We wouldn’t be happy to simply buy a company that is growing earnings at 11%, trading on only a 12 times P/E, but has no catalyst. When we buy stocks, there’s always an expectation that the company can grow a bit faster than the market expects and this will act as a positive catalyst for the share price.

Q: Could you tell us more about your research process?

A: We like to identify good quality companies that are attractively valued and with a positive earnings catalyst that’s driven by an underlying fundamental change in the business. Those catalysts come usually from an improvement of the sales, cash flow, or the margins. We believe this would potentially lead to earnings revisions and would lead analysts to reassess their fundamental view of the company and its earnings capacity, therefore driving the stock price higher.

To identify these investment opportunities we use both quantitative and fundamental research. We have a proprietary quantitative model that we have built and refined over the years. Many of the things already mentioned, the earnings growth, the acceleration and the quality of the earnings, the valuation go into this model. It isn’t a tool that gives definite universal statements, but our earnings and valuation models help us rate companies in their sector or country and suggest where we might find interesting opportunities.

After the quantitative analysis, we begin fundamental research on the companies that appear most interesting. We evaluate their business prospects, the drivers of the earnings, their quality and sustainability and the overall fundamentals. We’re seeking companies where we have high conviction that they are growing, have earnings acceleration, good quality returns, and reasonable valuations.

We look through financial statements, company news and any related news that may affect the industry or the sector. We also use third-party forensic accounting services that highlight some of the companies’ accounting issues.

We talk to and read research from global and local analysts. Their earnings estimates are part of the process that we take into consideration. We also talk to company management, either on research trips to Europe, at conferences in the U.S. or on conference calls. A high comfort level with management is particularly important with small- and mid-cap companies given these tend to be more reliant on the abilities of a smaller “bench”.

Q: Being such a diversified fund in terms of cultures, economies, growth levels, and accounting standards, do you apply a normalization to the earnings?

A: Europe has gone through the process of trying to adopt a common standard.We are not quite there yet, but over the last number of years accounting standards have become more and more similar throughout Europe. By the second half of this year, companies need to report in International Financial Reporting Standards, the European accounting standard. This doesn’t mean that you can compare all companies against each other, because there is still a lot of flexibility, but the accounting standard is becoming much more uniform.

Our way of comparing companies across borders is looking at cash flow return on invested capital instead of at the earnings. Cash flow cannot be manipulated as easily as the earnings. The numbers also need to be adjusted for the inflation in the different countries. Once we’ve done that, we can compare returns on a better basis than in the past. It gives us a good idea of the quality of the returns and enables us to actually compare across sectors and across time, which is clearly very useful. And when you do your general DCF (discounted cash flow) analysis, you can then adjust your assumptions for future returns.

Q: Can you give us examples of stocks that have worked well for you through your research process in the past and examples of stocks that have not worked well?

A: Vinci S.A. in France, is one of Europe’s largest construction and engineering companies and we’ve owned the stock since late 2003. It’s a quality company with cash flow return on invested capital of over 10% compared to cost of capital of under 5%. It was also attractively valued and not expensive at about nine times earnings. The earnings catalyst for us came in late 2003, when the company reported very strong sales and order numbers. It didn’t immediately lead to higher earnings growth expectations, but for us that was the key sign of faster growth and improving underlying business fundamentals. This was validated shortly thereafter, in February 2004, when they reported fourth quarter earnings that significantly beat earnings expectations. The stock has done well. When we bought it, the stock was about $60 and now it’s nearly doubled to over $110. Ryanair (RYA.I) is a good example of a successful sale that we made. This Irish company is considered by some to be the Southwest Airlines (LUV) of Europe. We bought the stock in 1997 on the IPO and it was a very successful story. The market valued the company fairly aggressively because of its previous success, but the competitive arena became tougher as several other competitors launched similar low-cost airlines in Europe.

Ryanair were very aggressive, cutting prices and simultaneously expanded into many new European markets and destinations. That combination led to erosion of the returns and passenger yields for their planes. We concluded that this erosion would probably lead to future earnings being worse than expected. Consequently, we sold the stock in mid-2003 and saw a profit warning and significant negative earnings downgrades in early 2004.

In terms of cases where the strategy may not have worked quite so well, it has tended to be in more cyclical sectors, or sectors where the cycle is quicker. In such cases it's rarer for us to get advance warning that business fundamentals are starting to deteriorate.