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   Interview

    Guest Interview:

   First Wilshire Securities Mgt.

    1214 E. Green St., Suite 104
    Pasadena,CA 91106

    Telephone: (800) 858-0679
    Fax: (626) 796-8990
    E-mail: info@firstwilshire.com

 

    Interview Quarter: 3Q2012

 Fred Astman, Chairman

 Scott Hood, CEO

  Who is the founder of First Wilshire and what is his/her investment background.  
  Fred Astman founded First Wilshire in the late 1970’s. Fred has been in the investment business since he began as a broker in 1961 and now serves as our Chairman. Previously, Fred worked in finance and managerial positions with a large consumer food products company and later with a large aerospace firm. Fred laid the foundations of our value-based investment strategy, which over the years has attracted like-minded professionals. Scott Hood joined First Wilshire in 1993 and now serves as our CEO. Scott previously worked for Merrill Lynch and a boutique small-cap investment bank in New York and Hong Kong. He is a CFA. Together, Fred and Scott make the final decisions on the portfolio as a team with our highly experienced analysts. 
  What are your guiding investment principles?  
  First Wilshire was founded on a value investing philosophy and has attracted other value investors who have added greatly to our perspective and abilities. Although we have refined our methods over the years, the guiding principles have remained the same. First Wilshire seeks to buy stocks trading at discounts to their intrinsic value. This is essentially buying stocks at low price-to-earnings and price-to-free-cash-flow ratios with strong balance sheets. We seek growth without having to pay a premium. The intrinsic value of the company relative to its current price guides our decision.  
  What were the major influences that led to your current investment strategy?  
  We believe that you are either a value investor or you are not. A true value investor is someone who has a keen eye for value and is repelled by waste in all facets of everyday life. Some people were born with it, some may have lived through a difficult economic time, but for whatever reason, they have an innate ability to approach investments in a sober way and pay great attention to risks. This ability keeps them from going off-course. With this foundation in mind, there are some notable investors and business managers who have influenced all of us. Of course, Buffett, Munger, Graham, and Peter Lynch have had their influence on us. As well, the thousands of companies and management teams we have studied over the years have taught us valuable lessons that we incorporated into our investment strategy.  
  Why did you decide to concentrate on the small cap market sector?  
  The main reason why we focus on small- and even micro-cap stocks is that there are simply more of them to choose from and they are less followed by other investment professionals, thus creating more opportunities to find bargains. More choices, less competition. We will consider larger companies, but only when we feel we have an information advantage or sentiment is very out of line with the financial reality of the company. Over the years the number of analysts following smaller companies has greatly decreased. The amount of funds and the number of money managers investing in smaller companies have decreased also. Out of 10,000 or so public companies in the U.S., over 8,000 of them are small- and micro-cap. Small caps are sometimes associated with new, money-losing, fly-by-night companies. There is some of that, but people don’t realize that many are leaders in their niches, operating for decades with huge competitive advantages and growth prospects. As an analyst, we also have access to top management and facilities, which sometimes is not possible for large companies. Apart from these obvious advantages, we think it is far more intellectually stimulating and allows for a life time of learning because the variety of businesses is almost limitless.  
  What investment advantages are there to buying small cap stocks compared to larger, more established companies?  
  Aside from the advantages of having a much larger pool of companies to investigate and less competition from other investors, small companies have the ability to grow much faster. It is very hard for a large company to double revenues in the short term since they often operate in many geographies already and dominate their markets. They are more likely to grow at levels bound by the overall economic growth. We see small companies that grow revenues at high levels all the time. It doesn’t mean they are good investments, but it does mean that growth can be much higher in small companies. Another factor is that companies in emerging areas of the economy start out small. Also, small companies can adjust their strategy more easily than large companies can. Large companies are often less nimble and more entrenched in their past. Of course, large companies are generally stronger with better access to capital and advantages in scale, but small, nimble companies are where future growth will come from.  
  How do you define “value” investing?  
  Value investing is generally considered buying stocks that trade at lower multiples of earnings and cash flows than the general market does or that trade below their book or replacement values. Value investing has outperformed growth investing over the long term and we are not surprised by this. In the case of growth stocks, there is a high expectation of growth built into the price. When people think something is “hot”, they’re almost willing to pay any price. And if these companies ever miss their numbers, they often get slammed by the market. And we find that this eventually happens. As for value stocks, there is very little expectation built in for growth so when growth ticks up even a little bit, investors adjust their expectation and assign multiples accordingly. Of course, we look for a growth component just as the growth investors do, but we’d like to pay “value” prices.

The question of how to define value investing is a good one since all investors would consider themselves value investors to the extent that they think they are buying stocks for less than what they are worth. But interestingly, many investors actually don’t care about or don’t know how to assess the “value” of the businesses. Many buy or sell simply because stocks have been going up or down. We’ve seen that many times during bubbles and crashes. People rush in or hesitate to commit capital because they’re trying to guess what others will do in the short term. That creates opportunities for us. Some investors may buy or sell certain companies in order to mimic an index, not based on value. Some buy or sell because that’s what the clients want them to do, like during the tech bubble. We try not to get caught up in crazes or buy into certain sectors because that’s what the clients want – That’s a very important distinction of what we do. So yes, theoretically nobody wants to buy stocks for more than they’re worth, but in reality, people do that all the time.
 
  Your selection criteria can broadly be categorized as Growth at a Discount, Deep Value/Pricing Inefficiencies and Turnaround Situations. Please give us an explanation for each.  
  “Growth at a discount” is the main component in constructing our portfolio. These are stocks that are value stocks by all measurements but also have respectable growth in them. This is not paying 30 times earnings for a 40% grower, but more like paying 10 times earnings for a 20% grower. “Deep value and pricing inefficiencies” are companies that may be trading below cash or way below the liquidation value of the company. We would focus on their historical and estimated cash flows and make sure they don’t burn through their cash, as is often the case for companies trading at such deep discount. This is a small portion of our portfolio. These stocks surprisingly are out there and we work hard to track them down.

The last area is turnaround situations. There are companies that have fallen on hard times for various reasons and the stock price has been clobbered. At this point, investors have sold them off and analysts have stopped following them. When others have written them off, it may present an opportunity if we do our homework. Very often they are cheap for good reasons but occasionally we find some that trade at unjustifiably low valuations because their turnaround efforts haven’t been noticed by other investors. If the numbers look good we will likely start with a small position. This is also the area where the most volatility can be introduced into our portfolio because there are often other shoes to drop and valuing a company in this much flux is very difficult.
 
  Please give us an overview of your research process?  
  Our research process is very time consuming and we would call it “blue collar”. All of our research is done in-house and our universe of companies is very large, so a lot of work goes into finding and following companies. We call it blue collar because it is real, on-site, hands-on research. An analyst needs to know why customers choose their products and service, why some customers don’t pay their bills, who the suppliers are, what the competitive advantages are, and many other questions that don’t get answered by reading at a computer terminal. We have kept a database of our research for well over 10 years that includes our past research, interviews, and even pictures and videos from our on-site visits. Once a company is screened out for the numerical characteristics we look for, it is evaluated to make sure that the numbers are real and the business in general looks good. The real work begins at this point. We talk to management and competitors and most often this leads us to other areas that need to be addressed, much like an auditor or detective. We are confirming not only that it is a good business with improving prospects but also that the management team has integrity and competency. If a company makes it into our portfolio, it is continuously followed by our analysts and reviewed frequently by our investment committee. There is a minimum requirement of reevaluation every quarter and interviews with management if need be. We want to know the situations better than everyone else. This takes an enormous amount of effort, but that is what is required to do better than the market over time.  
  What are you looking for when using your investment screens?  
  In the most basic framework, we look for companies trading at low price-to-earnings ratios with a strong balance sheet and a bias to growth. Cash flow is very important and must be as strong as earnings unless for good reasons. Our screens have become more sophisticated over the years and even more “inclusive”. Simply screening for low P/Es is not enough. By “inclusive”, we mean that in creating a first group of companies to evaluate, we may be more lax in letting through companies with short-term earnings problems, for example. Otherwise, you may end up excluding companies that had one time charge-offs or are in the midst of a successful turnaround. An example of a more inclusive screen is to look at companies that are trading at low valuations to normalized earnings. Our research team tries to identify industries that are poised for a strong recovery or accelerated growth and then looks at all the companies in the group. Other less straightforward screens we have done in the past include those companies with significant insider stock purchases, high R&D to earnings, spin-offs, and exposure to certain geographies or sectors that we feel are under-followed. Screening is a creative and evolving process that requires constant tinkering.  
  Is all your investment research done internally or do you use other sources?  
  We strongly believe in doing all of our research internally, although we utilize various sources of raw data. Once an idea has been discovered and reported on by others, it is most likely too late to invest. To be honest, we also don’t put weight in the opinion of outside analysts. This is not to say that they are not very smart and knowledgeable; it is just that we cannot use their opinions in our decision-making process, except perhaps to help understand the consensus view and gain industry knowledge. They are more short-term oriented while we take a long-term view. They also tend to follow one another. We might take a closer look at a stock that has low ratings from analysts (rather than high ratings) because it could be oversold. We believe that the best way to beat the market is to have more and different information than others, which means no shortcuts. You have to keep studying industries, visit companies, and reflect on what went right or wrong, particularly on what went wrong. It is very important to understand your companies well so that when the market is acting irrationally, you have the conviction in the business and its ability to generate earnings and not to be caught up with the short-term mood swings of others.  
  How well do you know the companies that you buy? Do you ever visit them, get to know the management, their products and operations firsthand?  
  We hope to know the companies very well and to visit all of them. In the last month our analysts have visited over twenty-five companies. This is laborious but is one of the best aspects of our job because we are all very curious people who appreciate the importance of having access to management teams and their facilities. The financial statements, filings, and industry trends come to life when you understand the products and how they are made, marketed, and distributed.  
  Can you give me a breakdown by priority of the top 5 most important characteristics that you favor in a small cap company?  
  There are many important characteristics, but I will list five of the most important. They apply to companies of any size. First, the stock price has to be low relative to earnings, cash flows and book value. Second, we greatly favor companies with growth prospects. Although value investing is often associated with slow growth, we have found over the years that you can actually have both value price and growth if you look hard enough. Third, the balance sheet should be strong and the cycle of cash collection should be favorable. They can keep the doors open if they should go through a long bad cycle. Fourth, we want a business that has proven itself over time and is not based on a single, possibly obsolescent, or temporarily hot product. If small caps get a bad name, it is mostly due to them being the launching pad for a single product, which then gets leapfrogged by competitors or falls out of favor with consumers. Lastly, a good management team is very important. We look for such things as integrity, longevity and an ability to deal with adversity. This is deeply important to us and often a deal breaker. No matter how good a business might be, poor management will find a way to mess things up.  
  What do you mean when you call yourself “bottom-up” investors?  
  We screen for and do research on individual companies and our portfolio is made up of our best researched ideas. We don’t care if the portfolio ends up being very different from any particular index. Of course, we utilize our estimates of macro factors in modeling the earnings of the company or assessing risk, but we do not construct a portfolio beginning with this bias. Top down, as we see it, is trying to outsmart the world over where the economy is going or what politicians will do. There is a strong tendency by investment managers to have very similar sector allocations in their portfolio as their benchmarks and then make small changes around them.  
  How do you control volatility and downside risk?  
  The best way to control volatility is by being properly diversified in cheap stocks. History has shown that a high-priced stock with high growth that gives the slightest hint of slowdown can be absolutely slammed. A low-priced stock tends not to have much positive expectation built into it but if it does have an uptick in growth, shareholders can be greatly rewarded. Volatility can be a challenge for clients during market weakness since smaller stocks can drop more due to having lower volume, regardless of how strong their underlying operations are. We had companies drop more than half during the financial crisis while still growing their revenues and earnings. Therefore, it is important to hang on during these periods.  
  How many companies do you typically own and do you have a maximum percentage to limit your exposure?  
  We typically hold thirty-five to fifty securities in a portfolio with a maximum percentage up to 10% in a single issue. Initial positions are usually in the 1-2% range and then we may build it up to 4% as we gain even more knowledge and confidence. When something grows above 10% of our portfolio, we normally start to trim it back, no matter how much we like it.  
  Do you keep your portfolios diversified by sectors and how does that work?  
  Diversification by sector is considered, but there are also other considerations such as geography, cyclical versus non-cyclical, and even common factors that may impact seemingly unrelated sectors. An example of this was during the real estate bubble, our investment team would always ask how a company we were looking at would be affected by a slowdown in real estate prices or in the availability of cheap funds through equity lines of credit. It may not have seemed obvious at the time but a homebuilder and a company like Harley Davidson began to move together because after people had the nice home, they found that they could get cheap money and buy themselves toys for the garage. Of course, it all came to an end after 2007. The point is that investors need to be creative in how they assess diversification.

Would you give me a short description of those in your investment team and their backgrounds?

Our team is composed of two portfolio managers, Fred Astman and Scott Hood, and six analysts. Our portfolio managers are focused on analyzing companies like our analysts with the additional task of ultimate decision-making. Over the years, our value investing philosophy has attracted similar-minded people who bring along their own set of skills and experience. Gregg Hillman has been with us since the late 1980’s and is a true student of business models and life cycles of companies. Howard Lu brings a strong engineering background and a deep love for value investing, and is our Director of Research making sure our research is done in the most efficient way possible. Bill Caton has been with First Wilshire for nearly fifteen years and works closely with Fred in carrying out our investment decisions using our in-house trading methods. Ben Sexson joins us from Caltech and brings with him entrepreneurial experience and an engineering background. Feliks Zlochistyy is a CPA with degrees in both finance and accounting. Karen Wu has a strong academic background in China and brings perspectives on Chinese markets and industries. The average tenure with First Wilshire is well over ten years. We have language expertise in Mandarin Chinese and Russian, among others. The investment team has academic backgrounds at universities such as Wharton, NYU, UCLA, Peking University, USC and Caltech, and five of us are CFA charterholders. Apart from strong academic backgrounds and experience, the most important characteristic is a deep love for value investing and a competitive drive to find the next great stock.
 
  How does your team work together to discover new investment opportunities?  
  Our formal schedule is to meet twice per week to cover our company news and share our thoughts on the economy, markets or world events. Once per week we meet to go deeper on individual companies or discuss accounting issues or gather ideas on how to conduct more detective work on a new issue. Informally, we meet throughout the day to discuss individual companies and talk to management teams. Usually one or two analysts will work on a new company and present to the portfolio managers and the investment committee. It is this time that we all attempt to focus on the counter thesis on a company. This usually results in further research and phone calls with management and third parties. A decision is finally made to purchase or pass on it. If purchased, one analyst will be assigned to follow the company closely in the years to come.  
  For the past 20 years, your annualized returns are over 17% versus 8.34% for the S&P 500 index. During that period, what were your best and worst investment periods?  
  One of the worst periods for us was during the dot-com boom in the late 90’s. The stocks of companies that made money were almost penalized for making money. Stock prices of companies we owned in 1998 continued to drop into the beginning of 2000 while posting better revenue and earnings. Although we correctly hung on to them and did not jump on the money-losing, trendy stock bandwagon, it was a frustrating time because our investors did not always understand the folly of investing in a bubble and increasingly questioned our strategy. One of the best periods began after the dot-com bubble burst. For the next few years, investors moved their funds into companies that actually made money and our performance benefited simply by our stocks reflecting a fair value. It is amazing to think back and consider all the challenges we have all faced since 2000; we went through 9/11, the Iraq and Afghanistan wars, the real estate bubble and bust, the Arab spring, and the European crisis. I would not want to repeat this period or know what the next 20 years holds, but we have to be ready to protect and grow our client’s hard-earned savings.  
  What are your account minimums, fees and do you offer Wrap programs?  
  Our minimums are $500,000 and our fees are 1.8% per annum. We do not offer a “wrap-fee program” as clients select their broker/custodian and pay commissions directly.  
  How can I find more information about First Wilshire Securities Management?  
  Investors can learn more by going to our web site at www.firstwilshire.com. We are available to answer questions by phone (1-800-858-0679) or email (info@firstwilshire.com) and are always happy to send out a more complete package.  
 
 
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