Q:  What is your investment philosophy?

A: Our philosophy is strongly based on fundamental field research and heavy use of management meetings. We invest in companies with three main characteristics. First, they should be able to have above-average earnings growth over the next three to five years. The second characteristic is high or improving return on invested capital, or ROIC. Third, the companies should have some sustainable competitive advantage that will allow them to maintain the growth and the high returns on capital over a three to five year period.

Finding all three characteristics among small-cap companies is a pretty rare event. Firms like Wal-Mart were once small-cap companies with a unique business plan that generated high returns; Starbucks was once a small-cap company. We’re looking for the next company that can grow from very small to very large and to hold them through their growth lifecycle.

Q:  Why do you prefer to focus on superior ROIC and superior earning growth rates? What makes those two aspects important for you?

A: Because of the tendency of these companies to outperform. Historically, fast-range growth and high ROIC companies have outperformed consistently over five-year periods. We annually make fiveyear studies and the results are surprisingly similar with respect to the combination of those two factors. A company that actually grows its EPS at a 25 percent rate for the next five years, should outperform other stocks in the market.

For instance, over the last five years, the companies with ROIC of 5 to 10 percent that grew their earnings by more than 25 percent, returned 165 percent of the Russell 2000 Growth. However, those companies with a five-year ROIC of 10 to 15 percent and earnings growth of more than 25 percent, outperformed the Russell 2000 by 558 percent. That’s a magnitude of almost four times, so ROIC is of primary importance to us. In essence, high ROIC is the major ingredient for having a business that ultimately returns cash to shareholders.

Q: What gives you the confidence that the consistency of earnings growth in the historical context will continue looking forward?

A: We run the historical study agnostic to stocks; we’re just looking at the growth, the ROIC, and the returns. The companies that will generate higher earnings growth and ROIC over the next 5 years, are likely to be very different from the ones in the past five years, so we're looking prospectively. If our fundamental analysis determines with a high degree of conviction that a company can grow earnings at a fast rate and achieve a high ROIC, there is a strong chance that it will be in our portfolio.

Q:  How do you implement that philosophy into an investment strategy and process?

A: Our strategy is to investigate small-cap companies and identify those that meet our three unique characteristics. It’s not an easy task, and it requires a lot of work, patience and face-to-face meetings with management teams. It also requires an understanding of how each of these businesses makes money, because only in that way can we get comfortable with an investment and make a long-term purchase. Our team includes myself, Yossi, and a few analysts, Andrew Srichandra and Derek Johnston.

We have a disciplined process that starts with a universe of companies with market cap from $100 million to $2.5 billion. Within this universe, we conduct an industry analysis to determine whether the specific industry can support a company with high earnings growth and ROIC. Then we spend the majority of our time on company analysis, where we try to get to the essence of the company, of its competitive advantage, and to estimate where ROIC can go over the long run.

Once we get comfortable with that, it comes down to a valuation analysis. It can be the greatest business in the world, but it may not be attractive for current purchase. We measure all the companies that fit our criteria relative to existing names in the portfolio and, if valuation is incrementally better than something we own in the portfolio, we'll swap out.

Q:  How do you approach portfolio construction?

A: We keep the portfolio to less than 100 names, currently it’s about 70 names. We have three major groups of companies: traditional growth names, aggressive growth names and balanced/safe havens. Traditional growth names, which represent about 40 to 80 percent of the portfolio, are companies with EPS growth of 20 percent or more over the next 3-5 years, high ROIC and some type of sustainability.

Aggressive growth names, which constitute about 10 to 30 percent of the portfolio, are the companies that are probably a little bit earlier in their lifecycle than the growth names. They may not be generating a higher ROIC today, but we expect strong growth over the next 3-5 years in both earnings and ROIC.

From a risk-control perspective, we make sure that we’re not taking up too much risk by limiting the aggressive growth names to 30 percent of the portfolio. However, we also want to make sure that we’re not burying our heads in the sand, so we have a minimum of 10 percent in aggressive growth to benefit from companies that can provide those types of returns over a 3-5 year period.

The third category, the safe havens, are companies with dominant franchises, high ROIC, and excess cash flow returns. However, these companies are growing with less than 20 percent; the growth is usually in the mid-teens. They are going to be more stable than the other two areas and they represent only 10 to 30 percent of the portfolio.

Q:  What is the turnover of the fund?

A: Our turnover rate makes us notably different from typical small-cap growth managers. Over the last three years, we’ve averaged less than 40 percent turnover. It truly is a buy-and-hold portfolio as compared to other managers who can have turnover of more than 100 percent.

The one thing we know is that turnover in the small-cap area is very, very expensive relative to other asset classes. In the large cap area, there’s a fairly decent liquidity in most of the names and the portfolio managers don't lose from moving the market. In the small cap area, when buying and selling, the costs can be up 8 to 10 percent, or the entire potential annual total return, for a particular stock. High turnover really eats away returns, so we take that very seriously.