Q: What is the history of the fund?

The fund was originally launched in 2007. I was hired in November 2008 to lead the group that manages it, and I immediately set out to reconstruct the fund’s investment process. 

We instituted the new process in the second quarter of 2009. There have been some enhancements along the way but the basic building blocks have been in place since then.

Q: What changes did you make to the investment process?

The previous process was built on traditional styles of investing, such as value and momentum. My goal was to make two main changes: to combine better information with less risk. First, we completely changed the stock-selection process to what we call “information-based investing.” Then, we instituted a much more stringent risk-management process. It combines third-party risk modeling information with a subjective team-based oversight process on a stock-by-stock basis in order to mitigate the stock-specific risk that might get introduced into the portfolio. 

Q: How does the fund differ from its peers?

Our investment style is not tied to growth, quality, or any of the typical metrics or styles of investing that are commonplace in the market. We are focused on finding good information and understanding what that information is saying about the chances a stock will perform well. 

Naturally, as a small-cap fund, we focus on small-cap stocks. We believe small caps provide an advantage both in terms of performance and opportunities for active management. 

Q: What is your investable market cap range?

Our investable universe and our benchmark is the Russell 2000 Index, but that can drift during the year. Last year the top end was about $4.5 billion and the bottom is generally about $50 million. If stocks that we have in the portfolio get above that range, we continue to hold them but we do not add to them; as stocks drift down into the range we consider them. 

Q: What core principles guide your investment philosophy?

Our core belief is that in order to consistently add value you have to have either some kind of analytical advantage or some kind of information advantage. We believe we have found the synergy between the two. 

We use our analytical capabilities to identify market participants who have an informational advantage, some special perspective on the market. We call these people “informed agents.” Once we have identified them, we analyze their activities and glean information from their perspectives to better understand how a stock is likely to perform. That is essentially the heart of information-based investing. 

We also think it is critical to surround this process with an investment infrastructure focused on risk management. We want to ensure that we understand the trading dynamics and the macro-environment.

Q: Who are these information agents and what kinds of information can you glean from them?

We have three categories: management, industry analysts and informed investors.

Management obviously knows a lot about their own companies. They share some of that information in quarterly calls, but they know a lot more that they don’t share. We watch what they do and how they manage the company—how they manage their capital structure, cash flows, accruals, etc., to prepare for what they believe is coming. 

We also look at how they buy and sell their own company stock in their personal holdings. That is all public information. The patterns in that information often reveal how they feel about their company’s future.

The next category, which we think is a very important one, is informed investors—institutional investors and investors on the short side, mostly hedge funds and derivative traders. On the long side, people buy and sell stocks for lots of reasons, like asset allocation, index rebalancing, risk management. But on the short side more often than not the trading is driven by information. And since these are very good investors, it’s generally very good information. 

We measure and analyze this supply-and-demand dynamic between the short and long sides. In its simplest form, when short-side investors cannot find a good reason to short a stock, that is a good sign the stock will appreciate. To use an analogy, it is very much like the ocean—when the tide goes out, the waves inevitably come in. 

When the tide is going out for a stock and the shorts pull away, often the company will have a couple of good quarters, make a transaction the market likes or introduce a successful new product, and the stock will appreciate. These informed investors are typically ahead of that information. Seeing their sentiment behind a stock gives us confidence in it as well. 

Finally, we listen to industry analysts—not the buys and sells they issue, which could be worthless, but the data and information they put out, which is valuable. We use their earnings and revenue estimates along with price targets and valuation data in determining our own valuations.

Q: What is your investment process? Where do you look for opportunities and what steps do you follow when you find one?

We go through a handful of steps in the investment and rebalancing process. There are 2,000 or so companies in our universe, and based on our information-based investing process there might be 400 to 500 stocks we want to analyze. Getting that down to a portfolio of 150 to 200 stocks involves a number of steps. 

First, we look at the economic and macro environments. There are some vestiges of traditional styles of investing here, because some market environments are conducive to momentum stocks and some are conducive to value investing.

On the momentum side, if we see a stable market environment with positive market trends, lower volatility, falling credit spreads, and solid leading indicators, we will be willing to hang on to the stock a little bit longer than we usually do. But over time successful momentum stocks grow larger and unsuccessful ones grow smaller. So, momentum builds in the portfolio if you don’t do anything about it. It’s a question of how much to cut back and when. 

On the value side, we keep an eye on the spreads of valuation across the market—the difference between the most expensive and the least expensive stocks in the market. That spread gets wider and narrower over time. Like a coiled spring, when the gap gets very wide it tends to want to come back together, so we keep our eyes open for a cap list that will accomplish that. When we see a turn in leading indicators or in volatility, we introduce more value-type, inexpensive stocks into the portfolio.

Next comes risk management, which involves a couple of different perspectives. We use a third-party risk model called Axioma to help us diversify the portfolio across different investing styles, such as value, growth, large cap, small cap, exposure to currency risk and volatility or liquidity risk. We also diversify across industries, as we feel the sector level is too broad.

Our team constantly monitors stocks in the portfolio, and does a deeper dive when analyzing new candidates for the portfolio, to look for any exogenous risk or anything outside of our expertise that might affect its price. We use an acronym for the six kinds of risk that we think are outside of our expertise; we call it our PALING test. We look at political activity, mergers and acquisitions, legal activity, investigations, natural disasters and governance, to see if any of them might be introducing risk into a stock. If we think they might be, we disqualify the stock and leave it out of the portfolio.

By the time we get through that whole process, we have narrowed the field from 2,000 stocks to 150 or 200. We go through this process 10 or 12 times a year, and trade a whole basket of stocks to improve the position of the portfolio.

Q: Can you illustrate the process with an example or two?

One example is RF Micro Devices, a manufacturer of radio-frequency circuits used in mobile phones and tablets. Using the tide metaphor, in 2012 the tide went out; the shorts pulled back from this stock over a period of months, and so we started building a small position. Apparently, the company had a couple of good quarters and the stock appreciated. 

It didn’t do much through 2013, but then in 2014 the tide went out again, and the shorts pulled back again. That February the company announced it was acquiring TriQuint Semiconductor, one of its competitors. The market loved it; the stock was up 14% or on the news and the company put together a couple of really good quarters. The stock went up four or five times and was the number-one position in our portfolio for a while. It was a huge home run for us.

In the fourth quarter of 2014, informed investors were building short positions again, and the analyst-based metrics—price targets and estimates of revenue and earnings—were telling us that there was not as much upside in the stock. Consequently, we exited out of the company. 

A second example is Republic Airways Holdings Inc., a regional jet operator in the Midwest and the Northeast that works with American Airlines and Delta Air Lines. It illustrates the second part of the process where we diversify across investment styles and economic forces, such as our exposure to currency exchange rates.

In 2013, Republic had some great first quarter results. It looked like there was some strong potential upside, and management was engaging in the kind of conservative balance-sheet and income-statement behavior we like to see. They were using cash flow to buy back shares without increasing debt, and managing their accruals very conservatively—both signs of management confidence. We also looked at the analyst-issued data on earnings, price targets and valuation. At that moment we started out with a small position. 

The stock underperformed the market in 2013, but it did significantly better in 2014, largely driven by the decline in petroleum prices. 

Generally, when the dollar is strong, petroleum prices are weak, and vice versa. Therefore, a strong dollar in 2014 was good news for Republic. For RF Micro Devices, though, a strong dollar can be a headwind, as most of its customers are overseas. Republic Airways was a so-so performer that did better when the dollar was strong, and RF Micro Devices was a strong performer that did less well when the dollar was strong. 

Putting the two companies together in the portfolio helps neutralize the effect of the exchange rate and minimizes that exchange-rate risk factor. Whether the dollar goes up or down does not affect the portfolio too dramatically. Net-net there was a positive performance across the portfolio. 

This balancing of interrelationships among the positions goes on across the whole portfolio.

Q: How does price fit into your research process?

There are two things you have to consider with price: how volatile it is and the recent trends. Quite often, when something negative is happening within a company, the market gets wind of it and the price starts to trend down even before the industry analysts update the data they issue. So if a company looks attractive but we see some of these down trends from a technical perspective, we know we have to be careful.

Q: How do you construct your portfolio?

Our goal is to concentrate on stock-by-stock performance and try to minimize the effect of the broader market forces on the portfolio. We use a third party risk model to capture a lot of those trends. It monitors 10 different investment styles—value, growth, momentum, among others—so we constantly have a measure of how broadly our portfolio is exposed to those styles and can neutralize that. 

We might sometimes decide to allow a style exposure to grow, but it has to be intentional. If we do not want the exposure in the portfolio, the model helps us control it.

We believe that risk is concentrated at the industry level, and the model measures 55 or 60 industries. We do not mind being overweight or underweight industries, but we want to limit that, and not be surprised by an unforeseen market event that’s outside of our ability to control. If there is a handful of stocks in a particular industry that we think are attractive and want to hold, we still want to limit our exposure to a quick swing in an industry’s fortune.

For instance, last year the portfolio had four stocks in the auto-parts industry, including Lear Corp. and Delphi Automotive. We thought the industry looked attractive and identified even more interesting stocks, but we knew we were overweight auto components and so we passed on them. 

Then Ford announced its growth in China and Asia was likely to disappoint, and all the stocks sold off. Since we had limited our exposure, we limited the damage to the portfolio.

Q: What drives your sell discipline?

For us sell discipline is an ongoing process. We constantly re-evaluate the stocks based on how attractive we think they are, how likely they are to outperform the market and how they fit into the risk profile of the portfolio. As a whole, each stock contributes one or both of those attributes to the portfolio. Either it is going to perform or it is going to help manage risk, so we can hold other stocks that we think are going to perform. At some point another stock may come along that is more attractive and still has the same risk characteristics.

We like to rebalance the portfolio in big baskets, which is more efficient in terms of both trading and portfolio management. This approach provides us with a list of the stocks that we are ready to move out of the portfolio or reduce their positions, and a list of stocks we want to move in.

Q: How do you define risk? How do you measure and control it?

One of the advantages of small caps is that active managers can add so much value. Our clients expect us to take some risk in exchange for adding that value. 

For us the heart of risk is tracking error—what’s our risk versus the Russell 2000 Index benchmark? I have to make sure that for every bit of active risk I take I get some sort of benefit, that the companies I am guiding into the portfolio are likely to outperform.

We do not believe in focusing on total risk because our clients have already decided to invest in small-cap stock. I do not think it is my position to put money into cash. Any cash we have in the portfolio we cover with the Russell 2000 futures, so the portfolio is 100% invested at all times. 

Overall, we love investing in the small-cap segment because we see it as a place where active managers can make a real difference.