Q: Why invest in micro-cap stocks? A: Investors with a disciplined approach who are searching for companies with growing earnings…and are prepared to do the research to find these stocks…are likely to be rewarded for their work. Historically, the sector has experienced higher volatility than others, but it has also delivered higher returns. However, we do not invest in biotech stocks and deep-value or turnaround situations. There are approximately 3,000 names in this sector of which 200 to 250 of them qualify for our investment screens to watch. We focus primarily on companies that are generating earnings, as our philosophy is that earnings drive the price appreciation of the stocks. And, importantly, we want to find these companies early on in the price appreciation cycle. Q: How do you find these stocks? A: We seek to invest in companies that are trading at a 20% or more discount to their long-term earnings growth rate. Our investment discipline is to select these stocks one at a time. We do not start with any sector or economic biases. We are interested in stocks whose market-cap valuations range from $50 million to $300 million. We pay a lot of attention to the reported earnings of a company. Q: Why are you looking to buy the stock of these companies at a discount? A: We invest in companies with a certain amount of discount so that we have downside protection. Companies that build consistent earnings track records generally experience expansion in their price-to-earnings ratio. Our job is to discover these companies before other investors discover them. Investing in this sector also means embracing higher volatility and greater likelihood of surprises. We seek to avoid these downturns and volatility when we buy at a discount. We are also looking for companies with strong balance sheets and cash flows that allow for the funding of future growth. Q: Do you pay closer attention to the management teams? A: Micro-cap companies generally have thin management. We are looking for a management team that has experience in growing businesses and earnings. Depth in management is important to us because it signals broad experience, financial control, and the industry knowledge needed to manage a firm’s growth in revenue and earnings. Q: What is your sell discipline? A: Our sell decisions are based on four criteria; if a stock meets one of these, we may sell it. For example, if a company’s stock is priced at twice to its earnings growth rate, we will sell it. At such a high price, we believe that the stock is likely to be susceptible to significant downward pressure. If a company’s market value exceeds $600 million, we sell the stock. We want to remain true to our investment discipline, so we do not want the fund to begin having holdings that are in the small- and mid-cap sectors. If a company’s fundamentals change, such as the loss of its largest customer, management problems, or it makes gross or operating margins revisions, we sell the stock. If the stock holding grows to more than 2% of the fund’s assets, we sell the stock; we do not want one stock dictating the fund’s returns. Q: What is your research process? A: Investing in this sector requires a disciplined approach in finding and evaluating companies. Very little research is available in this sector that one can rely on. Our approach is to discover names through our research process that are driven by earnings. We discover 70% of the names that we invest in using this method. We start with the reported earnings and then apply traditional fundamental research to the company business model. We discover 15% of our names through those that are suggested to us by research boutiques. Very few research companies are active in this sector, and it is also not very widely followed by a large group of investors. The rest of the fund’s names we discover through quantitative research. Q: How many stocks do you have in the portfolio? A: Typically we hold between 60 and 80 stocks; currently we have 74 stocks in the portfolio. Q: How do you deal with lack of trading liquidity in these stocks? A: We prefer to hold stocks that have at least an average daily trading volume of 30,000 shares. The management ownership of stocks is also important to us. In addition, we look at the other shareholders in the company to make sure that if we decide to sell stocks in the company we will have enough market for them. Q: Does it have any impact on your portfolio turnover ratio? A: Our portfolio turnover is driven by market volatility or a change in fundamentals. If the market runs up 40% or more in any sector or in any quarter, then we like to sell the stocks in that sector or during that quarter to reduce sector and security risk associated with the increase in valuations. When the fundamentals in stocks change, we are likely to sell them because we believe that there will be more problems to follow. Historically, we have averaged portfolio turnover of between 120% and 130%. We try to keep the process of buying and selling as tax-efficient as possible to minimize the capital gains distribution. Q: How do you gain research advantage in this sector? Do you find that visiting the management at companies adds value to your research process? A: We find the majority of the companies that we invest in through their reported earnings and the fundamental work of our research team of three analysts. We do not visit management, but we go to conferences. We find that visiting investor conferences is very productive. We can meet with more than 200 companies in three days. We not only hear from companies, we also hear from their competitors and the majority of other companies in the industry. This way we gain industry and company perspective. Management visits has not proven to be the best use of our time. We do not employ a sector view when we are researching a company; we use a bottom-up research approach that we conduct one company at a time. I started out as a tech and healthcare analyst. Typically, analysts have a background in retail media and the telecom area, and each one has specific knowledge. We, however, pride ourselves in being generalists and we search for a company based on the fundamentals rather than the macroeconomic picture. We do not start with the idea that we like a specific sector and then search for a company in that sector. We start with reported earnings and then we look for the company that meets our fundamental criteria. Q: Are you required to follow or track any index? A: We look at the Wilshire Micro Cap Index as one that is closet to our fund; however, we are not benchmark sensitive and we do not mimic the index. Our philosophy is to find the best companies, and our selection process is not based on the allocation or weights in the index. For example, the index has biotech companies, but we do not hold them in fund have biotech companies because these companies do not have earnings. Q: Let’s discuss some of your fund’s holdings? Why did you buy them and why you still hold them? A: SunOpta Inc. is one of our recent holdings. The company is a leader in producing soymilk concentrate and oat fiber. The company’s business focuses on the health and organic segments of the market, which are growing rapidly. The company has been adding manufacturing capacity and, of late, management has started to focus on opportunities for food distribution in the United States and Canada. The company recently began generating profits. CyberOptics Corp. is one of my fund’s top 10 holdings. The company plays a critical role in manufacturing electronic consumer gadgets, in addition to the manufacture of testing equipment and optical sensors that are sold to Flextronics and other Asian contract manufacturers. The stock is trading at a price-to-earnings multiple of 14, and the company has no debt on the balance sheet. We believe that electronic gadgets, such as iPod from Apple and flat screen monitors and TVs, will be increasingly popular, which is going to generate consistent earnings growth. Even though the company’s testing equipment is a small niche, the market is big enough to allow the firm to prosper. Radyne ComStream Inc. is another fund holding. The company is active in the ground-based portion of satellite communications systems and cable networks to transmit data, voice and video-over-Internet. The company's products are used in applications for telephone, data, video and audio broadcast communications, as well as private and corporate data networks, Internet applications, and digital television for cable and network broadcast. The company will benefit from the current trend in the TV signals to be broadcast in the HDTV format. There are some concerns that the company may experience quarterly volatility in booking orders. The stock is trading at a price-to-earnings ratio of 15, based on next year’s earnings. The micro-cap companies such as Radyne have volatile earnings, especially in the tech area, and we are concerned about that, though the company’s fundamentals are still solid. Lowrance Electronics, Inc. is another of our top 10 holdings. This family-run business manufactures SONAR and GPS applications. The company’s products are generally known as depth and fish finders, as well as terrain marking and mapping devices. The management has been successful in expanding the business into the GPS-based application in the last two years. The Company's SONARs are principally used by sports fishermen for detecting the presence of fish and by boaters as navigational and safety devices. Its GPS receivers are used in a variety of marine and non-marine applications, including aviation, automotive, hunting, hiking and backpacking. The company has doubled its earnings in the past year and could repeat this performance; it is still selling at 10 times earnings. On the downside, the stock is not highly liquid and there is no analyst coverage on the company. Q: When do you sell stocks in your holdings? A: Changes in company earnings, the business environment and the management drive us to sell stocks. If any of these changes significantly affects earnings growth, we sell. We have one or two companies that miss their earnings target every quarter, and that is why the fund is diversified into about 70 stocks in order to reduce individual stock risk.