(POPFX), which launched in September 2007 and managed to finish 2008 in the top 2 percent of mid-cap value funds. He describes the strategy behind this success and explains why he’s surprisingly bullish on two hard-hit sectors.     

Your fund turned in a solid performance despite a tough year. How did you do that?

What distinguishes us from other investors is that we’re value investors, but don’t put as much emphasis on low price-to-earnings. We focus on one of two things: private market value (assets that we feel are trading at a discount) or, more generally, free cash flow. A lot of what we do is driven by free cash-flow yield as well as the sustainability of that free cash flow and the ability of companies to finance their growth internally.

History is a great guide in terms of the sustainability of a company’s free cash flow, but we also estimate what future cash flows will look like. This approach tends to lead us into industries that are far more predictable than others–for example, consumer staples where the range of revenue outcomes is far narrower than at a consumer cyclical company. If a restaurant company does a lot of franchising and takes a percentage off the top, its revenues will usually be much more predictable than a company that owns all of its locations.

Of course, it also depends on what a restaurant is selling. In difficult economic times, customers might be less inclined to eat at Cheesecake Factory (NSDQ: CAKE) than McDonald’s (NYSE: MCD); both are fine companies, but a meal at McDonald’s costs far less than a meal at Cheesecake Factory. That’s one aspect we’re examining these days–whether a company offers value-oriented products. Such an approach tends to limit exposure to cyclical businesses.

Pasta is another example. Are people going to differentiate between brands, or is this a product where consumers will say, “If I can save 60 cents and can’t tell the difference, do I really care?” We look for companies that have strong brand recognition and loyal customers; sales at these firms tend to hold up in a difficult economy.

Your portfolio holds a number of financials. How sustainable are those cash flows?

Banks and insurance companies are really capital businesses, so the banks and insurance companies that we own tend to be overcapitalized relative to regulatory standards. Our investment decisions are based primarily on the amount of capital that they have as opposed to cash flows because the latter is, in many respects, an incalculable number. A property and casualty (P&C) insurance company can show phenomenal cash flows because they wrote a bunch of premiums on claims that won’t be settled for 10 years. But that’s irrelevant if those contracts are poorly underwritten; the cash flows this year aren’t going to do a lot of good if the growth isn’t sustained and all of a sudden the claims hit.

On that theme, if you look at Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC) or Citigroup (NYSE: C), their equity relative to assets is a low single-digit number, between 2 and 3 percent. The average percentage for our group of banks is in the double digits, more than double the average of the major banks. We tend to own smaller institutions that are overcapitalized. Many of them trade at discounts to book value and are buying back stock. It’s the complete opposite of what’s going on with the big banks. The other thing that we don’t like at a lot of the bigger banks is that their loans aren’t marked to market very well–in fact, they’re not marked to market at all. Relative to the large banks we prefer broker-dealers that are marking their assets to market. The big dichotomy is that many of the broker-dealers have securities that mimic loans they’ve marked at 30- to 60-cents on the dollar. Meanwhile, the banks are carrying similar fare at 90 cents on the dollar. There’s a huge gap there, which doesn’t give us a lot of comfort.

The majority of our investments are in companies with market caps below $15 million, so the big banks are out of our universe. But many of them got awfully close to becoming small- and mid-cap names.

What’s your assessment of the current market environment?

Our view is that we’ve had a very big run; we wouldn’t be surprised if we see somewhat of a pullback, but we maintain a fairly positive outlook. The market needs to broaden out to make this a real rally, and we think that will happen.

What sectors look the most appealing right now?

We also think that inflation is the next logical step. There have been lots of good data points out there on housing, really good cost controls, pretty good earnings and a lot of good data flowing out of China. We have exposure to several sectors that we think will run up as inflation becomes a more pressing issue. Resource names are part of this strategy; gold mining companies account for 7 percent of the portfolio, and we have a fair amount of energy exposure. We also have exposure to technology, a productive capital asset that should play well.

We like consumer staples, health care and utilities. I would throw P&C insurers in there too. A lot of the insurance companies hold assets that have increased in price, whether its equities or bonds, and the fundamentals are improving. We think that improvement will continue as the year progresses.

We think there are a lot of really bullish signs for the housing market. Interest rates on 30-year mortgages are below 5 percent, their lowest level in a long time. That’s done a world of good in terms of reducing excess inventories. The four major markets in California, for example, have seen sales pick up by more than 50 percent; inventories on a year-over-year basis have been cleaned out to the point where in many markets they’re below seven months of supply. That’s a significant decline.

A lot of that’s because inventory hasn’t been moving in, prices have been marked down to the point where people are buying, and affordability has risen dramatically. The national affordability indexes are at the highest level in 20 years; if you look at the long-term data, the numbers have reverted almost to the long-term averages. I think we’ll see some stability in housing prices and wouldn’t be surprised if home values begin to tick up over the next 12 to 18 months.

Given our outlook, we’ve built positions in a few homebuilders. The interesting thing about the homebuilders is there’s this common conception that these companies have been losing money and taking massive write-offs. But there are many companies whose cash balances have actually gone up over the past year–and that’s in one of the worst housing markets imaginable. These companies have bled down inventories and are evaluating which markets to target. Many of them are well positioned and under levered, plus they’re way off their highs and have reported fairly decent results. Florida and Nevada still have some issues, but you can find companies that are less exposed to those markets.

We also like insurance. Rates are already starting to tick up, and some key renewal dates are coming up. We think prices are going to lift fairly significantly between the January 1 renewals and the mid-year renewals. At the beginning of the year rates were up by about 10 percent. A lot of the Florida programs renew in June and July. We’re biased towards the companies that are sort of laying back and being opportunistic with their capital.

One of our biggest holdings is a company called Platinum Underwriters (NYSE: PTP), a reinsurance company based in Bermuda that’s an active buyer of its stock and just announced a fresh buyback program. The company trades at a 15 percent discount to book value, which it adds to every time it buys back stock. It doesn’t have a lot of exposure to equities or hedge funds and holds an extremely high quality fixed-income portfolio; it’s a pure play on improving prices and an uptick in demand for reinsurance. And management has been shifting their book towards writing more property insurance. If I’m correct and prices increase, you’ll see them pick up their writings as the year progresses. The company has a really strong management team and a strong capital position.