(BBTEX) into the top 1 percent of the core blend category last year.

         

Your fund was one of the top performers in 2008, despite facing a tough year. What drove that?

Tim: Our investment criteria were a big part of that success. We focus on companies that provide essential products and services to a large, loyal customer base, but whose shares trade at 75 percent or less of our intrinsic value estimate. Some of the companies in which we own large positions–Wal-Mart Stores (NYSE: WMT), for example–were actually up last year in a market that was down dramatically. I think that a number of the companies with the characteristics we value, whether in a recession or in a period of expansion, have businesses that are more resilient and hold up well.

Second, we avoided some of the real problem areas. One of the reasons we did well last year was that we sold all of our bank holdings in 2006. We try to avoid large risks, and our investment team identified the banking sector as particularly vulnerable because of what we felt was a credit bubble; we sold all of the commercial and investment banks that were in the portfolio as well as companies like MBIA (NYSE: MBI) and Ambac (NYSE: ABK). Some of those companies are down as much as 90 percent. We didn’t exit every investment that was hit hard, but we did a good job avoiding the worst performers.

That performance is surprising given the extremely concentrated nature of your portfolio. The prevailing wisdom is to spread your dollars out.

Michael: Although our portfolio appears concentrated relative to other funds, we believe that our target of 25 to 30 holdings diversifies out most company-specific risks. Our investment criteria make us comfortable with our ability to manage risk. With the stocks in our portfolio, we make sure we have good visibility into the drivers and risks those businesses face; we take apart the business and identify risk factors beyond management’s control. We also gauge their exposure to low-probability but high-severity risks that would jeopardize our investment thesis. Bearing those risk controls in mind, we tend to view the relative concentration of our portfolio in a favorable light; we wouldn’t want to be overly diversified and track the indexes too closely.

Tim: Even with 500 companies, the S&P 500 index performed miserably last year; the number of companies in a portfolio doesn’t necessarily reduce price risk–in fact, it may guarantee that you’ll post a loss if the market is overvalued.

What warning signs led you to sell the banks in 2006?

Tim: I won’t claim that we foresaw what has transpired–the severity of the credit difficulties has been far greater than we expected–but we were certainly concerned. We worried about the extremely tight spreads, the lending standards, the leverage taken on in both private equity transactions and securitization. At the time, people questioned why we didn’t own any banks, but that’s part of the bubble mentality.

Have you seen any recent warning signs of a bubble?

Tim: Nothing stands out. We reduced our energy positions in 2007 and 2008 as the prices skyrocketed. I wouldn’t categorize that period as the same kind of bubble, but certainly there was an extraordinary price increase in the energy sector. We try to focus on individual stocks, but we’re very aware of the environment in which our companies operate–our decision to sell banks based on macro concerns is a prime example.

I am concerned about inflation stemming from the aggressive actions taken by the Federal Reserve and monetary authorities around the world; that’s a macro issue that all investors need to think about, albeit over a longer time period. It’s the law of supply and demand applied to the value of money. As the central banks print more money, prices will almost certainly increase. Over time a lot of companies will face pressures on input costs.

Our strategy is to own companies with strong competitive positions that provide essential products and services. These businesses have pricing power and are usually able to maintain their margins. We own a number of companies that, even in the face of declining volumes, are able to increase prices–an advantage that should help them to sustain very strong profit levels over the next decade.

What’s your economic outlook?

Michael: We still see reasons to be cautious. Although there’s some evidence that the economy is bottoming or picking up, the fact remains that there’s still considerable unemployment, relatively low industrial production and subpar GDP numbers. The lack of credit growth, if nothing else, suggests that the economy is limping along, and we think that could easily be the case for the rest of the year.

To account for this outlook, we look at multiyear time horizons when we’re evaluating companies and modeling their expected performance. At the same time, we strive to be in tune with what’s happening in the near term and how our companies will fare through the downturn. We’re paying close attention to debt covenants and balance sheet issues.

We’re confident that the companies we hold will survive the recession, but we’re especially focused on firms that will emerge stronger because they’re consolidating market share and improving efficiency. We think that companies that are established market leaders are uniquely positioned to take advantage of what we’ve been referring to as a Darwinian environment.

Tim: But we don’t base our economic analysis on government statistics. Instead we focus on anecdotal comments from the businesses that we own or are evaluating. Either way the data is weak.

What are some of your favorite holdings right now?

Tim: One company in which we have a great deal of conviction is W.W. Grainger (NYSE: GWW), the leading industrial distributor of maintenance repair and operations equipment to industrial America. In April, its sales were down 13 percent year-over-year. That was 1 percent better than March, when sales were down 14 percent. Perhaps that’s a sign that the decline is flattening, but those results are still lackluster. And if you break the numbers down even further, you’ll find that government sales held steady but the heavy manufacturing segment was down 30 percent–a huge decline and not exactly out of the ordinary these days.

Some of our retail holdings such as Wal-Mart, Costco (NSDQ: COST) and Walgreen Company (NYSE: WAG) are doing quite well and posting fairly strong sales numbers despite the weak environment. Many retailers are reporting that buying activity tends to pick up during pay cycles as opposed to being distributed more evenly throughout the month–another sign that the consumer is in distress.

For investors, it’s important to separate what’s happening in the economy from the value of a particular business; just because there’s a weak economy, that doesn’t mean you shouldn’t own equities. In fact, in our case, we believe there are a number of businesses whose stock prices fully reflect the current challenges and whose long-term outlook is very good.

As we mentioned before, we try to avoid exposure to potentially severe risks that are outside management’s control. The health care sector faces huge potential regulatory and reimbursement risk, but we’ve found businesses that aren’t affected by these concerns.

DENTSPLY International (NSDQ: XRAY), which we added at the end of last year, had been on our wish list for a long time but usually traded above our target entry price. The leading provider of dental consumables, the company operates in a market where government reimbursement levels are quite low, especially in the US. That limits the impact from potential reimbursement cutbacks being contemplated in Washington. And an aging population in the developed world and rapidly growing middle class in developing nations offer plenty of growth potential both domestically and overseas.