Q: Would you start by giving us an overview of your investment style and general philosophy? A: We are a small-cap growth fund that invests in rapidly growing companies that we have identified as being the leaders in their respective industries. The fund uses a team management approach with dedicated specialists in four broadly defined sectors: technology, business and financial services, healthcare, and consumer. Each sector has a team of two people that are responsible for all of the investments within that sector. The teams are charged with identifying strong, fast-growing companies in fast-growing industries. Before a stock is recommended, the team does detailed fundamental research on the company and the specific sub sector of the industry where it competes. Q: What criterion do you use to identify a fast-growing company and how large does a company have to be to be in included in your small-cap universe? A: Since the definition of “fast growing” varies by sector and sub sector, as well as over time, each team has its own yardstick. For the consumer sector, we generally look at companies that have a top and bottom line growth of at least 20%. Within the consumer sector, you don’t’ get really crazy swings in valuations even when a stock is doing well relative to its industry. For a 25 % growth rate, maybe you get 25 times earnings when the sector is in favor. In the financial services area, you don’t find companies with growth rates that are this high – especially in the banking industry. But if you look at smaller niche areas, you can sometimes find financial related companies that have nice growth rates. One metric we do use across all of the sectors is enterprise value: how much would the reasonable investor pay for this company. That is an important determinant for us in evaluating companies and the teams use it across all sectors. Another test we use is free cash flow. We look for companies that have a strong enterprise value to cash flow ratio. As far as size, we consider companies with market caps less than two billion dollars to be small caps. We might go as low as 400 million dollars, but for many obvious reasons that is about as low as one would want to go. Q: Could you explain a little bit about your investment process and how do you select a specific stock from among 10 companies that are growing at a 20% rate? A: We are looking for companies that are not only growing rapidly, but are also leaders in their respective industries. That leadership could be based on a superior product, a proprietary technology, or even unique services that they offer. The company should have strong market share in the industry, and the market share should be increasing. In the retail space, we are looking for companies offering unique and differentiated products. For example, there are many companies appealing to the teenage dollar, but we are putting our bet on names like Urban Outfitters that offer a unique shopping experience, proprietary products, etc. We also look for companies that successfully erect barriers to entry. For instance, we’re looking for companies that have insulated themselves from Wal-Mart, because it’s very difficult to compete with Wal-Mart. Just look at the difficult time the supermarket industry is having. We focus on the long-term outlook for the companies rather than how they are performing right now. We try to determine how they will be doing over the 3-5 year time horizon. Q: Once you have identified companies in a sector that meet your requirements, what is the catalyst that drives your decision to buy or sell? A: By the time that we are satisfied that a company is fully qualified, the team has already accumulated a substantial amount of background information, research, and related analysis. That gives us a solid base from which to decide if their top line or bottom line is fully reflected in the multiple. If we think they are close to a peak we will watch from the sideline, but if we believe that they have the potential to increase growth, we may bite. We also use various technical tools to help us in the buying decisions. And we work with our trading teams who are very experienced in the growth space. They are right on top of the markets and very good at helping select the best points to buy and sell. While we do computer modeling and look at the results, we don’t rely on models for making decisions. Instead, we develop our own sense of what is likely to occur, and use the model results more as a reality check. Q: Turning now to your research process, most managers seem to start with a screening procedure supplemented by fundamental research to generate a primary buy list. Is your process similar to that? A: Well, no, our process is not really like that. We do not use screens. Instead we rely on years of experience of the team members. They have been working in their area of expertise long enough to intimately know all the companies in the space. They talk with analysts, attend conferences and IPO meetings and, in general, they are on top of what is happening in the industry. While they each follow an extensive list of companies, they don’t need a screen to identify the ones that are interesting. Q: What happens when there is a disagreement within the team whether to buy or sell a stock? A: I think within each team there is a very healthy level of respect for each member’s views; but there are certainly times when one of us will feel more strongly about a particular decision than the other. In most cases, we pretty much go with the person that’s has done the work. We always have two people covering each sector and often they will have differing views. Our experience has been that having someone challenge your views usually results in better decisions. Ultimately, it is the chief portfolio manager, Jerry Fry, who is responsible for the process. He continuously monitors the process and makes sure the things are running smoothly. Jerry has a strong background in the healthcare and technology sectors. Q: There are two kinds of structures that I have seen in fund management companies: one where the analysts do their work and make a case to the portfolio managers who make the buy and sell decisions, and one where the analysts are the portfolio managers and make the decisions. Which structure would most closely describe your team approach? A: Before we put our team structure in place, our process was similar to your first case. We had a group of analysts who were trying to find ideas to pitch to one of the portfolio managers. It was the portfolio manager who would decide if the name went in or out, and the analyst kind of lost ownership of the name at the playing time. Our current process is just the opposite. We have eight people doing research. Six of the eight act as both portfolio managers and analysts, and two are analysts working with the portfolio managers. Everything about the consumer sector is completely controlled by the two portfolio managers. The team as a group does the research, works closely with the traders, monitors positions, and decides what to buy or sell. Overseeing the process is someone that sits on top and makes sure the things are running properly. Jerry’s role includes diversification and risk management. He acts like a traffic cop to make sure that the portfolio meets its diversification objectives and is in line with the portfolio’s benchmarks. Q: Is this specific fund measured against any specific benchmark or yardstick? A: The Russell 2000 growth is the one that we use as a benchmark. Q: Would you describe and discuss your approach to diversification? A: We diversify pretty much along the broadly defined sectors. Since we use a bottoms-up approach and we are not tied to a specific sector, the names that we own tend to be spread out among the sectors. We do strictly adhere to our 5% rule meaning that not more that 5% of the portfolio can be held in a single name. The distribution among the sectors and sub sectors varies from month to month. We look at the returns by sector on a daily basis, and run a very detailed report by sub sector weekly using weighted returns. We want to know if our performance was the result of stock selection or sector selection. We normally average about 80 stocks in the portfolio and our turnover rate is more than 70%. Q: To better understand your approach, could you give a couple of specific examples of how you picked a specific stock, what thinking went into the selection, what happened with the stock, and then how did you end up selling it. A: An example in the consumer sector might be Coach (COH). We still have the name in our portfolio so I don’t have the end of the story yet. We first saw the company presented at a conference three years ago. The company had been spun out from Sara Lee a few months before. They were transitioning into a fashion accessory business and had just launched for the first time a logo collection. Within a few weeks of opening the line in Japan, sales of that line had grown to 10% of their total sales. We saw the potential of the line as they moved into their other markets, and believed that it should be able to really move the needle. It has proven to be one of the great success stories in retailing in recent history. While we did not predict how successful the company would be, as the story unfolded, each step got better and better. They keep expanding market share tremendously and widening their appeal all the way from teenagers to grandmothers. They have designer customers that are trading down to their bags, and customers that don’t typically go into the affordable luxury space trading up. The company’s operating margin is more than 30 percent and continued growth have given it increasing economies in scale. They still have a lot of room to grow. Even in Japan, where they grew 85% last year, they still only have a 4 % market shares. The company believes they can expand that to an excess of 10% market share. So at this point the stock has done well and has very healthy multiples; but you pay for scarcity value. There is not another consumer product company out there that has margins over 30%. Q: And why do you continue to own it? A: When we look at the continuing sales growth and see numbers in the high 20s and lower 30s, it suggests the company still has tremendous momentum behind it. We have seen their new collections and feel that they should resonate well with the customers. Q: Do you have an example in the non-retail sector? A: Perhaps Protein Design Lab (PDLI) in the biotechnology industry would be a good example. The company specializes in monoclonal antibodies. While they didn’t have their own pipeline, they had the technology to humanize antibodies. It is a company that we believe has a terrific future. Historically, antibodies used in the manufacturing process were from mice that can sometimes cause an adverse reaction because they weren’t human. Protein Design Lab technology is a technology to humanize the antibodies to therefore make them acceptable to humans. Although the stock had a good run back in 2000 when it peaked just above $80, it has been below $20 recently. Many investors gave up on the company and were not willing to wait the years necessary for the company to bring a product to market, but they were shortsighted. While the company doesn’t have its own drug yet, it has been using its technology in partnership with other companies. They receive a royalty on drugs that are developed using their technology. One drug that has recently been approved is Avastin, which is a colorectal cancer drug developed by Genentech. While PDLI gets only a small royalty, it goes right to the bottom line. PDLI is also working on their own pipeline. They have a few early stage drugs that are promising but it takes a long time to determine their value. Q: Maybe you could describe a stock for which you had high expectation that did not work out, and, specifically, how you reacted to the situation? A: Often times we do take a long-term approach and hold on to stocks even though they are not performing. But when it is clear that the company’s situation has changed, we don’t hesitate selling. A good example would be American Italian Pasta. They are a pasta manufacturer, but don’t run restaurants. They recently gave guidance that their outlook had become cloudy due to the low carbohydrate diet craze. We had already starting questioning the potential impact of the craze, and the management warning was icing on the cake. We sold out. While we still believe in the company, we just felt that there was a better place for our clients’ money than waiting for the craze to end or for the company to reinvent itself. Q: We are starting to see more and more success stories in the e-commerce and e-retailing space. Blue Nile is one example, but there are a number of other online companies that are having some success in the jewelry business. What are your views of online retailing and how do you evaluate the trends? A: Five years ago everyone believed that online retailing would eat into the business of all the brick and mortar companies. That didn’t happen. Instead, many of the brick and mortar retailers have benefited by building very healthy online businesses that are adding profits to the bottom line. If you look at companies like Williams Sonoma, this is the first year their online business is going to pass catalogue sales. So consumers have definitely become comfortable shopping over the Internet. There are a number of strictly Internet-based companies, like Amazon and Blue Nile, which have found a niche and successfully exploited it to the detriment of some brick and mortar retailers. But at this point, I can’t think of another sector that faces a big risk from an online startup.