Q:  In your experience, what are the particularities of the small-cap growth area?

A: Over time, the small-cap growth asset class has been a wonderful asset class to be in. Small-cap returns compound at a higher rate than the other asset classes, such as large-cap growth stocks or largecap stocks in general. However, investors should understand that the good longterm returns inherently go with more volatility. The investors that truly have a long-term outlook will greatly benefit from being in the asset class.

For the last 3 to 4 years small caps have done relatively better than other asset classes, such as large caps. The profit recession in 2001 affected all companies, but it affected small-cap companies more than large-cap ones. They fell further and, if you think about it, that makes sense. Large-cap companies have a large base of revenues to spread expenses across, and inherently, are less volatile.

However, small-cap companies have been able to adjust their cost structures to drive a rebound in their profit margins and that has fueled earnings growth over the last few years. Today, both small- and large-cap companies are in line with their long-term averages in terms of profit margins. I don’t anticipate that type of rebound effect going forward, but we’re left with a lot of good small-cap companies that dominate their particular businesses and have good revenue growth rate plans. This should drive revenue and earnings a bit faster than for the large-cap growth side. In essence, we see a good probability that small caps will continue to do well for the next 3-5 years.

Q:  Technology and healthcare are very diversified sectors. Could you give us a few examples of specific stocks?

A: In the technology area, ARM Holdings (ARMHY) is a good example. We came across this company in connection with Artisan Holdings, which was ultimately purchased by ARM. ARM is in the business of providing semi-conductor intellectual property, or IP, which were typically handled internally by firms. This represents the next evolution of the entire business, where IP can be outsourced and leveraged as one or two companies provide the essential building blocks, or core architectures, needed for semi-conductor design.

ARM has come to dominate the semiconductor IP industry, growing at a faster secular rate than the overall semi-conductor industry, which is also growing at a rate north of the GDP. Inherently, it has strong growth characteristics since it’s become a standard in the industry. For instance, there’s a 90 percent chance that your cell phone is based on ARM architecture. If the semi-conductor manufacturer design team wants to have a component within a cell phone, it’s essential for them to design to ARM standard, so the company is in a very good competitive position to allow sustainability of returns and growth over time.

In terms of ROIC, the company carries approximately 35 percent operating margin and we believe that’s moving north. The business requires very little capital expenditures, so they have very strong ROIC and strong sustainability characteristics due to their competitive advantages.

Q:  Many of the outsourcing companies from Israel or India, like Cognizant or Infosys, have similar margins and little capital requirements for their growth. Do these companies meet your criteria? In fact, Infosys has a higher net margin than Microsoft.

A: Many of them do and some are outside of our market-cap ranges, but you’re right, they have the ability to do that. Within software, we have some unique names, such as Blackboard, a company that provides software to the higher education market. In essence, schools will use its software to allow professors to put their lesson plans on the system for students to access. It dominates its business and has a high level of recurring income because it would be very painful for schools to replace the software system.

Q:  A company that makes money through upgrade cycles because you just don’t throw away your Intuit from the accounting system.

A: Yes, if Intuit or Adobe were smallcap businesses, they would most likely fit our criteria, especially from a ROIC standpoint. But in the small-cap software area, that's a bit tougher. We deal with less established businesses. But if we can find a company with the ability to be the next Adobe or Infosys, then we take a hard look at it.

A year or two ago we owned Macromedia, which provides Flash technology. It was ultimately bought out by Adobe. It had a dominant market position, generated very high cash flow returns, high ROIC, and was in a very sustainable position because so many developers developed to the Macromedia Flash standard. That is a typical software/technology company for us.

Q:  Can you give us an example in the consumer discretionary area?

A: Lifetime Fitness would be a good example. This is a health club company similar to the likes of a 24-Hour fitness center, but it differentiates itself through a large-box concept with a moderate membership price. It provides members with a combination of sports, family recreation and spa resort characteristics. It’s really a destination for families, which resembles a mini country club for the middle class.

They’ve had tremendous success with this concept. The ROIC is very high and when they ultimately get to full capacity, the margin can be north of 50 percent. The key there is having success in generating the traffic. Now it’s a matter of execution and roll out. If they are successful at this part, we can see the company generating very large amounts of cash for their shareholders.