Small Cap GARP Fund

A good small cap fund is tough to find. A successful fund can find itself swamped with incoming new assets. It becomes difficult to stay in the small caps when assets under management reach over $500 million.

Here is a small cap fund that has only $115 million under management. Its track record is less than 2 years so it does not have a Morningstar rating. But its performance as a Small cap GARP (growth-at-a-reasonable-price) fund has been more than respectable. Morningstar catagorizes the fund as a growth fund but its style is more a blend. This is not an aggressive growth fund so its style will hoover between blend and growth (see the style performance chart).

My only crticism is the fund is expensive because it charges a 12b-1 fee. I try to avoid funds that charge 12b-1 fees. But if you are looking for a good Small Cap GARP style fund the Champlain fund has alot to offer.

Below is some additional information on the fund from Litman Gregory.

Also here is the link to the firm's website.

http://www.cipvt.com/

The Financial Pragmatist

Libby Mihalka

February 2007

DUE DILIGENCE REPORT: Champlain Small Company Fund (CIPSX)
Manager: Scott BraymanCategory: Smaller-Cap Growth at a Reasonable Price

Over the past few months we completed due diligence on Champlain Small Company Fund. Our history with portfolio manager Scott Brayman dates back to late 2004, shortly after he left NL Capital Management (where he managed Sentinel Small Cap Fund) to start Champlain Investment Partners. After following the firm for almost two years, we resumed coverage and have since had several phone calls with Brayman and the three analysts, a face-to-face meeting with Brayman at an investment conference, and a visit to their Vermont offices. As a result of our research, we are adding the fund to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category, reflecting our confidence in the fund’s ability to perform at least as well as the benchmark over time. Approved is a designation that reflects a high level of selectivity, and few funds we research manage to clear this bar. Below is a summary of Champlain’s investment process, the firm/team’s background, and the basis for our favorable opinion.

Summary of Investment Process:

The investment focus is on buying small-cap companies with superior business models at a good price. Brayman defines a superior business model as one where a company earns a profit that exceeds its cost of capital. He believes investing in these good businesses at a good price is a high-probability path to wealth creation. Brayman thinks about capital preservation and strongly emphasizes managing business risk. He focuses on companies with more-predictable operating results, while trying to avoid companies with less reliable business patterns that can lead to big losses. Managing valuation risk is also important. The team looks to capitalize on Wall Street’s shortsightedness or overreaction to a company’s short-term problems, thereby limiting downside potential. In managing portfolio risk, Brayman builds a diversified portfolio of 75 to 100 names. His goal is to “build a portfolio that outperforms notably in three years, and compellingly in five years.”

Idea Generation/Fundamental Research:

The team starts with the S&P 600 as its investment universe, as they believe this benchmark offers a higher-quality group of stocks than the broader Russell 2000 Index. However, they look at numerous companies outside of the S&P index as well. The process for winnowing down the universe is based on a qualitative assessment of a company’s business models to determine if it’s the type of company they want to own. This qualitative assessment is based on a number of “sector factors” that are designed to highlight predictable (i.e., consistent operating results) and defensible business models, while minimizing exposure to factors that can create high variability in cash flow, and ultimately stock prices. Brayman emphasizes the word “minimize” because in some cases it’s difficult to completely steer clear of the risks that the sector factors are designed to avoid.

Brayman applies these sector factors to five major sectors: technology, health care, financials, industrials, and consumer. In technology, the sector factor is low obsolescence risk. Brayman thinks trying to correctly time the buying and selling of the latest hot tech product is a loser’s game. Owning these companies/products would force him to make too many decisions around the success of the product, determining the appropriate valuation, as well as the timing of trades, all of which he says increases the odds of a mistake and potentially a big loss. Instead, he looks to own tech companies with recurring revenue or those that sell a unique product. In the consumer sector, he looks for brand loyalty and tries to avoid brands going out of style. In health care, he wants to minimize exposure to government payors because changes in government reimbursement are too tough to call and can lead to big stock-price declines. In industrials, Brayman wants to avoid decisions centered on the timing of economic cycles, so he looks for problem solvers and innovators in the industry. In financials, he looks for companies that have a very strong niche because he believes large-cap financials have an advantage over small-caps due to their scale and therefore a comparatively lower cost of funds.

Brayman estimates that the sector factors eliminate about 60% of the universe. For the companies that pass the sector factors, Brayman looks for superior relative growth, low debt, quality earnings (i.e., positive cash flow), proven management, and strong company fundamentals. Touching on each of the components, Brayman is looking for the best growth opportunities within each of the five major sectors. He is constantly ranking companies in each industry (based largely on feedback from the firm’s three sector analysts) to see what stocks are the cheapest and why. As for the low-debt criterion, Brayman prefers companies that are able to grow their business organically, i.e., they don’t have to go to the credit markets to fund growth. Related to debt is the “quality earnings” attribute, which Brayman defines as strong cash flow from operations. When assessing management, Brayman looks to see how they manage the balance sheet, how it deploys capital, the deals management has done, how they have followed through on what they said they do, and how they manage inventories. Brayman also wants to see managements’ interests aligned with shareholders, who they have on the company’s board, the compensation structure, and how much “skin they have in the game.” As for company fundamentals, the team evaluates factors such as the competitive environment, barriers to entry, end-market opportunity, financing, and long-term growth expectations.

Valuation:

For companies that pass the sector factors and look appealing based on the company attributes listed above, the team then turns to valuation. They look at valuation from a few perspectives because Brayman believes valuation is an art and every valuation approach has its strengths and weaknesses. Their valuation methodologies include: an internally generated discounted cashflow (DCF) model, a DCF using HOLT (a third-party valuation tool), transaction-based analyses (if applicable), and historical valuations relative to a company’s history and its peers (although this last approach gets little weight). As part of their valuation analysis the team runs through scenario analysis (particularly with the DCFs) to get an understanding of what the big swing factors are in order to get a sense for the range of outcomes. Because each valuation approach can result in a different price target, the team uses a weighted-average of the different results, where they give the most weight to their highest-conviction valuation.

When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies (i.e., a more-mature business that they can look at and learn from in order to assess trends in revenues, margins, etc.). A general rule with respect to the growth rates they are willing to use in the DCF models is that a company can only grow as fast as it can reinvest its cash flows. For example, if a company has a 10% return on investment, and is retaining 80% of earnings, by definition its cash flows can only finance 8% growth assuming the balance sheet items stay static, i.e., the company is not issuing stock or borrowing money. If a company says it’s growing much faster, the team is very skeptical and they would have to clearly understand where the capital will come from to fund the growth. Brayman is biased against companies that constantly dilute shareholders with equity or debt, leveraging up the balance sheet to sustain a higher growth rate. Generally speaking the “steady-state” growth rates used for the DCF are 5% to 6%, although some may be slightly higher at 7% to 8%. The rationale here is that Brayman also believes growth expectations are generally hyped and peak-to-peak earnings growth is about 6% over time, “yet every company is touted as a 15% to 20% grower in small-caps.” He says the reality is that the Russell 2000 growth rate is about half of the forecasted growth rate over time.

As part of the team’s valuation work, they also look at what they call “strategic value.” The team evaluates if each company has “something really special” that a larger company might be interested in acquiring. For example, if a small company has a great product but no distribution, a large company might easily fold it into its business. For these types of companies, they will selectively increase the target price by a “nominal” amount, generally no more than 10%. The team also adjusts for the dilution of options.

As for the degree of the discount at the time of purchase, the team tries to buy at a 20% to 25% discount. They will accept a somewhat lower upside for a “rock-solid company.”
Portfolio Construction: The portfolio consists of approximately 75 to 100 stocks of small companies, and to a lesser extent medium-sized companies. Position size is a function of business risk, liquidity, and valuation discount. More-predictable business models with a longer operating history will typically be larger holdings, not necessarily the cheapest stocks. Smaller positions generally have less operating history or higher levels of perceived risk. Brayman has loose sector-weighting guidelines (no more than 25% of the fund’s assets will be invested in any one industry), and overall sector weighting are a byproduct of bottom-up stock selection, not a sector call. The fund is managed close to fully invested.

Sell Discipline:

The team generally begins to trim a holding when it is within 5% to 10% of its estimate of fair value, and in most cases will sell completely when a stock hits fair value. But if a stock has a lot of price momentum (and fundamentals remain strong) the team may not sell completely in an attempt to take advantage of Wall Street’s optimism. Explaining this, Brayman says, “Historically we know that markets and stocks tend to overshoot. If they want to overshoot, we’ll let them, but we begin a program of systematically cutting back on a stock.” The team also has a “down 25% rule,” where they have to take a fresh look at the stock if it is down by 25% from the time of purchase, but in practice the team is taking a close look when the stock is down 10%.

Firm/Team Background

Champlain Investment Partners was founded in 2004. All key professionals at Champlain (both investment-team members and business operations) formerly worked together at National Life Group’s investment-management subsidiary, NL Capital Management. The four-member investment team is led by Brayman, and the fund is run using an investment process that has been in place since 1996.

While Brayman is responsible for making the final investment-management decisions, the three analysts play an integral part in generating investment ideas. The three analysts are divided by sector: health care, technology, and consumer. Brayman covers financials, industrials, and energy. Each member of the team applies the investment process to the names in their sector, determines fair value for each stock, and then recommends buy and sells.

The analyst team is made up of Van Harissis, who covers consumer stocks. Harissis has more than 20 years of investment-management experience, and prior to joining Champlain his most-recent role was lead portfolio manager for Sentinel Common Stock Fund and co-manager of Sentinel Balanced Fund. David O’Neal covers health care. Prior to joining Champlain, he was a health care equity analyst for the small-cap and mid-cap equity products at NL Capital Management. Daniel Butler follows technology. His most recent experience was as a technology analyst for Sentinel’s small-cap product.Champlain offers a small- and a mid-cap product, and the investment team is responsible for both strategies. The mid-cap product (which is currently only available via separate accounts) is often made up of companies that the team owned in its small-cap strategy, and with which they are very familiar, that migrated up in market cap as a result of their success. The only difference between the small- and mid-cap products is market capitalization. The mid-cap product can only buy stocks with a market capitalization above $1.5 billion. Brayman targets a median market capitalization of $1 billion for the small-cap product versus $4 billion to $6 billion for the mid-cap product.

As of year-end, Champlain manages approximately $585 million in domestic equity assets (including mutual fund and separate-account assets). The vast majority of assets are in small-cap.

Performance

When assessing Brayman’s performance, we take his record from Sentinel Small Company Fund into consideration, which he ran from late 1995 until he introduced Champlain Small Company Fund in November 2004. One important consideration in evaluating Brayman’s record is that there was a meaningful change in the number of portfolio holdings. Brayman started running this strategy at NL Capital in 1996, and for the first two years, Brayman was basically a one-man shop and held an average of 50 holdings. As he grew the investment team, the number of names increased. Since 1999, the portfolio has held between 75 and 100 names. Brayman contends that the higher number of names does not dilute the portfolio’s upside potential. A larger team means they can cover more ground, and Brayman’s experience is that a lot of the upside comes from interesting emerging-growth ideas, which are names that he’s confident in but doesn’t want an above-average position size for liquidity or increased risk reasons. As Brayman puts it, “Large positions are positions I’m more comfortable with. If I’m comfortable with them, a whole lot of other portfolio managers are also comfortable with them. Big gains come from names that others are uncomfortable with. But as management proves itself and peoples’ confidence goes up, there’s tremendous price upside.” Despite the increase in names, we think Brayman’s entire track record is applicable. He is still the lead portfolio manager and he is still using the same investment philosophy and process.

Since the beginning of his record, Brayman’s annualized return (through December) is 14.7% compared to 9.8% for the Russell 2000 Index iShares. (Note: Prior to the iShares’ inception, we use the Vanguard Small Cap.) A big component of Brayman’s strong outperformance is due to very good absolute and relative performance in 2000, when the fund was up 38.9% compared to a 3.8% loss for the benchmark. Outperforming in a down market is consistent with our expectations for the fund, although the extent of the outperformance in 2000 is not something we’d bank on in the future. Qualitatively, we expect the fund to lag its benchmark during strong small-cap markets, and outperform in average or weak environments, particularly when there is a flight to quality such as in calendar year 2000. Our view is based on the team’s clear focus on buying companies with consistent earnings and attractive valuations.

The fund’s historical record highlights the success of the downside risk control. Since 1996, the Russell 2000 iShares benchmark had 35 periods where rolling 12-month returns were negative. The average loss during these negative periods is 11.3%. During those same 35 periods, Champlain Small Company Fund suffered a loss in only 16 periods, and the fund’s average return was a 0.2% gain. The fund’s worst 12-month performance is a 19.9% loss, compared to a 27% loss for the benchmark. The fund has also beaten the benchmark in up markets. Since 1996, there are 86 rolling 12-month periods where the Russell 2000 iShares was positive.

During those periods, the fund’s average gain is 21.7% versus 20% for the benchmark. The fund’s best 12-month gain was 47.8% compared to 64% for the benchmark. Looking at the fund’s consistency over rolling three-year time frames, the fund has beaten the benchmark in 81% of the periods. The 10-year-plus track record provides evidence that this disciplined investment process has led to a high degree of consistency.

Litman/Gregory Opinion

As a result of our research, we feel there are a sufficient number of positives to warrant adding Champlain Small Company Fund to our Approved list in the Smaller-Cap GARP category. Below are the key positives that underlie our opinion.Champlain employs a thoughtful and well-laid-out investment process that’s designed to stack the odds of success in their favor over time. The team uses an uncommon process for generating ideas via the sector-factor criteria, which not only creates clear-cut parameters for what qualifies as a buy (or a sell in the case of a changing business plan), but aids in minimizing the likelihood of an unexpected negative surprise. In our conversations with the team, the decision-making process was clearly articulated and conversations with each of the team members made it extremely clear that the process is applied consistently. The team sticks to its circle of competence.

There is a focus on capital preservation and elements of conservatism are apparent throughout the process. The team looks for investments with a clear eye towards preserving capital (such as consistent earnings, attractive valuations, sound financials, and proven management) in order to increase the probability of a favorable outcome. By lining up these attributes, the team believes it has gone a long way to make sure the portfolio is set up for long-term outperformance. There is a definite focus on avoiding a big downside move, and the team consistently demonstrated that they are willing to be patient (and even miss out on some of a stock’s upside) to ensure that operating fundamentals are intact and they won’t have a big negative surprise on the downside.

The team does thoughtful quantiative analysis. We find their analysis to use realistic, conservative assumptions that are based on an understanding of the company, its history, and the industry, as opposed to unique insights, superior number crunching, or better information gathering. Although we don’t think the team wins by gaining an information edge, there’s a clear focus on gaining a solid understanding of the issues that could negatively impact the business, and making sure a sufficient margin of safety puts the probability of being right in their favor.

Their qualitative thinking comes out in the team’s valuation analysis where they take a well-rounded view and look at a number of methodologies and scenarios. Their goal is to be aware of their assumptions and what the sensitivities are to those assumptions. In Brayman’s words, “The more scenario analysis you do, the more probability-weighted thinking you do, which helps you to understand the potential risks.” They also have an interesting way of thinking about valuation with their “strategic value” component. Our discussions about companies where the team applied a strategic value component to its valuation assessment served to emphasize the team’s knowledge of companies and the industries.

Another positive is the team’s stability. We recognize that Champlain is only two years old, but the team has worked together previously and in our conversations with Brayman, he clearly wants to build a team that stays together. All but one of the team members has equity and Brayman is planning to give the remaining member equity in the near future. The ownership in the firm makes investment-team departures less likely.

Brayman is also shareholder-oriented. He strikes us as someone who wants to win for shareholders. He conveys a sense of high integrity, and there are clear signs of intellectual honesty as well as a willingness to admit mistakes and cull losses; there are no signs of hubris. Brayman is very mindful of assets and plans to close the fund at $1.5 billion, a level we find reasonable. Expenses are reasonable at 1.4% given the relatively small asset base.

Our decision to add the fund to our Approved list reflects our confidence in the fund’s ability to perform at least as well as a benchmark, if not better over time. As such, we would be comfortable using this fund as an alternative to an index fund. We reiterate that Approved is a high hurdle for us, and as always, we will continue to stay in touch with the team and provide ongoing updates.

While there are enough things to like about Champlain Small Company Fund to give us the confidence to add it to our short list of Approved funds in the Smaller-Cap Growth-at-a-Reasonable-Price category, we are not able to gain a high enough degree of confidence to get to Recommended. We reserve Recommended for funds that have a clearly identifiable investment edge, giving us a high degree of confidence that the fund will beat the benchmark over the long term. In the case of Champlain, we feel that they do several things well, all of which stem from a well-thought-out and consistently applied investment approach. But in the end, we couldn’t identify a specific, clear cut edge. For example, we thought both their qualitative and qualitative analysis was good in that it was thoughtful and well-reasoned, but we did not identify an edge or something that they clearly do better than the competition. When coming up with their models, the assumptions they use (e.g., revenues, margins, and growth rate) are often based on a combination of company operating histories, industry knowledge, and studying similar business models of larger companies, as opposed to unique insights gained by digging deeper than the competition. At the same time, there’s an element of conservatism that’s used in their models, where the team doesn’t need to make aggressive assumptions in order to be right on the stock.

We think this is a positive, but again, by itself it’s not a clear edge. In the end, determining an edge is somewhat subjective, and we recognize that Champlain’s process itself may provide them with an edge. However, we don’t feel strongly enough that this is the case to recommend the fund outright.

As for concerns, we don’t have any major issues. One area we will continue to monitor is the growth of the team’s mid-cap product. Currently the mid-cap separate account is only $1 million, but the team is considering the introduction of a mid-cap mutual fund. To the extent that this product grows and detracts from the amount of time the team is spending on small-cap (either through following more names or additional marketing efforts) we would view it as a negative. All else equal, we favor teams that focus on a specific strategy.
—Jack Chee

_________________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.