Q:  Could you give us some stockpicking examples that illustrate your process?

A: A good example of our opportunistic approach would be Fresenius Medical Care, the German renal care company. This is currently our largest holding but when we bought this stock in 2002, it had dropped down from about 100 euro to 20 euro for two main reasons. The CEO was trying to change the business model and to switch from reusable dialyzers to single-use dialyzers. The shortterm impact was negative and the company missed earnings for two quarters and the stock fell. But as I got to understand the business, I saw the substantial cost cuts in the long run.

Another reason for the decline was a general misunderstanding about a lawsuit. It was a case of fraudulent conveyance, but because it involved asbestos litigant W.R. Grace & Co, and because Fresenius was only covered by German and European analysts, most investors assumed it was an asbestos suit. Having a global team, we could see that there could still be damage to the company, but we expected only a small settlement. In November 2002, after building up a position in the company, it settled for only $15 million and the stock immediately went up 30%.

In another example, the knowledge of the dialysis care industry took us to a little company called NxStage Medical. The company developed a small portable device for home hemodialysis, which provides better quality of life for the patients who need to spend many hours weekly at clinics. The home method is appropriate for only 10% to 20% of the patients, so it won’t take away all the Fresenius business. The management is solid and we like the business model. They have a lead of several years on any competitor because they have the only FDA-approved machine.

Q:  Could you highlight your portfolio construction process? How many stocks do you have and what is the turnover?

A: At the end of the year we had about 110 names in the portfolio; usually we have between 90 and 120 names. We believe in the concept of the life cycle of global opportunities and we try to invest in the small-cap companies in their early stage of growth. We may own them for three or five years, whatever it takes to grow to above $5 billion in market cap and appear on the radar of the large-cap managers. Once the liquidity enters the name at above $5 billion, we harvest the gains and sell these stocks to the large-cap managers.

But we are not forced to sell a successful stock just because it exceeded a certain market-cap level and, generally, we let our winners run. Many traditional small-cap managers are handcuffed by their market-cap limits, while for us such strict rules don’t make sense. Our market-cap limit of $250 million to $5 billion refers only to the time of purchase, so we have enough room to let the winners run.

The turnover is very low, between 20% and 40% on average, because of our long-term investment horizon. The low turnover keeps down the transaction costs and the market impact costs and provides benefits from a tax perspective. Last year, for example, over 98% of our payout was a long-term capital gain.

Q:  What risks do you perceive and how do you manage them?

A: Our benchmark, the S&P/Citigroup Extended Market Index, is a developed market benchmark, while we manage money with a growth tilt. So we deviate substantially from the benchmark, but we are benchmark aware when we talk about risk control. Although the benchmark doesn’t drive our investment process, we are cognizant of how we deviate by sector and by geography.

One of the risks in the small-cap space is the liquidity risk. Therefore, if we invest in a liquid stable-growth name, we build larger positions. But if we buy higher-risk or contingent-growth names, especially at the smaller end of the market-cap range, we hold smaller positions. We also have an equity risk team that provides monthly risk overviews so that I can determine if there are any unintended risks in the portfolio. But this is really a stock-picking fund, so the exposure is mostly the result of our bottom- up analysis.

Q:  Do you believe in thematic investment within the small-cap universe?

A: We stick to the bottom-up approach but we leverage our knowledge. The beauty of being a global investor is that we identify a theme in the United States, and see if we can find similar companies in Europe or Asia. For example, one theme that originated in Europe was the consolidation of the world exchanges. We were able to invest in several exchanges globally and to benefit from that.