Q: What is the history of the company and the fund?

The original Kaufmann Fund was a small- and mid-cap fund focused on growth investing that was started in 1986 by portfolio managers Hans Utsch and Larry Auriana, who still oversee the fund today. Now, we have eleven portfolio managers on the team.

In 2001, the Kaufmann Fund was purchased by Federated Investors. It continues to be managed by the same team and with the same investment process. The small-cap fund was started December 18, 2002, while the large-cap fund was introduced in December 2007.

Throughout, we have continued to focus on growth investing and a fundamental, bottom-up analysis process whereby we look for companies that have company-specific catalysts that can create value with little to no help from the economic backdrop.

Q: Why should investors consider investing in small caps?

Typically, a small-cap company has a cleaner business model with narrower or singular market or product focus and that allows us to conduct deeper investment analysis and in understanding business variables. We rely on our fundamental research to discover what will impact that stock.

As fundamental research analysts, we gravitate to simpler businesses. For example, a company with two businesses would permit us to zero in more efficiently on finding the catalyst, to determine the inflection point in the small-cap company. Our portfolio managers can then spend time learning about and interacting with the suppliers and customers of that business.

Growth-oriented small-cap companies need capital to grow, and often these emerging ideas, businesses or products require public equity to supply the company with the capital to facilitate growth. We feel this equity has a purpose, be it to purchase or upgrade equipment or to fund expansion or specific innovation. This purpose can have a major impact not only on the company itself but perhaps also on the industry. 

Small-cap companies are often under-covered, under-researched and lacking Wall Street banks’ attention simply because these fast growing companies cannot generate substantial fees. Their bank loans are not big enough, and the public float of stock is not big enough. 

However, this is a real advantage to an investor like us. If a company meets our investment parameters, our relatively small investment can position us as an important shareholder to them. That in turn forms the base of a relationship that we can build upon; one that will help us to understand them even better going forward.

Additionally, we have our own trading desk, separate from Federated. We have three dedicated traders that help us through any trading and market liquidity issues. Traders work with our portfolio managers to help us size appropriate positions.

We understand that this is a riskier asset class and that is why we structure this fund a little bit differently to our large cap fund.

Q: How would you describe your investment philosophy?

We look for companies that can stand on their own, and that can grow through innovation, investment, and management turnaround. 

Every sector is different and each sector’s portfolio manager has to find alpha or additional return to market in different ways for different companies. We are looking for inflection points and company-specific catalysts for each individual security. 

If there is one theme in our approach, it is to find the companies that are sitting on an inflection point, one that can turn the business in a positive fashion, permit it to grow through innovation, through investment, and create value for shareholders.

Identifying an inflection point for each investment opportunity forms the foundation of our investment analysis. The inflection point can come in many forms—a change in sales trajectory, new product launch or a new market or company restructuring business operations. 

The weighting of our sectors may vary quarter to quarter, but this is entirely a byproduct of our bottom-up investment process. We are looking for stocks that can stand on their own and create their own catalyst. While we monitor our weighting daily, weekly and monthly, it does not drive our investment process. That is still done one stock at a time, just as it was back in 1986, when the fund began.

Q: What is your investment strategy?

We have a stable team of 11 professionals working together for 17 years to focus individually on sectors, but they operate as more than just sector specialists, writing research reports; they are portfolio managers. We like our specialists’ incentives to be in-line with our shareholders, so, as an incentive, the majority of our sector specialists/portfolio managers’ compensation is tied to deriving alpha in the portfolio. 

We are fond of saying that we view each of our sector specialists as a citizen of their industry. As a part of the investment process, we attend investor conferences, but we also like to sit down directly with management teams and meet with companies in order to gain a greater depth of understanding of both their process and their business model. We do a lot of field trips to different cities.

Even if we have not invested in a company for years, we still meet with good management teams, or if a company features a good business model but lacks a good management team, we meet with them as well, with an eye toward possibly investing in them in two or three years, or even in 10 to 15 years. And we endeavor to meet not just with management but also customers. We often gain insight into a business’s competitors and, depending on what we learn, we may find ourselves ultimately investing in the competition instead.

Q: What does your investment process cover?

It starts with our fundamental analysis. If we like what is going on in a business, then we do an analysis of its financial statements. A good business has to either create cash from operations or demonstrate a viable path to such cash generation. Cash is how you are going to buy back shares, invest in new equipment, or issue a dividend. And we look at just how much capital they will need.

We look at valuation on a stock by stock basis. That means we look at each one comparatively, vs. its peers and vs. the market, but each sector analyst has a slightly different perspective on valuation. It depends on the sector and so we consider valuation to be subjective. You need to be aware of valuation, but sometimes valuation takes care of itself. For example, if the inflection point is large enough, and the stock is trading at a premium to some of its peers, that will outweigh a valuation concern for us.

We are company-specific and stock focused, and that has a direct bearing on how we view valuation, growth catalysts, and potential upside. Two stocks from the same industry may be looked at in two different ways, whether they’re growth or value, expensive or cheap. The metrics will vary from company to company. For example, we like to see margins that have doubled in two to six years, sales growth is accelerating from 2 percent to 6 percent in three-to-four years; cash flow is rising driven by cost-cutting, business consolidation, or lowering interest expense.

We take a broad perspective to growth. What others might term as value companies we see as growth-oriented companies. Dozens and dozens of the companies we hold, in all three funds, not just in the small-cap fund, are like this. They may exhibit topline growth of just 2 percent to 4 percent, but upon closer inspection you will see that margins have doubled, or cash flow generation has doubled, and their earnings per share is going up every two to three years.

By taking a company-specific approach to our fundamental analysis, each company, each situation, is assessed on its own merits. 

Q: Can you explain your research process using examples?

We source many of our new ideas from the Initial Public Offerings. We view IPOs as private companies that come through our office looking for a partner. We analyze those businesses to find attractive companies at reasonable prices.

As an example, a holding company that has three of the largest metal forgings facilities in the U.S., predominantly supplying the U.S. auto industry, recently went public. Now, historically, we would not have invested in a company like this because it is a commodity business where only pricing matters. 

However, the company completely restructured itself over time. They now operate very differently from how they did 10 or 15 years ago. There are three major businesses. They are a major supplier of the metal parts that go into engines. The company will benefit from the government mandate of the new fuel standards which imposed that, by 2025, the average fuel consumption of passenger automobiles has to approach 50 miles per gallon. They are the leaders in providing lightweight parts that meet higher fuel efficiency standards. 

They have a dominant market share. They typically receive orders as early as three years in advance, which provides them a clear view of where business is going. They continue to add content per vehicle. They are making each progressive engine design more and more fuel-efficient. 

We have visited their headquarters and one of their plants already this year and will visit them another half dozen times this year since participating in the initial public offering. They are focused on costs and expanding margins, and continue to innovate new products and processes to be more efficient and more profitable. By going out there, we saw for ourselves the transition from heavy, more cumbersome engines to more compact, lightweight, streamlined designs.

As portfolio manager Hans Utsch is fond of saying, when you want to buy a house, you don’t buy it online and you don’t buy it over the phone—you don’t buy it sight unseen. You go visit it—you turn on the faucet. We believe in applying this same principle when we buy a company. We want to see it for ourselves, in person. 

When clients invest in our small-cap fund, we are essentially taking their money and putting it in the hands of management. If we cannot trust those management teams, if we cannot sit down with them to discuss macro events and how they navigate through them, then we are not going to invest in the company.

Q: How does your investment organization differ from your peers?

One significant way we differ from our peers is in having a large team of portfolio managers with a special focus. We believe that having 11 different portfolio managers with the autonomy to put stocks into the portfolio and take them out is very important. 

When an individual manager finds a security that he or she thinks has the right mix of inflection point, reasonable valuation, and a good risk/reward ratio, we believe they should have the autonomy to put the idea in the portfolio.

We have weekly, monthly and quarterly meetings where we sit down together and discuss all the ideas. What we do not have is a process where the portfolio manager presents to the team and requires approval of one person or another in order to move forward. 

Our process enables the individual to focus on their best ideas in their sector. It is on their own merit. Should there not be sufficient capital to fund a particular idea, that portfolio manager can choose to sell another position in their sector if it creates alpha. Alternatively, another portfolio manager might offer to sell a different position instead, and allot that capital to this investment. 

Ultimately, Hans Utsch and Larry Auriana do have super-vetoing power, but we believe each portfolio manager of his or her sector has the full accountability to create alpha on their own merit. 

We want to take the macro portfolio manager out of the process and, instead, motivate each to compete against the others as we believe this obtains the best results, the best balance of our holdings. Encouraging autonomy allows us to incentivize the portfolio manager, who is incentivized for generating alpha and driven by performance.

Q: What segment of the small-cap market does the fund focus on and what is your portfolio construction process?

We define small cap as companies with market capitalizations similar to companies in the Russell 2000 Index and our benchmark is the Russell 2000 Growth Index. Our investible market cap ranges from $34 million to $7.5 billion and we invest 80 percent of the fund’s assets within that range. 

We have 167 securities in the portfolio and total assets under management in the small cap strategy are currently $750 million. The number of holdings can vary. Our annual portfolio turnover is currently 74%, but we do not maintain a formal turnover target. 

In terms of weighting, there are no fixed limits on sector weights. We do monitor the weights on weekly, monthly, and quarterly bases, but it does not drive our investment process, which is still done stock-by-stock, just as it was back in 1986.

Q: How do you define and manage risk?

When it comes to investing in individual securities, the risk lies in the underlying fundamentals of the business; it can be the business margin profile, the operating cost structure, or the management team. We are well aware of liquidity risk, currency risk, credit, leverage, or debt. We really focus on the upside potential, given the current risk profile of the company. 

If something is changing to the negative, more likely than not we will exit the position. However, sometimes certain risks create opportunities on a fundamental basis. If we feel nothing has changed in the business model and we are comfortable with the management team, we may use the perception of increased risk as an opportunity to purchase that security.

For example, we have a portfolio manager who is also a medical doctor who runs our biotech practice, which is a large weighting in the healthcare space for us. However, the returns in the last five years in that sector have been extraordinary. Having Dr. Brakel on our investment team puts us at a distinct advantage. As a physician, he understands the science, the process of establishing both efficacy and safety, and the risks at each phase of a drug going through the FDA approval process.

Understanding the nuts and bolts of each company is critical to assessing not just the potential upside but also the possible downside to each investment.