Where are you finding opportunities for the fund?

I continue to see meaningful upside potential in the stocks of commercial aerospace aftermarket suppliers. These are companies that produce parts and sell them to aircraft producers and airlines. These stocks usually trade at a premium to market multiple when traffic growth bottoms. Interestingly, a number of stocks in this category across the world are trading at a discount despite the fact that global air traffic started to grow in the fourth quarter after experiencing its worst ever decline in 2009.

What is your outlook for these stocks?

In addition to the upside potential, my modeling also suggests that consensus expectations for 2010 and 2011 are low for our top picks. This combination creates a potentially favorable risk/reward profile.

What types of stocks are you finding that best illustrate what is occurring?

Within the commercial aerospace supplier group, I have a favorable view of stocks that have significant earnings leverage to growth in the commercial aerospace aftermarket. I also prefer stocks with non-discretionary content, for example, companies that produce parts that need to be changed based on aircraft usage.

These companies usually have revenues that basically break even from sales to aircraft manufacturers, but realize gains in the long-term as long as the plane remains in service. For example, 25 years is the usual economic life for an airplane, although the physical life could exceed 40 years. For these types of suppliers, earnings are a function of air traffic growth, pricing, and operating leverage.

What are the drivers behind that growth?

The first driver is global air traffic growth, which has averaged around 5% over the past 30 years. The demand for air traffic exhibits income and price sensitivity. Income sensitivity has been most apparent in developing countries where a new, urban middle class is emerging. In addition, in developed markets, a low-cost carrier model that emerged after deregulation also supports traffic growth.

The second driver is pricing. My focus on non-discretionary parts comes into play here. Since it is impossible, or economically unacceptable, to substitute most of these parts, suppliers have long-term visibility. Substitution may result in losing insurance coverage or problems with leasing companies. The other key factor is the ability of the suppliers to increase pricing meaningfully above inflation, or in the 4% to 5% range.

The third driver is time. As an aircraft moves beyond a five-year warranty window, revenues start to grow, with the 10th year being a key inflection point.

What may be the impact of GDP growth?

Obviously after periods of subpar traffic and GDP growth, top line and EPS growth could be much faster. Our analysis identifies multiple stocks on both sides of the Atlantic with meaningful upside to consensus and at a discount.