Q: What is the history of your fund?

A: I began managing the Small Cap on Sept. 2, 1992, so we are real close to our eleventh anniversary. This was an existing mutual fund that we bought, so we have had this for quite a while. The goal that we have over time is to generate better returns with lower volatility than that of the Russell 2000. Our goal is to put together a blend of growth and value that is a durable all-weather blend. In theory, the small-cap value core gives you a little lower volatility and a little bit of a protective level in a negative market. Technically, if you look over the last eleven years, in periods of negative returns we generally pick up reasonable amount of ground. But, yes, we have growth stocks in the portfolio as well, so that we have a reasonable performance in an up cycle and the results have been quite good over the last eleven years.

Where we don’t fare well, is if a single style is in favor. If you go back to the Internet period, it was a huge emerging growth type of market and the most speculative one, too. At such point in time, we are not going to keep up in a huge up-cycle for emerging growth stocks, because we are a blend – growth and value. So, we lost ground in the 1999 and early 2000, but made it all back, when results went the other way.

Q: How is your portfolio structured?

A: The portfolio is pretty broadly diversified. We have over 250 names in it. Because it is a blend of growth and value, it is spread out across the small cap universe and we are pretty broadly representative. We are not slaves to the index, we are aware of where the overweight is on a relative basis.

Q: What is your investment process?

A: I manage this process through fundamental research. We have the whole resources of T. Rowe Price to help us do this. We have 44 analysts and 15 associate analysts around the world that comprise the research effort in T. Rowe Price. And all the domestic analysts generally have some input into this portfolio. We get together in meetings on Monday mornings for the whole small-cap area: a “growth” meeting at 8:30 in the morning, then we have a “small value” meeting at 11:30 to look at what has happened in the portfolio, where are the new ideas, what are we buying, what are we selling, what do we see occurring out there. It’s the analyst’s job to come to me with good ideas and that is really where we get the bulk of our ideas. We probably see more than 1,000 companies a year at T. Rowe Price, though it is the analysts that are out there knocking on doors and hosting meetings and going to visit companies and looking at things that really gives us the input that we need to build the portfolio.

It is an informal collaborative process that we have, where we get together and talk about ideas on a daily basis. The doors are open – people are walking in and out coming up with ideas that they think will peak my interest. For example, we talked about Consolidated Graphics (CGX). We had just gone out to see them not long before that and that’s a stock that Joe Milano, who runs the New America Growth portfolio now but is still in our advisory committee, actually had me involved in back in the late 1990s. Then we decided that it was probably more economically sensitive than we might like and we sold it, but we went back to it last fall looking at it, saying you are going to get an economic recovery, operating margins can move up fairly smartly in that process and that can be the case where you can get a real turn in the cash flow of the operation. The management team also owned a pretty significant amount of stock. A business that could have good earnings acceleration with an economic pickup is a pretty well managed company.

That would be an example of one we looked at and watched from time to time. But what we like to do is really have a core of small cap value ideas because over time that’s where a lot of our better investment results have come from. It is an area that Hugh Evans, who works with us, refers to as a “get-rich-slow area.” You have these little companies and in many cases they are not well known. They have lower valuations, and one day they get discovered, and the stock perks up, and you make your money, and that is an area that has had good returns, because they are less institutionalized in most cases, or less solid.

Q: You mentioned earlier you were looking for a company for your core holdings. Generally, how many companies do you consider core holdings?

A: The core of the portfolio would be something greater than 50%, small-cap value types of ideas. Then we can have growth ideas that would be amongst some of the larger positioned sizes in the portfolio.

Q: When you identify them, would you give some yardsticks other than the ones that you mentioned earlier on the growth measures and also on the value measures? I understand you do your own research and you do your own fundamental research. What is considered attractive to you and what is not?

A: Every sector has its own characteristic, so we would tend to look at it more on an individual basis. You look at dimensions and it is about 16% of the business so that is one of the reasons we would be interested in that. On the growth side, we typically tend to follow what is considered as a Growth-At-Reasonable-Price approach. We would look at where we thought the growth rate of the company could be and then want to buy on some multiple of earnings that was close to that or lower, that would be one parameter that you would want to look at in some sectors. Some growth sectors, for instance, the broadcasting industry, you may not be able to look at on a P/E basis, but you might look at rates such as multiple of broadcast cash flow that would be important. In the insurance sector, you might look at price to book value because that tends to be how those stocks would tend to trade. For an industrial company we might often do a discounted cash flow analysis to see how that would trade. So every different sector would have slightly different valuation things that we might pay attention to.

There are some situations where we might buy a company with limited earnings. For instance, in the biotech space, if we thought it was a compelling investment opportunity and that the potential for the drug that might be under development would be such, that if we had some reasonable prospect of success, we could expect a nice return. We have two doctors on staff doing the research.

Because we are running a blend of growth and value, we are really looking at opportunities across the market spectrum, so we look at valuations across the spectrum as well.

Q: Are there any sectors that you definitely avoid or it changes depending on the valuation?

A: Well it does tend to be driven by valuation. There are some areas that we are not really keen on because we don’t see that it has tremendous growth prospects. Utility area is historically one that we have not done a lot of work in over the years. I used to be a utilities analyst, I know the area, but it has been really hard to find a lot of really attractive ideas in the utility space, so that is an area that we have often been underweighted in. It is not unusual for us to be underweighted in the financial sector. Again, we don’t avoid it, but there are going to be times that interest rates may not look favorable, that you don’t want that sort of threats for those types of things in the portfolio.

Generally, we are not biased against any sectors. If we can find interesting ideas, we will step up and buy them and in various times we have had much lower weights in technology than in the index and had equal weights or greater weights in the technology relative to the index, so it really just depends on what the valuations look like at any moment in time.

Q: Your research process is primarily having the companies come and visit you or you going out and visiting the companies?

A: We have some screening that the group does where we look at different screens, where we look for operating margins and reasonable valuations and try to find attractive businesses and good prices. So that tends to be the way that works, but most of the ideas come when analysts see something interesting, so he pops in and says: “I think this idea is perfect for you.” Having done this for eleven years, watching the analysts, watching how they think, and figuring out under what circumstances these guys are very effective, can be real helpful.

Q: What is your philosophy regarding portfolio construction? How do you organize the portfolio?