Investment Philosophy

Overview

The small-capitalization segment of the U.S. market contains thousands of under-followed and, in many cases, mispriced securities. We believe these pricing inefficiencies can be exploited through a systematic and disciplined process. This is the approach we use to achieve our primary goal: outperforming the Russell 2000 Value index while substantially reducing portfolio volatility.

Process

The process begins with a series of quantitative screens to identify the most undervalued stocks within the universe. The primary selection universe is companies with market capitalizations below $2.5 billion, with particular emphasis on those companies between $80 million and $1.5 billion. We use six primary screens: EPS revision trends, cash-flow/price ratio, book/price ratio, trailing earnings/price ratio, dividend yield, and a net-net (working capital)/price ratio. In an effort to avoid value traps, we focus on consistency of earnings and relative price strength as additional criteria. Only the most undervalued 10-15% of all stocks screened are considered for additional work.

Strategy

Sector and industry analysis are important elements of portfolio construction. Such analysis is largely determined by the industry and sector concentration revealed in the top decile of our quantitative screens. Additionally, our use of relative strength sets us apart from most traditional managers in the small-cap value arena.

Those companies surviving both the quantitative and relative strength screens are subjected to more intense traditional research analysis, with particular attention to the balance sheet. We look for companies with conservative, easily understood financial structure and a large cushion of tangible assets relative to the stock price. In addition to an undervalued and financially sound company, we look intently for a catalyst which may cause the stock price to move quickly to its intrinsic value.

Portfolio Construction

Sector and industry analysis are critical in determining the construction of the portfolio, which typically contains between 45 and 65 stocks. Holdings are well diversified by sectors and industries. Particularly attractive industries may comprise up to 15% of the portfolio and the maximum sector weighting is 40%. Securities are roughly equal-weighted at time of purchase ranging from 1-2%. Maximum position size is 7%.

Sell Discipline

The Small-Cap Value strategy and process are combined with an aggressive sell discipline. Sell criteria include: sustained price erosion, declining fundamentals, overvaluation (relative to our screens), industry or sector deterioration, a large and rapid increase in market capitalization, and overall portfolio diversification objectives.