Q:  What is the investment philosophy of the fund?

A: We are long-term investors and we believe in constructing well-diversified portfolios of high-quality companies. We believe that in the long run earnings drive stock prices higher. If we can correctly identify a company’s earnings growth and pay a fair price for it, then the earnings will do the work over the long run.

There is both a qualitative and a quantitative support for that quality tag. Quantitatively, we look at balance sheets relative to the peers, at the margin structure and the returns for shareholders. Qualitatively, we form an opinion on the management and their business strategy.

Being a small-cap growth manager focused on high quality stocks sounds like an oxymoron, but it’s not. We take a long-term, institutional approach versus attempting to be the hot fund of the month or quarter. Some managers may prefer to take big bets in speculative stocks and or to chase momentum from one sector to then next. This can lead investors to perceive small-caps as an aggressive and low quality asset class. But our research continually results in the identification of high-quality companies, with sustainable competitive advantages that can translate them into strong earnings growth.

We try to build a portfolio with an average earnings growth rate of about 20%. Over the long run, we’re trying to capture two-thirds to three-fourths of that growth in stock price appreciation. IF we accomplish that we feel we will beat the long term returns in our asset class and our peers.

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

A: What differentiates us is our approach to diversifying that doesn’t just focus on sector weights. We diversify by the growth rates of the companies. Our strategy is to own a stable of stocks with thoroughbreds, pacers and mules.

The mules are companies growing at 10% to 15% a year. In this segment we tend to find regional banks and industrials to name a few. They are not necessarily defensive in nature, but may just compete in more mature industries. The pacers are companies growing at 15% to 20% a year, such as business service companies, for example. The thoroughbreds are more rapidly growing companies, including technology and healthcare.

When we diversify the portfolio, we’re not just doing it by industry or sector, but by the types of companies we have in each sector. We want to avoid being 100% in thoroughbreds as that would create too much volatility. We also can not be 100% mules because we wouldn’t be able to get overall average earnings growth of the portfolio up to our goal of 20%.

We don’t manage to certain percentages in each type of name, but we do monitor it to ensure that in different market and economic environments those categories are representative of what is appropriate. We currently believe that the economy will continue to grow and that at some point growth stocks will begin to outperform value and defensive strategies. Four years ago there was less certainty about the economy and we had a heavier weighting in the pacers and the mules. That’s also a way to approach risk.

Q:  Why did you set your earnings growth benchmark at 20%?

A: Henry Mehlman and I have been managing money together for seven years. We were intent on constructing high quality growth portfolios that maximized returns while limiting risk. Our fundamental company research, combined with specific portfolio risk constraints, indicated that a portfolio with an approximate 20% forward earnings growth rate held an attractive balance between growth and risk.

There are a number of reasons why you may not capture that 20% earnings growth. We strive to correctly identify a company’s earnings power and to value it correctly. However, companies can deviate from their original business strategies or new competition can erode competitive advantages. Sectors can fall out of favor, which impact specific stock and market markets can quickly change as we’ve seen in 2006. But the goal of capturing the two-thirds to three-fourths of that growth incorporates many of these unforeseen risks.

As growth managers, we are naturally attracted to higher than average market growth rates. Compared to some of the indices, we have higher expected earnings growth and higher P/E multiples, but we tend to have lower PEG ratios than the market. In other words, we’re looking for the growth but we pay a lot of attention to valuation.

Q:  How do you define small-cap and how do you define growth? Is the 20%-figure on historic or forwardlooking earnings?

A: We define the universe as $100 million to about $1.5 billion in market cap. Our average market cap has been roughly in line with our peers; at the end of June our average market cap was just under $1 bln, similar to the Russell 2000 and 200 Growth. The growth rates are 3 to 5 year forward-looking growth rates. About 90% of our companies have had solid profitability records in the years prior to owning them, as well.

Q:  How do you deal with small-cap specific issues such as the lack of coverage or liquidity?

A: We have a fundamental, bottom-up approach, and last year our four-person team, that covers both small and mid-cap stocks, met the managements of over 600 different companies. We’re not afraid to buy companies that don’t have any Wall Street coverage and about 40% of the names we own have what we consider to be minimal coverage, or less than four regional firms covering the stock and noe of the majors.

Less coverage means more work, but we feel that provides us with an information advantage because we take the time to learn the stories, know the managements, and visit companies while other people can’t.

Liquidity is important and it can affect position size. Our strategy is to have initial positions of equal weight. The only exception is that sometimes we may have to take less than an optimal position because of liquidity. We have to be comfortable that we can build a position and get out when we have to. If we can’t buy at least 0.5% of the fund’s total assets, then we don’t even bother buying that name as the time and resources it takes to cover the stock are not justified by the impact it can have.