I recently interviewed Howard Schilit, author of Financial Shenanigans. The full interview is posted on GuruFocus.com. I will post the first part of the interview here followed by a link to the full inveterview on Guru Focus.

I recently finished reading the third edition of Financial Shenanigans. I loved the book asked the author of the book Howard Schilit for an interview to discuss his book. Mr. Schilit was kind enough to grant me the time to ask him several questions about the book. I am not the only one who loved the book. As I mentioned in this article, Dan Loeb said Financial Shenanigans is a book “you got to read”.

Here is a bio of Dr. Schilit.

I. Entrepreneur – founder of two investment research companies and book author

Financial Shenanigans Detection Group, LLC – 2010

Center for Financial Research & Analysis, LLC – 1994-2005 – sold to TA Associates

Dr. Schilit is an international leader in forensic accounting and corporate governance and author (with Jeremy Perler) of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (McGraw-Hill) 3rd Edition, April 2010. He has been a leading spokesman before Congress, the SEC, and media outlets about causes and early warning signs of accounting tricks in public filings. Dr. Schilit recently founded the Financial Shenanigans Detection Group, LLC. In 1994, he founded and ran a global forensic accounting research organization, Center for Financial Research & Analysis (CFRA) until 2005.

He frequently lectures on the subject of financial shenanigans to university students, investors, bankers, lawyers, and insurers. Business Week referred to Dr. Schilit as the “Sherlock Holmes of Accounting,” and Smart Moneymagazine twice selected him as one of the “Power 30″ of investing. A former professor of accounting at American University, Dr. Schilit holds a doctorate in accounting from the University of Maryland.

2. Academician—full-time accounting department faculty member

American University – 1978-1996 Associate and Assistant Professor

University of Maryland – 1974-1978 Lecturer

Education:

University of Maryland – 1974-1981 Doctor of Business Administration (1981)

Masters of Business Administration (1976)

SUNY Binghamton – 1973-1974 Masters of Science in Accounting (1974)

Queens College – 1970-1973 Bachelor of Art in Accounting (1973)

3. Certification: Certified Public Accountant in Maryland

Can you tell us about your previous experience in Forensic accounting?

For over a decade while still a professor, I studied several hundred SEC Enforcement actions against companies charged with fraudulent financial reporting.

Then in 1993 published first edition of Financial Shenanigans which described how companies manipulate earnings.

In 1994, founded Center for Financial Research & Analysis (CFRA) and published exposes for institutional investors on companies using aggressive or unusual accounting practices to hide operating problems.

For people who already read the 1st and 2nd editions of the book, what have you updated in the latest edition?

The 2010 Third edition expands on the earlier editions in several key areas:

a. described some new earnings manipulation tricks used by such companies as Enron, WorldCom and Freddie Mac;

b. introduced topic of Operating Cash Flow Manipulations and identified four broad categories of such tricks

c. introduced new topic called Key Metrics Shenanigans that illustrates numerous non-GAAP metrics companies have been using to put positive spin on a deteriorating business

In your book you detail a lot of blue chip companies that have engaged in “cooking the books”, on the other hand there are a lot of pump and dump schemes in small cap stocks. Where do you think shenanigans are more common?

Shenanigans of all sort are found in companies of all sizes, across all industries and know no geographical boundaries. That said, investors in very small companies, lacking solid internal controls, professional internal and external auditors and a competent and fully engaged board should be on the highest alert.

The two main sections of the book are cash flow shenanigans and earnings shenanigans, what about balance sheet shenanigans?

You are certainly correct in observing that there are actually three financial statements and my book focused on shenanigans on only two of them — the statement of income and the statement of cash flows. The omission of the balance sheet as a category of shenanigans, however, was not an omission. Remember that every accounting transaction has two parts of the entry — one part typically affecting the balance sheet and the other affecting the statement of income or statement of cash flow.

To read the rest of the article click here.

Vice Fund

Jeff Middleswart is portfolio manager of the Vice Fund (VICEX)and Director of Research for Behind the Numbers.  The Vice Fund is a mutual fund primarily focused on the alcohol, tobacco, gaming and defense industries.  Founded in 1988, Behind the Numbers (BTN) is an independent research provider to institutional money managers. Given that BTN research is focused on stocks to avoid or sell short, Jeff has an extensive background in ferreting out potential problems from companies’ financial statements. Prior to his work on the short side, Mr. Middleswart served as Senior Analyst at Barre and Co (now Southwest Securities) where he focused on high yield bond analysis. Jeff manages the Vice Fund (VICEX) with a value bias and focus on dividends and dividend growth.

Jeff began managing VICEX in Feb. 2010.

I would like to start out a little bit with your background; can you tell us about your experience with short selling?

With so many companies paying their executives with stock these days – the predictable outcome of government attempts to limit pay in the 1990s; there are incentives to both search for short-term items that will fuel even greater growth and to cheerlead the stock.  What we have seen is that many of these gimmicks may last 6-24 months, but in the end they cannot be sustained indefinitely.  Companies cannot simply restructure their way to higher profits unless there is sales growth, and they cannot expand sales growth in the future when they cut advertising and R&D spending to make current earnings.  Looking at the results of the stock market indices over the years, which tend to be dominated by a handful of companies, many investors would be surprised to see that in any given year 25%-40% of the companies in the index decline.  Thus, short-selling is a sizable asset class and one that remains viable in the majority of years.  I’ve been looking for short selling ideas for 17 years now by finding fundamental issues with companies.  We have had a number of successes where we were the only ones raising the red flags as problems for a company until they explode and the stock is pummeled.  Some of the favorites in the past were Paging Network, Sunbeam, AES, Providian Financial, Weight Watchers, and Constellation Brands.

What factors do you look for when short selling a stock?

There are dozens of items to look for.  We like to find businesses in decay where pricing is falling, new technology is superseding the current offerings, and there is less need to buy something a second or third time as rapidly.  Tires, batteries, computers, modems were all examples of this.  Companies where the income statement looks great, but somehow they never produce any cash flow and the balance sheet continues to pile up debt and receivables are other areas to look for.  A business that is not self-financing can be something easy to trip up when the cost of capital rises or it cannot roll-over debt – these are often companies that have little real growth and seek to be a growth company by acquiring other ones but they are addicted to the next deal and start to overpay.  Constant restructurings are another thing to look for.  Often you will see a company that has realigned its business, changed employees, sold business lines, bought others, announce that it is writing down assets every year for a decade – then you look closer and see that even after these accounting charges, profitability is lower now than when all the restructuring began.

What factors do you look for when short selling a stock?

There are dozens of items to look for.  We like to find businesses in decay where pricing is falling, new technology is superseding the current offerings, there is less need to buy something a second or third time as rapidly.  Tires, batteries, computers, modems were all examples of this.  Companies where the income statement looks great, but somehow they never produce any cash flow and the balance sheet continues to pile up debt and receivables are other areas to look for.  A business that is not self-financing can be something easy to trip up when the cost of capital rises or it cannot roll-over debt – these are often companies that have little real growth and seek to be a growth company by acquiring other ones but they are addicted to the next deal and start to overpay.  Constant restructurings are another thing to look for.  Often you will see a company that has realigned its business, changed employees, sold business lines, bought others, announce that it is writing down assets every year for a decade – then you look closer and see that even after these accounting charges, profitability is lower now than when all the restructuring began.

I just reviewed a book titled The Art of Short Selling , do you agree with most of the author’s philosophy or do you have a different methodology?

I think you’re talking about Kathryn Staley’s book.  I would agree with areas that she focuses upon as well.  The key word is “Art” as there is not a set of rules that work in every situation.  Some companies can have great financials but their number one customer is going bankrupt.  That company may be a great short, and there won’t be an accounting red flag that trips.  Red flags have to be viewed in context too – cutting R&D will inflate current earnings, but every cut is not necessarily bad.  A company may spend 10% of sales on R&D for 10 years in a row, then work on a large project that drives the R&D spending to 14% of sales one year and it returns to 10% the next.  That’s a cut in R&D but may be easily explained.  She does a good job of pointing out that the more accounting items that are unsustainable; the stronger a company may be as a short-sale candidate.  I would always emphasize cash flow over income though.  A company that generates strong cash flow can normally finance itself, pay for growth and generally avoid the massive pitfalls with some of the accounting gimmicks that may still hit their results.  A company with weak and declining cash flow makes a stronger short sale when the income statement items work against them.

How can one use lessons from short sellers to invest long only?

Short selling provides a frame-work of essentially negative selection.  You are looking for reasons NOT to own something.  By knowing what unsustainable results look like and what bad companies look like, “longs” can be evaluated to determine if those problems are present.

Jim chanos has made big headlines with his announcement of his “short of China”; do you have any opinion on this matter?

I will say that this not a situation I’ve studied at any level as much as Jim Chanos has and I’m not much of a macro player.  I believe China has some growing pains and likely some problems in the near-term.  Real estate prices in key areas are out of reach for many citizens, their export markets in the US and Europe are still down – so I agree with the current view that China could see more selling pressure.  Longer term, the country is still industrializing, its domestic market is growing (thus it may not always be dependent on export markets) thus it should still have some good long-term growth characteristics.

Do you short sell at all in the Vice Fund? No. While there has been some short selling in this fund in the past, we believe it is our mission to stick with the “Vice” concept because we believe it works.  In addition, we want to leave it up to investors to address the level of hedging or short exposure that makes them comfortable.

Can you explain to the readers the philosophy of the Vice Fund? In the basic terms, our view is that “vice stocks” outperform over the long term.  To go a bit deeper, I’d say there are two parts to this philosophy. The first is that we believe that companies in these four industry groups typically have characteristics that we find attractive. These include strong cash flow, the ability to pay and increase dividends, pricing power, and barriers to entry. The second aspect is that these companies often sell at modest valuations, in part because they are shunned by investors. Good fundamentals and low valuations are a nice combination in our view.  So while a few of these vice companies are likely to appear in your portfolio anyway, we simply focus on these areas, and consider these groups of companies a core holding.

Why did you choose these specific industries and not other ones that people might find distasteful like oil companies, or chemical companies etc? One reason is that we like companies with stable cash flows and low cap-ex requirements, and many of the vice companies fit that bill. Oil and chemical companies can see large swings in results solely due to changes in commodity prices that are beyond their control and vital to their business.  That can also force up their cost of doing business – drilling an oil well costs more when everyone else has contracted with the bulk of the rigs for example.  Another key idea is that the vice industries are not easy to get into. To start up a brewery able to compete with dominant player like SAB Miller is difficult. Yes, there are microbreweries that have taken market share from the big guys, but if they are truly successful, they become acquisition candidates.

That’s not to say that we don’t find companies outside the primary four that we like. You mentioned chemicals, and we do own Monsanto, which are certainly a dominant player and cash flow generator. Also, I should point out, it’s not that we simply like to invest in companies that some investors find distasteful.  It’s that the valuation of certain companies can be compelling because of investor behavior. There have been several studies of late concluding that “sin stocks” have outperformed for this very reason.  Plus, for us to be interested, these companies must have the cash flow characteristics and barriers to entry we’ve mentioned.  After all, there are plenty of stocks in distasteful industries that aren’t compelling investments. And we’re not even talking about Coke and YUM Brands!

According to the fund rules are you allowed to buy and stocks outside of these four industries? Yes, and we have in moderation.  But we expect most of our investments to remain more or less equally distributed amongst alcohol, tobacco, gaming and defense, with a few special situations from other industries mixed in.

If the main emphasis of the fund is high barriers to entry, high dividend yields and cash flows, why limit yourself to only four industries; there are many companies outside these industries that possess these characteristics? As alluded to above, we will invest outside the four primary vice industries when we find a company with similar characteristics especially pricing power. However, we believe the vice industries should serve as a core holding in most stock portfolios given how shareholder friendly they are, so we want to ensure this niche is available to investors with our fund.

You seem to like contrarian industries; one might say this is a value approach, yet your average stock has a P/B of over 3.3. Would you consider yourselves value investors?

Many of the stocks we buy have large share repurchase programs in place.  Repurchasing shares reduces shareholder equity.  Also dividends reduce shareholder equity and our companies pay above average dividends too.  Those are the primary reasons why price to book value is over 3x.  We do consider ourselves value investors because many companies we own trade at low multiples of cash flow. The value of most assets is dependent upon the cash flow it can return to the investor. We think we own a group of companies that will provide investors with high cash flow in relation to purchase price. We do, however, understand that there are some assets that have great value even though they aren’t producing much cash flow at the moment. These can include raw land or manufacturing assets that are difficult to reproduce due to technical challenges, market conditions or regulation. We like investing in these types of assets, but that’s not our focus with the Vice Fund.

Do you place more emphasis on company specifics, or overall industry characteristics? While we can talk generally about vice industries, there is wide variability among the companies in regards to operating attributes, market share, competitive structure and valuation. We are far more focused on company specifics.

Your largest holding is Philip Morris Intl; can you tell us what you find attractive in the company?

Emerging markets are still seeing growth in number of smokers and people trading up to name brand cigarettes so Philip Morris has growth potential.  It has large market shares that it continues to work on building overseas.  Plus the lawsuit and regulation issues that impact tobacco in the US are not nearly the same overseas.  A $12 billion share repurchase program and a dividend of over 4.5% generate great shareholder returns too along with the growth.

Your second and third largest holdings are tobacco companies also. Can you explain why you are so bullish on this industry?

To read the remainder of this article on GuruFocus.com click here.

Mariusz Skonieczny is the founder and president of Classic Value Investors, LLC. Classic Value Investors, LLC, is a private money management firm committed to delivering superior long-term investment performance to its clients.Mr. Skonieczny is responsible for portfolio management for the company’s clients. He is also the author of  Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market. The purpose of this book is to help readers understand the basics of stock market investing. Material covered includes the difference between stocks and businesses, what constitutes a good business, when to buy and sell stocks, and how to value individual stocks. The book also includes a chapter covering four case studies as well as a supplemental chapter on the pros and cons of real estate versus stock market investing.

He has been a guest on numerous radio shows across the country such as The American Entrepreneur, Sound Retirement Radio, and The Commercial Real Estate Hour.

Below is our interview:

It can also be found on Mariusz’s website classicvalueinvestors.com

Interview with Jacob Wolinsky of Value Walk

Mariusz Skonieczny, Classic Value Investors: On your website, you say that for years you were a typical clueless investor following advice from so-called stock “experts” and as a result, you were constantly losing money. What was the determining factor that made you make the transition to value investing?

Jacob Wolinksy, Value Walk: I was always interested in investing since I was a child. I made some big money during the tech bubble specifically in AOL stock. Now in hindsight I realize it was entirely due to luck. After that it was all downhill, I lost money in the tech bubble crash and even in the bull market that started in 2003.

One day I was browsing a website, as far as I recall it was not even a financial website. I found an ad advertising a free copy of a book that Warren Buffett described as the “best book ever written on investing” if you sign up for a for a free trial for some product. I did not sign up for the free trial but I found out the book was called The Intelligent Investor by Benjamin Graham. I took out a copy from the library and realized right away that the mistakes Graham described were the exact mistakes I made. I went on to re-read the book several times and knew right away that value investing was the way to go. I went on to re-read from the other greats Buffett, Dreman, Lynch, Neff, Greenblatt, Klarman etc. and since then I have been hooked.

Mariusz Skonieczny, Classic Value Investors: What types of investors are likely to benefit from your blog, Value Walk, the most?

Jacob Wolinksy, Value Walk: I thought my site would attract mostly new to intermediate investors. However, I am pleasantly surprised that my site is also attracting some really experienced value investors. After posting one of my few first articles on Guru Focus I got an email from Alice Schroeder (author of bestselling The Snowball) telling me much she loved my article about Buffett. I use statcounter and see that I get daily hits from the big Wall Street firms, and occasionally get hits from top value firms like Baupost Group, Pershing Capital, Royce Funds and more.

In fact one of my early emails was from a hedge fund manager in Europe. He manages several billion in his value hedge fund and has crushed the European index for about ten years. He loved one of my articles so much that he asked it to reprint it on his site.

So to answer your question in a roundabout way I would think my site is more geared towards beginning and intermediate investor. However, it seems I attract investors who are probably a lot smarter than me!

Mariusz Skonieczny, Classic Value Investors: Recently, you started another website, Value Investing Forum, in order to exchange investing ideas. Tell us more about it

Jacob Wolinksy, Value Walk: I realized that there is no real value investing website page like a SeekingAlpha type of website but value oriented. I would have ideally liked to start a website like SeekingAlpha that was devoted to value investing with a forum as part of the website. The only problem is that it would require lots of time and I simply do not have the time for it.

Therefore I opted to just focus on the forum for now.

Mariusz Skonieczny, Classic Value Investors: Why did you start it? There are other websites such as Value Investing Club or SumZero that exchange investment ideas. How is your website different from what is already available to investors?

Jacob Wolinksy, Value Walk: Value Investing Club is very elite and only accepts 250 members. Sum Zero is exclusive but less so than Value Investing Club. In addition both sites require members to post articles several times a year which I know many members find inconvenient.

On the other hand you have message boards like Yahoo where anyone could post. People post about tech analysis, their “brilliant” market forecasts, pump and dump schemes etc.

My goal with Value Investing Forum is to create a forum where there is a level of competency and where there are no posting requirements. I also like the forum because I knew everyone who I invited to the forum, and I know these are people I could trust. Of course I hope the forum gets big enough that I won’t know many of the members.

Mariusz Skonieczny, Classic Value Investors: Is Value Investing Forum open to everyone or do members have to be approved? What kind of qualifications does one have to have in order to be part of the forum?

Jacob Wolinksy, Value Walk: The forum is not open to everyone. Initially I invited people that I knew personally, who were competent value investors. In fact, probably almost every single person I invited knows more than me! I just figured someone had to start the forum even if they were not the best in the forum. We have a nice crowd; some hedge fund managers, mutual fund managers, analysts, bloggers, and some non finance people who have been value investing for several years.

The forum is very new so in the future we will have to determine eligibility. I co-manage the forum with a colleague Alex Garcia so it will be a joint decision. The criteria will likely be someone who runs a value site with rich content, works for a value firm, or can send a write up they did on a stock. Not requirements that are too high, but preventing people who know little about value investing from being accepted.

Mariusz Skonieczny, Classic Value Investors: Can nonmembers view investing ideas?

Jacob Wolinksy, Value Walk: Right now non-members can view. However, this policy might change in the future. Right now we are trying to attract people to the forum and we are very new. However, in the future if the forum gets large enough I would prefer only allowing members to view.

Mariusz Skonieczny, Classic Value Investors: Is there a cost associated with being a member of Value Investing Forum? What about being able to view other people’s ideas?

Jacob Wolinksy, Value Walk: No cost whatsoever and we never plan to charge in the future!  In fact we lose money on the forum due to hosting costs and purchasing the domain name. In addition, we spent time putting together the forum, and we spend time moderating it. Sometimes I ask myself why I do it!

But I like what I am doing because I feel that the forum will provide a good platform for value investors to exchange ideas. In addition, I gain ideas that I might use myself to invest in. I heard that the reason Joel Greenblatt runs Value Investor Club is because he gains tons of ideas for himself. However, for us this is not the main goal.

Mariusz Skonieczny, Classic Value Investors: How many positions do you hold in your portfolio? What is your view on diversification?

Jacob Wolinksy, Value Walk: Currently I hold about 45 positions in my portfolio. I used to hold more but I have been doing a lot of selling lately so it is now around 45. I post my positions on my website so my readers can see the stocks I hold http://valuewalk.com/about-2/my-portfolio/.

I waver back and forth in my head whether I should be more concentrated or not. I think there are valid arguments to both sides of the debate. I think this can be demonstrated by the fact that you find many great value investors on both sides of the aisle.

I think I am slightly more inclined towards a concentrated portfolio. The reason my portfolio is diversified now is because as the market was declining in 08 and early 09 I kept finding lots of cheap stocks and kept buying. Now as bargains become less available I probably will revert to a more concentrated as it is harder to find true bargains today.

Mariusz Skonieczny, Classic Value Investors: Do you emphasize quantitative, qualitative methods or both when analyzing companies?

Jacob Wolinksy, Value Walk: I definitely emphasize quantitative methods in analyzing stocks. That being said I of course prefer both. However, if it comes down to one or the other I prefer “cigar butt” stocks that are selling cheap that lack qualitative features.

Mariusz Skonieczny, Classic Value Investors: You use more than one method of valuing companies. How would you describe your valuation techniques?

Jacob Wolinksy, Value Walk: I do not have a specific approach I use to my investments. In general, I would say Benjamin Graham, David Dreman and John Neff have had the greatest influence on my investment style. That is usually “cigar butts” companies that are selling really cheap.

However, I will not limit myself to their style. For example my largest holding is Nucor which I believe just surpassed US Steel as the largest steelmaker in America. I will probably hold the stock for many years unless there is a really adverse change to the company. The company has an excellent balance sheet, has paid continuous dividends since 1966 I believe.

Nucor also has a shareholder friendly management. When the company has a good year (which it does most of the time) they pay a special dividend. So even though the dividend yield is about 3% most years you get a 6% dividend. The company achieves amazing returns on capital, earnings and investments. The company now is relatively cheap but I would probably continue holding it even if it went above my estimation of intrinsic value. Now, this would be anathema to Graham and other classic value investors, however it would fit more with Buffett’s type of approach.

Mariusz Skonieczny, Classic Value Investors: Does the size of the company matter to you?

Jacob Wolinksy, Value Walk: No, company size does not matter. I own stocks that range from a few hundred million dollars in market cap to over 100 billion in market cap. I look for wherever I can find value. During January and February 2009 I was finding huge bargains in large caps and was scared to buy small caps in case we did enter a depression I thought large caps would be able to muster it better. At that time I was overweight large caps; however that was due to a unique circumstance.

That being said, I do prefer small stocks. Value small stocks perform the best historically. Many people believe growth small stocks outperform large caps but this was disproven by David Dreman. I did some research into the topic and it appears he is right. However, value small stocks are by far the best performing stock class.

Also, small caps are neglected by analysts and one has a better chance of finding value there. There are also many more small caps to choose from than large caps. So even though I will buy a stock based on value and not market cap I slightly prefer small caps.

Soon I will be doing research for a value hedge fund that focuses exclusively on value nano-cap companies. They take over really small companies trading far below their intrinsic value. They then get on the board, take an activist role, and try to turn the companies around and then sell for a large profit. So, I hope to gain some further experience in the value nano-cap/small-cap investing through this work.

Mariusz Skonieczny, Classic Value Investors: What advice would you give to beginning to intermediate investors?

Jacob Wolinksy, Value Walk: I will tell you the advice I give everyone. Never take stock tips from anyone. It could be your brother, your stock broker or the “expert analyst” on CNBC. The main part of investing is controlling your emotions. This is not as easy as it sounds! I was value investing for years and when the market tanked after Lehman collapse I kept buying and buying. This was really hard as every stock I bought kept going down more and more. It was one of the most emotionally difficult tasks of my life but I ended up being rewarded very handsomely. I did all the buying I could while maintaining enough cash to invest in case the market went down further. I also had to sell some undervalued stocks like Coke at 38 to buy even more undervalued stocks like Caterpillar at 25.

That being said value investing is not for everyone. I always say value investing is contrary to human nature and therefore most people cannot practice it. No matter how many beginning investors I tell about value investing they just do not get it. I provide evidence of its outperformance and they still do not get it. I forget the exact quote from Warren Buffett but either you get it right away the concept of buying a $1 for 50 cents or you don’t.

Of course having the right sentiment is not enough. You must learn some value techniques and know accounting. Once you have the right sentiment, have learned about calculating intrinsic value you might be ready to start investing.

Mariusz Skonieczny, Classic Value Investors: What five books would you recommend to someone just starting out in investing?

Jacob Wolinksy, Value Walk: If we are talking about people who know nothing about investing I would first recommend they read up on asset allocation. William J. Bernstein, and John Bogle, and even Burton Malkiel have several good books on the topic. I do not agree with all of them completely. Burton Malkiel is a huge proponent of the efficient market theory; however 90% of his advice is relevant for the beginning investor.

In terms of value investing my top five books for beginners would be

1. The Intelligent Investor by Benjamin Graham

2. John Neff on Investing by John Neff

3. Contrarian Investment Strategies in the Next Generation by David Dreman

4. The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham

5. Money Masters of Our Time by John Train

Mariusz Skonieczny, Classic Value Investors: Would you share a recent investment and why you chose it?

Jacob Wolinksy, Value Walk: To be honest I have been doing a ton of selling lately. I mentioned this a little bit earlier in the article. I have found the bargains from 2009 and 2008 are no longer available.

The only security I bought recently is an ETF. The ETF is ticker JOF which is an index of smaller cap Japanese stocks. When I bought it, it was selling at less than book value. I try to avoid ETFs but Japanese equities are outside my level of competency and therefore opted for the ETF. Japan faces large problems including a huge Government debt, and what I think is an even bigger problem; an aging population in a country with low immigration and low birth rates.

That being said, Japan has experienced a 21 year bear market. I think Japanese securities especially small cap in particular might do very well over the coming years. I am trying to increase my area of competence in Japanese stocks by communicating with my close colleague Steven Towns of www.steventowns.com. Steven Towns is a genius value investor who focuses almost exclusively on Japanese stocks. I will never buy a stock on his or anyone else’s recommendation but he gives me good leads, and he is trying to help me understand the Japanese market so I can do some of my own research.

I still think there are bargains in the US market. I did a quick screen a few weeks ago and found over 1800 stocks selling below book value. Besides Japan, I plan on focusing some energy on finding value in select US equities however; it will take more effort than in the past few years.

Scott Barbee’s bio

Scott founded the Aegis Value Fund (AVALX) and has served as Portfolio Manager since its inception in 1998.  He is also the owner of Aegis Financial Corporation and the Portfolio Manager for the Aegis High Yield Fund (AHYFX). Prior to Aegis, Scott worked as an analyst with Simmons & Company, and later Donald Smith & Company.  He received his M.B.A. from The Wharton School at the University of Pennsylvania in 1997 and holds undergraduate degrees in Mechanical Engineering and Economics from Rice University.

Aegis High Yield Fund has beat the Barclays Capital High Yield Index since its inception in January 2004. The fund recently won the Lipper Award for having the highest risk adjusted return for the 5-year period ending December 31, 2009, ranking best out of the 337 funds in the high current yield category as measured by Lipper over the period.

The Aegis Value Fund was started in 1998 as a small cap value fund. It has crushed its index, producing a 10.5% return per annum versus 6.4% for the Russell 2000 value index.

Mr. Barbee was king enough to answer several questions I had for him below is our interview:

I like starting off an interview with the following question. Value investing is contrary to human nature, how did you get started in value investing?

I first became seriously interested in value investing while working at Simmons & Company, an oil-service investment banking boutique that was my first employer out of school.   I had first started working in the Securities Group in 1993 and was supporting the sell-side analysts after graduating from Rice University with degrees in Mechanical Engineering and Economics.  At the time, I remember Simmons was still ordering 10-Ks and 10-Qs from an overnight delivery service.  One of my jobs was to aggregate the news, accounting and valuation statistics for the oil-service universe for a monthly oil service overview we were publishing.  That’s the first time I remember becoming interested in investing in stocks that were statistically cheap on historical metrics.  Looking for cheap stocks based on historically-based attributes particularly appealed to my contrarian, engineering-focused mindset.  I ordered a public company statistical database and began running screens for cheaply valued stocks in the broader market, and remember buying Advanced Marketing Services, a book distributor that was a Benjamin Graham net-net.  As my investment in Advanced Marketing started to make money, I began reading everything about value investing I could get my hands on.  In 1995, I went to Wharton, where I was able to take a class from John Neff, who successfully managed the Vanguard Windsor fund for many years.  During this time, I also met Donald Smith, Rich Greenberg and Alan Kahn, three talented deep-value investors who helped me get into the business.

On a similar note how did you get started specifically in small cap value investing and high yield investing?

While at Wharton, I became interested in the academic research of Eugene Fama and Kenneth French, which seemed to demonstrate that very small companies trading at big discounts to book-value were delivering impressive historical returns.  The research dove-tailed well with my own findings that deeply undervalued companies with the most interesting stories tended to be smaller market-caps.  Small-caps were also easier to study, as they typically had only one or two business lines, and regulatory disclosures seemed more granular and comprehensive.  So when I started the Aegis Value Fund in 1998, I focused on small-cap, deep value stocks.  Later, we realized that the companies that we were looking at, which were typically going through periods of fundamental stress, also often had high-yield debt issues outstanding that traded at attractively discounted levels.  We started the Aegis High Yield Fund at the beginning of 2004 in order to take advantage of these kinds of situations.

There are many different schools of value investing, which school would you say you adhere to the most? Who has had the greatest influence on your investment philosophy?

We consider ourselves to be deep-value investors, and typically focus on buying companies at prices under tangible book value.  In this respect we are probably closer to the old-school, deep-value investment style that Benjamin Graham himself applied in his own work, as opposed to the new-school, Bill Miller-type approach.  We have a contrarian nature, so deep value seems to work better for us.  In terms of who has had the greatest influence on my own investment philosophy, it’s difficult to pick just one.  Certainly books by Benjamin Graham, Seth Klarman, Joel Greenblatt, and Louis Lowenstein have all made deep impressions on my thinking, as did my class with John Neff.  I’ve also picked-up significant experience vicariously over the years in conversations with Rich Greenberg, Donald Smith, Alan Kahn, Walter & Edwin Schloss, Bill Berno, and many others.

How do you manage risk?

First, I describe risk as falling in two general categories.  The first is the risk of permanent capital loss, which occurs when the fundamentals underlying a company’s intrinsic value are initially too optimistically assessed or deteriorate post investment.  We focus the vast amount of our own effort on this first category of risk, looking very carefully at the fundamentals of the companies in which we invest.  By doing substantive due diligence work and monitoring our investment carefully, we hope to mitigate the potential for a breakdown in investment thesis or an erroneous assessment of intrinsic value.  The second general category is the risk of temporary capital loss due to a quotational decline stock price that is not materially indicative of a deterioration of company fundamentals.  This kind of investment illiquidity or quotational risk can be very difficult to guard against as a deep value investor, as it has more to do with the financial condition of other shareholders than with the subject company itself.  Perhaps the only way this illiquidity risk can be addressed is by holding additional liquidity when the Mr. Market gets too keyed-up and putting the liquidity to work when Mr. Market is sober and depressed.

Do you ever meet with management?

Sure.  We spend a lot of time talking with management, either in person or over the phone, typically after fleshing out the fundamental issues over several hours of deskwork.  We think interaction with management is an important part of the investment process and one that can lead to a better understanding of the various businesses in which we invest.

How do you go about finding stocks? Do you look at the 52 week low list? Do you use a screener for stocks with high dividends and low payout ratios?  Do you favor stocks with higher dividend yields? What percentage of your returns comes from dividends as opposed to increases in the price of the stock?

Our process begins with a quantitative overlay, screening for companies trading at discounts to tangible book value.  We also tend to look for less levered situations, as a levered discount to book can easily evaporate with a small erosion in asset value, which can certainly happen during times of distress.  Additionally, we look for either current cash flow, or evidence of better future cash flow.  Corporate share repurchases, insider share repurchases, restructurings, and other potentially impactful corporate events also factor into our selection process.  As we dig deeper into a particular situation, we typically will recast the balance sheet, giving credit for hidden , or undervalued assets.  Similarly, we make deductions for hidden or understated liabilities or overstated assets.  Dividend policy and payout ratios don’t have much of an impact on our process, except in cases where a recent dividend elimination is driving temporary selling pressure on a stock, and dividend returns are only a very minor portion of our overall returns.

I see the average stock in your portfolio has a P/E of 8.4, average P/B .7, average P/S .3, These numbers are all much lower than the average stock in the Russell 2000 value index. Are these metrics that are important to you when you make your investment choices?

As a result of our focus on screening for companies that are very cheap on a price-to-book value basis, the Aegis Value Fund generally holds positions that tend to be significantly cheaper than the Russell 2000 Value Index averages from an overall statistical viewpoint.  We also tend to stress cash flows over earnings, but also recognize that cash flows may be temporarily depressed at a company that is restructuring or facing a cyclical downturn.

Your top 10 ten holdings make up about 35% of your portfolio. I would consider this neither diversified nor concentrated. In general do you favor a more diversified or more concentrated portfolio?

Our top ten holdings typically consist of 35 to 45 percent of portfolio value, depending upon the levels of conviction we have in our top investments.  We generally hold about 80 names in the portfolio overall, so we have a large number of smaller position portfolio companies.  We are in the process of working some of these smaller holdings into or out of the portfolio.  Other smaller holdings might fall into the higher-risk category where the likelihood of significant stock appreciation outweighs the risk of capital loss.  Generally, we don’t add to a position once it has reached 5 percent of fund assets.  With regard to my concentration preferences, my ideal portfolio would probably consist of 20 high-conviction holdings with 5 percent of capital allocated to each.

I normally do not look at 1 yr performance but your numbers are spectacular. Your fund returned 154% over the past year through March 31, 2010. How were you able to accomplish this, did you change your portfolio a lot when the market hit bottom in March 2009 or did you continue holding onto the same stocks as before?

Given that the market bottomed on March 9^th, our trailing one-year performance has captured a tremendous rebound in quotational values as the financial crisis subsided.  Many of the deep value small-cap stocks that we owned were heavily owned by hedge funds and other proprietary trading desks that funded positions with borrowed money and capital susceptible to shareholder redemption.  As the credit markets began to freeze-up in late 2008, these institutions were forced sellers, which disproportionately impacted deep value small-cap liquidity.  Pricing was driven to a steep discount to the intrinsic value of the underlying companies.  When the financial pressures and forced selling began to lift in March 2009, the prices of small-cap deep value stocks experienced a dramatic rebound.  We remained very fully invested through the downturn, and with the exception of some minor adding and trimming around the edges, including our selling off a few positions to meet redemptions, the portfolio remained basically invested in the same names.

How does a typical day look like? (For instance: Two hours checking news, two hours search strategy, two hours doing research on the best picks of the search strategy, two hours talking to clients, one hour checking the positions of the portfolio.)

I spend about 80 to 90 percent of my day in research.  Generally, I tend to absorb material fastest when I am reading, and so I spend a tremendous amount of my time reading pieces:  10-Ks, 10-Qs, conference call transcripts, analyst reports, articles, etc.  I spend a lot of time, 10-15 hours a week, on the phone with various management teams and other investors going through the fundamentals of our various investment prospects.  I also spend a significant amount of time talking and working through ideas with our analyst team.  I would say the balance of time is generally spent on various client interactions, press communications, and other regulatory and business management issues.

What was it like starting a small cap value fund near the peak of the bubble when large growth companies were roaring and producing spectacular returns?

We started the Aegis Value Fund in April of 1998, just prior to the demise of Long-Term Capital Management.  As the Fed lowered rates to bolster the banking system in the wake of this crisis, tech stocks just melted-up.  It was a particularly frustrating time to be a value investor in all these “old economy” names, many of which were actually declining in price, primarily because investors were selling off these investments in order to speculate in overvalued tech stocks.  So from a customer retention standpoint, it was a very difficult time.  However, from the standpoint of investment opportunity and conviction, it wasn’t so bad.  Many value stocks had traded down to mid single digit P/E ratios and were at deep discounts to book value.  It seemed fairly straightforward that the tech stocks were too highly valued and that this was likely to correct, and at some point these small-cap value stocks would have their day.  The only uncertainty was how bad the overall economy would become when the tech bubble popped.

I see your second largest holding is Alliance One International, Inc. (AOI), legendary investor Seth Klarman owns about 9% of the company. What do you find attractive about this stock and did you originally find this idea by looking at Seth Klarman’s portfolio? Being that he is one of the largest shareholders of the stock have you ever had any interaction with him regarding the AOI?

We first became interested in the tobacco leaf dealing industry after AOI’s predecessor company Dimon bought out Intabex in 1997 and there was significant financial stress being caused by excess leaf inventory in the system.  We had been shareholders of Standard Commercial and Dimon prior to their merger to form Alliance One, and have successfully bought and sold these stocks over the last 10 years.  Currently, we are attracted to Alliance One International because of its low valuation, as the company trades at a very modest premium to book value and at a ratio of price to our estimate of normalized earnings in the mid single digits.  The leaf-dealing market has consolidated into two dominant, global players, and the company has reduced leverage and cut costs significantly over the last several years.  Furthermore, the company recently refinanced its debt, pushing out maturities and taking maturity default risk off the table.  Tobacco is a business with generally stable demand attributes.  We like Pete Harrison, Alliance One’s CEO, who did a fine job cleaning-up Standard Commercial, which had been a big winner for our fund in the past.  So we can certainly appreciate why Seth Klarman might like the company.  Of course, it’s always nice to see a deep thinker with a solid record involved in a name we hold, and you could certainly do much worse in life than buying into names that Baupost owns in its portfolio.

Do you ever find small cap companies in bad fiscal shape that might be a good buy and the bonds a good buy or the stocks a short and the bonds a long which might make it a good arbitrage play?

We often run across companies where we are doing our equity work and realize they have a bond trading at an interesting price level.  In fact, it was a series of events such as this that convinced us that managing a fund focusing on high yield corporates would make some sense for us.  While we do not short stocks in any of our funds, we do run across situations from time-to-time where we are comfortable owning the bonds, but would pass on the equity.  The Aegis High Yield Fund gives us an opportunity to capture the value of the work we do in those cases by owning the bonds.

Third Avenue Management just opened a credit fund citing opportunities in the distressed debt, high yield etc market not seen since the early 90s do you see large future gains in these asset classes?

Where we sit today, the high yield corporate markets have experienced a significant amount of spread tightening in the last year.  Interest rates generally, upon which those spreads are based, are also near generational lows.  So I think the market had a very unusual period of incredible performance as high yield liquidity returned.  From this point forward, returns in high yield are almost certain to moderate.  That said, we believe that there is the opportunity for investors to dig up situations, even in today’s more competitive environment, where investors can be well compensated.  Fortunately for us, our asset size allows us to be particularly flexible and opportunistic.

Are you making changes to your portfolio based on the changing economic atmosphere?  How important is the macro environment when it comes to high yield investing?

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Jay Kaplan

Jay Kaplan’s Bio from Roycefunds.com

Jay S. Kaplan, CFA, is a Portfolio Manager and Principal for Royce & Associates, LLC, investment adviser to The Royce Funds.

He serves as Portfolio Manager for Royce Capital Fund—Small-Cap Portfolio, co-manages Royce Value Fund with Whitney George, and Royce Dividend Value Fund with Chuck Royce. He also serves as an Assistant Portfolio Manager of Royce Pennsylvania Mutual Fund and Royce Total Return Fund. He has 20 years of investment industry experience.

Prior to joining Royce & Associates in November 2000, Mr. Kaplan spent 12 years with Prudential Financial, most recently as Managing Director and Portfolio Manager of the Prudential Small Company Value Fund.

He holds a bachelor’s degree from the State University of New York at Binghamton and earned a Master of Business Administration degree from New York University.

Value investing is contrary to human nature, how did you get started in value investing? Also on a similar note there are many different schools of value investing, which school would you say you adhere to the most? Who has had the greatest influence on your investment philosophy?

I am not really sure that it’s contrary to human nature. Everyone likes to buy stuff on sale and nobody likes to pay full price. From that perspective, value investing is not contrary to human nature at all. Buying a good asset at a discount is something that everyone can relate to.

I started out as a credit analyst. There are really two ways you can look at credit. You can look at assets or you can look at cash flow and how a company meets its financial obligations. So you’re looking at stress testing and the volatility of cash flows, and how bad things could be before a company can’t pay its bills.

Applying that to stocks, it’s like looking at a margin of safety. It is about how bad things can get before you lose money. My core philosophy is that if I buy stocks where expectations are low to non-existent, and those expectations are met, I probably won’t lose money. And if those expectations are exceeded, there could be a nice upside.

I also adhere to Royce’s core principles, which consist of finding companies with pristine balance sheets, high returns on capital and buying them at attractive prices. However, my core approach comes from my experience as a credit analyst and buying stocks based on cash flows.

I was also a junk bond analyst for a few years, which gave me a good fundamental underpinning for my current value approach. My core focus on credit and cash flows have had the largest impact on me.

What does a typical day look like?

There really is no typical day. There is a typical start of the day, which consists of waking up early and commuting. We check positions and prices and more often than not the news dictates what the rest of the day will be. If the day does not contain much news, we will focus on looking into new holdings. If the day is full of news, then it could be a day of maintenance.

During the course of the day, there are usually meetings with management teams, often several of them. There are client meetings, though we have less here than at other firms. We spend more time managing money.

So the early part of each day is pretty similar, but the second part of the day you never know. That is one thing that makes the job so fascinating. You don’t know what each day will bring.

Several of your funds are run with other portfolio managers; do you all have to reach a unanimous decision before buying or selling a stock?

We don’t always reach unanimous decisions. Some Funds are set up differently. We tend to take larger positions in companies in which there is widespread agreement and smaller positions when there is less of a consensus.

You co-manage several funds with Charles Royce, are you ever able to convince your boss of your convictions when he does not agree with you initially? There are times where he’ll ask me, “Why are you buying or selling XYX Company?” and I will tell him why, and then he will go and make his own decision. In many organizations, the object of the game is to convince someone senior to you to do what you want. That is not how we operate. When Chuck sees something, he will ask about it, not to tell me not to do it, but rather to see if I want to do to it. I will tell him what I think and then he will do what he thinks. Sometimes he agrees, and sometimes he doesn’t agree. Everyone is entitled to his opinion here.

Since all Royce Funds are diversified how are you able to keep track of so many securities?

As a firm, we are very focused on the small-cap market. So we know a lot about lots of small-cap securities. The managers here also tend to be very experienced. We usually don’t hire people right out of college on our investment staff. Most of the people come with significant experience and know a lot of companies. So when you have been doing it long enough, you are able to keep track of a lot of companies.

Most companies’ fundamentals don’t change very much. When companies do change materially, that is what you focus on. It is the 80/20 rule; you spend 80% of your time on 20% of the names because a lot of things do not change much in a short amount of time.

How do you manage risk?

First, let me tell you how we define risk. A lot of people define risk as the amount your portfolio deviates from an index. We do not think of risk in that way. We think about risk as not losing money. We hate losing money.

So we like to think about our performance in terms of risk adjusted terms relative to an index. With that in mind, we run diversified portfolios because there is a lot more risk in small-cap companies. Another core component of our philosophy is that we invest in companies that have very strong balance sheets, which we think provides good protection against the company going to zero.

You know, when you’re a value investor you invariably run into problems, whether it’s an industry problem, a company-specific problem or something else. When we see companies at what we think is a good price, the company usually has problems. So between diversification and buying companies with strong balance sheets, we try to manage risk.

Do you ever meet with management?

All the time. With small companies, we meet with the most senior people and discuss strategy and any issues in the company. We like continuity of message and we want people who do what they said they were going to do. This is very important to us. If they tell us they are going to do xyz, and we meet with them six months later and they have not done xyz, that makes us uncomfortable.

How do you go about finding stocks? Do you look at the 52 week low list? Do you use a screener for stocks with high dividends and low payout ratios?

I do not look at 52-week lows, or high dividends or low payout ratios. I screen based on balance sheets, return on capital and valuation. In valuation, we look at operating income instead of P/Es.

We also meet with companies, as I mentioned earlier, and we watch news flows. Most small-caps are relatively less liquid, but when there is news they tend to become very liquid for a short period of time. Because of our knowledge of companies, we are good at acting on news. But at the end of the day, it comes back to those three principles: balance sheets, return on capital and valuation.

One argument for buying stocks with dividends is that a dividend will cushion a stock’s fall as bargain hunters see an attractive yield and start buying the stocks. After the peak of the financial crisis where many companies dramatically lowered or eliminated their dividends do you think this argument still holds weight? Or do you see the events of the past few years as an anomaly unlikely to repeat itself anytime in the near future?

As we saw in late 2008 and early 2009, it’s tough for any stock to be fully cushioned in a financial crisis. However, most companies that we owned are now back in good financial shape and didn’t experience dramatic dividend declines.

In our funds that have a dividend-paying component, we don’t chase high dividends. We think about dividends as part of the menu of items in a company’s capital allocation toolkit. There are a few things a company can do with its free cash flow: they can reinvest it in the company, they can do mergers and acquisitions, they can pay down debt if they have it, they can buy back stock, or they can pay dividends.

So when we look at dividends, we frame it in the context of what is the best risk-adjusted use of capital for the company—could giving some of the money back be part of that? If you do not have a good way to use that money, maybe you should give it back.

When companies decide to pay a dividend, we see that as a commitment on their part. Companies almost never want to cut or eliminate dividends. I see dividends as more like a marriage than a date. It is easier to break up when you are dating than after you’re married. So when a company decides to pay a dividend, it is using one of its capital allocation tools.<

If we just chased the highest dividends, it would probably lead us to companies under stress where the market doesn’t believe those dividends are sustainable, which would set us up for those dividends to be cut. Or it leads you into Master Limited Partnerships, REIT’s or Utilities, which are areas we tend to avoid, because, those companies often don’t meet our balance sheet and return on capital criteria. So we don’t hunt for the highest paying dividends we can find.

I think dividends are good capital allocation tools, and are a sign of good discipline. This tends to lead me to more mature companies. Most of our dividend-paying stocks tend to be even more conservatively managed than many of our other stocks because the companies tend to be more mature.

With interest rates at record low levels do you think stocks that pay dividends are even more important?

No, but it is nice to get a better yield. But I am not sure it is a factor for us. We are really trying to find good investments—and if it has a dividend that is a plus. If you look at the small-cap universe (and it’s also true for large-cap companies) during the rally that began in March 2009, stocks that don’t pay dividends have significantly outperformed stocks that do. In general, we think companies that pay dividends are higher quality, and the rally has so far been led by low-quality stocks. Hopefully in the next phase of the bull market (whenever that is), higher quality, dividend-paying stocks will outperform.

I have seen studies that show that on an after tax basis dividend stocks barely outperform non-dividend stocks? Do you believe these studies are flawed? If not, do you think dividend stocks are best to hold in a tax-free account?

I have not seen the studies, so I can’t comment on it. All things being equal, it may be better to hold taxable income-producing securities in a tax-free account.

Large cap stocks are usually more able to withstand economic downturns without eliminating or decreasing their dividends. How do you ensure when you buy small-cap stocks that the company can keep paying the dividends and increasing them in the future?

We can never be sure. There are no guarantees, and there’s always risk. For us, it always goes back to good balance sheets, good free cash flow generation, and high returns on capital. We think these things give us a margin of safety. These things also mean the company has a good chance of being able to keep paying the dividend.

We understand that when times get tough, it sometimes makes sense to cut the dividend. For us, it is all about capital allocation management. And if you think about it, when people give us money to manage they are giving us capital to allocate. When we invest that money in stocks, we are entrusting the companies to allocate that money well. The whole dividend question is really about efficient capital allocation.

Small-caps have outperformed large-caps this past decade. Do you believe there will be a reversion to the mean, and large-caps will outperform small-caps in this next decade?

I can’t predict what will happen over the next ten years. But if history is any indication, small-caps have outperformed over very long periods of time and there is no reason to expect that to change. There are cycles, of course. Small-caps have had a pretty good run. But when you come out of recessions, small-caps tend to do very well, so maybe this is not out of the ordinary.

If I knew what the future would be, I could just retire. Everyone in this business tries to prognosticate—half will be right and half will be wrong. We come in every day and look at our portfolio and look at the market and try to get a good risk-reward return, and we hope to deliver long-term satisfactory results. Sometimes large-cap does better and sometimes small-cap does better. Right now, small-caps are outperforming. Will that continue? I am not sure.

One argument for buying stocks with dividends is that a dividend will cushion a stock’s fall as bargain hunters see an attractive yield and start buying the stocks. After the peak of the financial crisis where many companies dramatically lowered or eliminated their dividends do you think this argument still holds weight? Or do you see the events of the past few years as an anomaly unlikely to repeat itself anytime in the near future?

As we saw in late 2008 and early 2009, it’s tough for any stock to be fully cushioned in a financial crisis. However, most companies that we owned are now back in good financial shape and didn’t experience dramatic dividend declines.

In our funds that have a dividend-paying component, we don’t chase high dividends. We think about dividends as part of the menu of items in a company’s capital allocation toolkit. There are a few things a company can do with its free cash flow: they can reinvest it in the company, they can do mergers and acquisitions, they can pay down debt if they have it, they can buy back stock, or they can pay dividends.

So when we look at dividends, we frame it in the context of what is the best risk-adjusted use of capital for the company—could giving some of the money back be part of that? If you do not have a good way to use that money, maybe you should give it back.

When companies decide to pay a dividend, we see that as a commitment on their part. Companies almost never want to cut or eliminate dividends. I see dividends as more like a marriage than a date. It is easier to break up when you are dating than after you’re married. So when a company decides to pay a dividend, it is using one of its capital allocation tools.

If we just chased the highest dividends, it would probably lead us to companies under stress where the market doesn’t believe those dividends are sustainable, which would set us up for those dividends to be cut. Or it leads you into Master Limited Partnerships, REIT’s or Utilities, which are areas we tend to avoid, because, those companies often don’t meet our balance sheet and return on capital criteria. So we don’t hunt for the highest paying dividends we can find.

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