to the Select fund idea. We hope to be a little more successful from a business perspective this time around.

Legend: In terms of the Long/Short Fund, do you know exactly when you went to long/short strategy on that fund?

Ric Dillon: We got permission in mid-2002, and by the end of the year were fully invested, so from 2003 through 2005 we would have been running it as a long/short fund. That is why those statistics would show up as they do.

Legend: From the standpoint of that particular fund and also the long/short partnership, prior to the Partnership, who had experience on your management team with shorting?

Ric Dillon: I had run long/short money as a fund prior to coming here. The other folks here, while they had not done it on a fund, had all done it personally. To be clear, the partnership was long/short from its inception in December of 2000. If you were to look at the partnership in the first couple of years, its results were very different from the mutual fund because it was long-only. Then in 2003 you will see a conversion and the results were very similar to 2003, 2004, and 2005.

Legend: Is there anything different about the partnership?

Ric Dillon: Yes, it uses leverage. While the positions will be the same and the net long position will be the same, the total exposure is very different. If the mutual fund is 80% long and 35% short, which is a total of 115% invested but net 45%, the partnership might be 110% and 65%, which is the same net 45%, but total exposure is 175%. So you will notice a tremendous amount of difference in terms of the investment exposure. If things are going really well for us, the partnership should do much better, or if things are going really badly for us, the partnership will do much worse because of that total exposure being roughly 50% on average greater than the mutual fund.

Legend: From the standpoint of the partnership itself, what kind of minimums are there?

Ric Dillon: $1 million.

Legend: In looking at the top holdings in your Long/Short and Small Cap Funds, there is something called a Diamond Hill Short Term. Is that just a cash alternative?

Ric Dillon: Yes, a cash substitute. The Small Cap Fund finished the six months on June 30th and the twelve months on December 31st with almost 30% cash, so of course you find all kinds of vehicles to put it in.

Legend: Is the First American holding also a cash alternative? You have a pretty heavy weighting there.

Ric Dillon: Yes. We have a half dozen different investments that are all cash, so you can see equity would be at 70% and anything below is cash.

Legend: Can you distinguish the long-only strategy within the Long/Short Fund and any similarities that it has with the small cap piece? Are they roughly the same, based on the same types of models, or do you do things differently?

Ric Dillon: No, they have the same valuation framework. In fact, if you were to dig out the holdings from two or three years ago, you would find a tremendous amount of overlap. Today you will not find much overlap because so many of those small cap names have done so well that we have not left them in the long-only part, which is the Select part of our Long/Short strategy. Just to clarify, our new Select Fund has the same holdings as the long side of our Long/Short Fund. That long piece of Long/Short Fund is our Select, or our All Cap Concentrated, or whatever you want to call it. A few years ago, it was dominated by small cap names while today it is dominated by mid- to large-cap names.

Legend: We see from the yearly returns that the Small Cap Fund had a 25% return approximately in 2001, whereas the Long/Short Fund returned 6.11%. Were not these time periods prior to the Long/Short Fundís ability to short?

Ric Dillon: Yes, clearly the Small Cap Mutual Fund had a great 2001. I guess what one might say is that some of the biggest winners in the Small Cap Fund were either not represented, so we missed them, or not represented enough in the fund. In 2001, by the way, I think it was a pretty good year for the Russell 2000 value. Some of the names that would have been represented there we just did not have in our All Cap Concentrated. The 6% seems a little low, I would have thought it was higher than that, but I will trust that you are right. The fund started in June of 2000, so the six-month number in 2000 was around that kind of number versus calendar year 2001. The S&P in 2001 was down approximately 12%. Versus the S&P it was really good, but clearly we did not have the best names in our Small Cap Fund or enough of them, since the Small Cap Fund did so much better.

Legend: Large value did not perform anywhere near as well in 2001 as did small caps.

Ric Dillon: Probably what happened was the large value names that we did have held back the performance at bit. While we might have had a dominant position in the small cap, it was not enough. We should have had everything in small caps, one could say in hindsight, because the Long/Short Fund clearly did not do nearly as well in 2001 as the Small Cap Fund did. There was hardly any difference though in 2002. Then in 2003, of course, small cap again was great. In 2003, it was long/short, so it lagged considerably. Now this year small caps lagged, so the Long/Short Fund was actually better than the Small Cap Fund this year.

Legend: What is the fundís market capitalization rate? Is there a cap as to the size of the company that you go after, or is it just a general range?

Ric Dillon: It is a general range. The only thing that we will not do is buy positions with market caps under $500 million, just because we reserve that exclusively for our Small Cap strategy. That is the only caveat we put on it. We have had the bias, admittedly not enough in 2001, towards small cap the first three years. That bias has pretty much gone away now.

Legend: How about on the micro-cap side, do you run into any liquidity issues?

Ric Dillon: No, as long as we stay out of the sub-$500 million, I do not think we have had any issues. There has been only one company that we filed a 13 D, on and that was a sub-$500 million company in the Small Cap. That is why we do it, so we do not run into those kind of liquidity issues.

Legend: Do you have a target for a number of positions in either of the funds?

Ric Dillon: Yes. In the small cap the prospectus talks about a range of 30 to 50, and it finished the year right around 50. In the next prospectus, the small cap might say 40 to 60. We do not want to have too many names. In a small cap portfolio, even 60 might be considered a few numbers out of the Russell 2000. We may have to relax that a little bit. On the Select strategy, which again is the long part of the long/short strategy, our range for the number of stocks in the portfolio is 25 to 35. We finished 2005 around 30. On the short side we also finished around 30. Definitely Select, as the name suggests, or as the former name All Cap Concentrated indicates, shows that it is intended to be a more concentrated portfolio than our long-only strategies like small cap or even large cap.

Legend: Who were some of your contributing performers or sectors on the short side?

Ric Dillon: We did make some money last year on the short side, maybe 3% or 4%. I know we had good results from being short the auto companies. In some of the other consumer discretionary areas and even some tech areas we did well on the short side.

Legend: Are you looking to keep a relatively similar position on the short side?

Ric Dillon: Yes. We have not made any major changes, just little things around the edges. This is always somewhat surprising, but even in our Long/Short Fund we have low turnover.

Legend: That is very surprising.

Ric Dillon: Regarding the Partnership, which I mentioned has been long/short for five years now, we have been short several of the short names the entire five years.

Legend: That is a sign of patience.

Ric Dillon: Yes. Cisco Systems is a great example of that, Wal-Mart another good example. Both are much closer to being fairly valued where we would cover them, so maybe in 2006 they will both be gone as short positions. But for five years we have been short names like that.

Legend: Do you find it a little more difficult to play the long/short strategy when there is a lack of volatility in the market?

Ric Dillon: No, probably not. The reason is that the volatility, as you know, is measured on an annual basis, and since we are looking at things in longer time periods, the short-term volatility really does not play as much of a role for us as it would for someone who has much higher turnover.

Legend: Morningstar does not provide an expense ratio on the Long/Short Fund, institutional share class. Could you give us an estimate?

Ric Dillon: There is a 90-basis-point management fee, and there is a 20-basis-point administrative fee. In addition to those two, there is something that is always going to be a little different. That is, the other expenses which are almost exclusively dividends of stocks that are shorted, have been running around 20 basis points. I do not know why they do not give that, but I think a good number to use would be 130 basis points. It might be a little less than that, but the 90 and the 20 are a given, so that is 110 basis points. And there is always going to be some expenses associated with dividends of stocks being shorted. It has never been a big number, but 15 to 20 basis points is probably a good guess.

Legend: What is the reason for the focus on going large cap in the Long/Short Fund? Why have not you started a small cap long/short fund?

Ric Dillon: What we are really trying to do is just find the best ideas, no matter where they are in the market cap spectrum. The reason it has become more large cap on the long side is driven by the opportunities in the energy area. There are only two holdings that are small cap. Everything else in the energy area happens to be large cap. I think it is just nature that energy companies tend to be larger companies. Burlington, Devon, ConocoPhillips, Anadarko, and Apache are all large cap names.

Legend: Do you anticipate adding any new investment personnel in the near future?

Ric Dillon: As far as adding to the team of five that I mentioned, Chuck, Tom, Chris Welch, Chris Bingaman, and myself, I would say the answer is no. None have been contemplated, nor discussed, so it will stay at that for at least the next six months. On the analytical and trading support side, in addition to Jason and Bhavik, I would guess that there would be at least one or two added.

Legend: How much of the principalsí personal monies are in these strategies?

Ric Dillon: On the equity side, if you exclude residential real estate and company stock, for me it is 100%. For the others it is either 100% or pretty close to it. I think that Chuck has some municipal bonds, and that would be the one exception. We do not have separate accounts personally, so I cannot buy Devon or any of these energy names because I have to put my money in the funds. With the mutual fund disclosure, you can see all this disclosed. We have substantial representation in our funds. What you will not see is the partnership. Many others have a lot in that as well. But we cannot buy individual stocks, instead we have to put it in either the mutual funds or the partnership.

Legend: Is the partnership relatively the same securities as the Long/Short Fund?

Ric Dillon: Absolutely, itís just the leverage that is the difference. One of the things we do not want to ever have is a conflict of interest. In our Select strategies, those being our favorite ideas from our large cap and our small cap and the Select is that long portion of the long/short, we cannot buy anything in the Select strategy, i.e. the long side of long/short, unless we also have it in the large and/or the small cap. So it has to be a subset. And if we really like Cimarex, which is a small cap energy name, we have to have it in the Small Cap Fund or be buying it simultaneously in the Small Cap Fund to put into our Select strategy or into our Long/Short strategy, for the obvious reason that if we did not have such a rule, we could be accused of making investments only in certain portfolios where we have our own money. Worse, in the Partnership where we earn an incentive fee, we could be accused of putting our best ideas there because that is where we have an incentive fee, so we cannot do that. You can see every holding on the long side of our Long/Short Fund and find them either in the Large Cap and/or the Small Cap Fund if you go to our website and get a copy of our semi-annual report for our mutual funds. You can go through and check every single holding and you will find that. You will also see that not a single holding that we are short is long anywhere else. We have very carefully put these processes and procedures in place to make sure we do not have any kind of conflict of interest. We can make mistakes, but they are not going to be out of a conflict of interest.

Legend: Can you describe for us how the stocks get on either your long or short list? What is your process? Occasionally we run into long/short managers that actually have two different processes.

Ric Dillon: We have just the one process. What we are doing is looking at all the companies that would be in the universe of roughly 3,000. We start with a first approximation on all those companies, which comes from different data sources that are input into algorithms. This process is fully discussed and disclosed on our website. This is something that is both our proprietary and intellectual property and software, but you can read about it. Then we go into each particular stock that we are looking at that might be of further interest. Letís take Yahoo, for instance, which we are short, but it says we have gone through all this and we have Yahooís top line growing at 20%, and the margin actually expanding. The stock is only worth $23 a share but it is selling at $40. Then we will short it. That is how we do it. On the long side, with energy stocks such as ConocoPhillips, we say we think that the various crude prices and natural gas prices are going to act a certain way, and we think that the stocks should still sell at a discount, but not as much of a discount that it currently sells for. We believe that the present value of the company is $80 and it is selling at $59, so we go long. That is how we do it.

Legend: When you hold a stock and it gets so large that it moves into a higher capitalization range, is that an automatic sell?

Ric Dillon: No. The only thing we will not do is initiate a purchase, but other than that we essentially ignore it and continue to hold it as long as we think it adds to the portfolio value.

Legend: If you had something in your Small Cap Fund that you deemed it was time to move out of because of the appreciation factor, would you automatically sell it out of your Long/Short Fund?

Ric Dillon: Again, we would not sell it because of the appreciation factor unless it became fairly valued. But absolutely, we cannot own anything in our Long/Short Fund that we do not own in our Large Cap or our Small Cap Funds.

Legend: Ric, thank you very much.

Ric Dillon: Thank you very much. We appreciate your interest.

 

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