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.

U.S. Small Cap Stocks Appear Over Valued

Small Caps appear due for a correction. They have outperformed their Large Cap brethren since the dot-com bust. It is now time for Large Caps to prevail. I have discussed this trend several times in my blog and newsletters. See last quarter's newsletter posted at our website: http://www.altamontwealth.com/newsletters.html

Here is a New York Times article that further bolsters this argument.

The Financial Pragmatist

Libby Mihalka

March 18, 2007

Beyond the Bubble, With Small-Cap Stocks

By MARK HULBERT

SMALL-CAP stocks are significantly overvalued. In fact, they are even pricier, on average, than they were in March 2000, just before the Internet bubble burst. In contrast, the average large-cap stock is moderately undervalued.

This picture of a highly bifurcated stock market is painted by data from Ford Equity Research of San Diego, which tracks around 4,500 publicly traded companies in the United States. Among companies that have been publicly traded for at least seven years, the firm reports that 55 percent have higher price-to-earnings ratios today than they did in March 2000. The bulk of these pricier issues, however, are in the smaller-cap sectors. Among the very largest companies, the average P/E ratio is now just a third of what it was seven years ago.

If investors focused only on the broad stock market averages, however, they might conclude that the entire market is undervalued. According to Standard & Poor’s, for example, the P/E ratio of the S.& P. 500 currently stands at 17, based on trailing 12-month operating earnings. The comparable ratio at the end of March 2000 was 31.1, almost double the current level.
Though the S.& P 500 includes many large-cap stocks, it also contains smaller-cap issues. Why is the index’s P/E ratio nevertheless so much lower than it was seven years ago?

The answer lies in how the index is put together. The S.& P. 500 is a capitalization-weighted index, meaning that each company’s contribution to it is a function of the company’s size. That would not necessarily skew the average P/E ratio for the index itself, if the average valuations of both larger and smaller stocks were similar. But that’s not the situation today, according to Ford Equity Research: the 50 companies in the S.& P. 500 with the smallest market caps have an average P/E ratio that is much higher than it was seven years ago, while the ratio for the 50 largest-cap stocks in the index is significantly lower.

According to Ford Equity Research, the average P/E ratio among the 50 largest-cap companies is now 19, about a third of the average of 60.7 for the biggest 50 in March 2000. The average market cap for the 50 largest companies is now $123 billion, versus $153 billion in March 2000.
Contrast those numbers with those for the 50 smallest companies in the index: their average P/E ratio is now 30.7, versus 20.3 seven years ago. And their average market cap is now $3 billion, versus $1 billion.

In other words, the smallest-cap stocks in the S.& P. 500 are significantly more overvalued today than they were seven years ago. Yet their higher P/E ratios barely affect the ratio for the index as a whole. That’s because the combined market capitalization of the 50 largest stocks account for nearly half the market cap of the entire S.& P. 500, while that of the 50 smallest stocks add up to just 1.2 percent of the total.

“Investors who pay attention to the P/E ratio of cap-weighted indexes such as the S.& P. 500 therefore need to exercise great care when drawing conclusions about stocks’ relative valuations,” Richard Segarra, director of research at Ford Equity Research, said in an interview. “At best, the P/E ratios for such indexes shed light only on their largest-cap stocks; we should avoid drawing any inference from a cap-weighted index’s P/E ratio about the valuations of its smallest-cap members.”

MR. SEGARRA found that the index’s prevailing pattern also holds true across the universe of stocks that his firm tracks. As a result, an investor who emphasizes market sectors according to relative P/E ratios would have a very different portfolio today than in March 2000. Back then, he would have favored small caps over large caps — and been handsomely rewarded for this choice. The trend is seen in the annualized total returns since March 31, 2000, of three Dow Jones Wilshire indexes: 10.1 percent for the U.S. Microcap Index and 7.2 percent for the U.S. Small-Cap Index, but only 0.5 percent for the U.S. Large-Cap index.

Today, however, according to Mr. Segarra, that investor would favor large caps over small caps. Not only is the average P/E ratio of large-cap stocks only a third as high as it was in March 2000, it is nearly 10 percent below its average level of the last five years. There’s no guarantee, of course, that large caps will outperform small caps over the next five years — but there’s a good argument to be made that they will.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

Trendstar Due Diligence Report

To my clients, here is a new fund I have started adding to many of your portfolios. I have just finished my due diligence on this fund so it was not included in your year end rebalancing. I am very excited to add this fund to our stable of high quality investments.

If is difficult to find good small cap managers that have a great track record but does not have too much under management. Many small cap fund under perform because they have more than $500 million under management.

This is a no load and no commission fee fund. The annual expenses are very reasonable for a new fund. I will be sending out the Morningstar Extended Report on this fund in the next two weeks. In the meantime, enjoy this research report.

I am in Santa Fe New Mexico the rest of the week on a due diligence trip to Thornburg Management. I will report my findings when I return.

Libby Mihalka
The Financial Pragmatist

January 2007
DUE DILIGENCE REPORT : TrendStar Small-Cap Fund (TRESX)
Category: Smaller-Cap Growth at a Reasonable Price Managers: Tom Laming and James McBride

We recently completed due diligence on TrendStar Small-Cap Fund and we are adding it to our Recommended list in the Smaller-Cap Growth-at-a-Reasonable-Price (GARP) category. Our history with lead portfolio manager Tom Laming dates back to late 2003, shortly after he left Kornitzer Capital (advisor to The Buffalo Funds) to establish TrendStar Advisors. At that time we identified a number of positives, but because we felt that getting a business off the ground could create a number of distractions and divert Laming’s attention away from investing, we decided to revisit the fund at a later date. We re-established contact with Laming a few months ago with a focus on the firm’s small-cap product, an asset class where we have a limited number of Recommended investment options that are available to new investors. We have since had several hours of phone conversations with Laming and co-manager James McBride. We also met with Laming for three hours in our Orinda offices. In the end, we gained a high level of confidence that the fund will outperform an index fund over time. This report lays out the firm/team background, the investment philosophy and process, the portfolio-construction process, and the reasons for our positive opinion of the fund.

Team and Firm Background
TrendStar Advisors was formed in August 2003 shortly after Laming and McBride left Kornitzer Capital. Laming joined Kornitzer in 1993, and subsequently served as the chief equity strategist and was the lead architect of the investment philosophy and process that was used to manage the Buffalo mutual funds. Laming also served as co-lead portfolio manager on Buffalo’s small-, mid-, and large-cap funds as well as a global fund. He was the sole manager of Buffalo Science & Technology Fund. McBride was a research analyst at Kornitzer from November 2000 to August 2003, and he also worked on all of the Buffalo equity funds.

Two months after establishing the firm, Laming introduced TrendStar Small-Cap Fund and TrendStar American Endeavor Fund. Laming manages these funds with the same investment approach he employed at Kornitzer. The Small-Cap fund focuses on domestic stocks with companies less than $2 billion in market capitalization at the time of purchase. American Endeavor Fund considers only U.S.-based companies that receive more than one-third of their sales or income from outside the U.S. This fund is all-cap by prospectus but is, in fact, mostly large-cap. Both funds are co-managed by Laming and McBride, although Laming is the lead portfolio manager.

TrendStar currently manages approximately $400 million, including separate accounts.

Philosophy/Process
Laming starts by looking from the top-down for fast-growing companies followed by a bottom-up analysis that focuses on valuation. He first looks for broad industry trends, and ideas can come from trade publications, industry research, contacts, and company filings. Specifically he’s looking to identify growth drivers that he thinks will provide tailwinds for the revenue lines of companies over the next three to five years. Importantly, he only invests in trends that he believes have a high degree of predictability. For example, demographic trends have very predictable outcomes, enabling Laming to determine with good accuracy how many people are in various age brackets and what segment of the population is growing the fastest. Laming says 45- to 64-year-olds will grow by over 18 million people between 2000 and 2010. Over the same time period, companies that sell to 25- to 44-year-olds will see their end market shrink by a few million people.

This top-down portion of the process gets Laming focused on the faster-growing segments of the market. He then identifies companies that are aligned with these longer-term growth trends. Companies that do not appear to be primary beneficiaries of a trend are eliminated from consideration. For example, within the demographics trend, grocery stores would not qualify as a primary beneficiary. Although they sell to 45- to 64-year-olds, they also sell to the slower-growing (or declining) segments of the population, which dilutes their growth prospects. Instead, Laming seeks out companies such as Ethan Allen, a retailer of home furnishings that targets the rapidly growing population of 45- to 64-year-olds. This process of identifying companies that have the most direct exposure to a long-term trend narrows the investable universe (stocks under $2 billion in market-cap) to roughly 350 to 400 stocks.

Once a company passes the top-down trend qualification, Laming turns to valuation. He determines whether a stock is overvalued or undervalued using a multiple-regression model that allows him to analyze several variables that contribute to a stock’s valuation. (This is in contrast to other valuation methodologies that rely on a single variable such as a P/E multiple.) The key variables Laming looks at are profit margins, growth rates, and balance-sheet quality, although there are other less-important parameters. Laming uses regression to determine the importance of each variable for stocks’ valuations. For example, Laming’s regression analysis suggests that margins have the highest correlation to stock-price movements. So, all else equal, higher margins warrant higher stock prices. But margins are not equal for all companies, and Laming must estimate a value for each variable in order to arrive at a stock price. In doing so, Laming devotes a lot of time to studying a company’s historical profit-margin structure as well as margins within an industry to assess whether a company can maintain or improve its margins. He tries to avoid companies with declining margins, as it would translate into lower stock prices. Laming often uses a normalized margin in his model. He also estimates growth rates, which are ultimately tied to the strength of an underlying trend, as well as the balance sheet. Strong balance sheets are important to Laming because he wants to hold companies that can grow organically, not those that are dependent on capital markets for growth. The regression provides a measure of relative valuation, with the end result that roughly half of the companies in Laming’s universe will appear expensive and half will appear undervalued. The regression is only run on the companies that pass the top-down screen.

Ultimately, Laming ends up looking at a blend of high-P/E stocks and some very low-P/E stocks. But in all cases the high P/Es are associated with a combination of very high profit growth, and typically low or no debt. The low-P/E stocks are generally companies with lower margin structures (such as retailers) and they may have higher (but not excessive) debt.
Sell decisions are typically the result of rising valuations or changing business models (e.g., a company changes its business focus or makes an acquisition that meaningfully dilutes its ability to benefit from a trend). Sells generally don’t result from changing themes. This is because Laming looks for long-term trends (not fads) that can ideally persist for at least five years.

The Portfolio
The portfolio has 50 to 60 holdings, which is more concentrated than most small-cap funds. Laming doesn’t buy stocks over $2 billion in market capitalization, though they can appreciate past that level; at the end of March 2006, all of the holdings were below $4 billion. Typical position size is 1% to 3%, and position size is largely determined by valuation, although the strength of a trend and a company’s long-term ability to benefit from a trend come into play. There are no sector limitations and the fund will generally be concentrated in the health-care, technology, financial, and consumer-discretionary sectors, all areas with favorable long-term trends, in Laming’s view. Turnover has been very low at 10% to 15%. The fund is usually fully invested.

Style Analysis
As part of assessing a fund’s performance, we spend a lot of time evaluating a manager’s investment style to ensure we are using the most appropriate benchmark. We do not employ hard-and-fast rules for determining investment style. Instead, it’s a mosaic, which includes a number of quantitative and qualitative factors such as a manager’s investment objective, valuation methodology, the aggressiveness of a manager’s assumptions, investment horizon, historical portfolio and sector weightings, etc. Selecting the “best” benchmark can be a tough call if the fund has attributes of different investment styles. But this is an important step in understanding how a fund should perform in different market conditions, and it enables us to stick with a manager during an inevitable period of underperformance (provided our original thesis is still intact). After going through this analysis for TrendStar Small-Cap, we are categorizing the fund as Smaller-Cap Growth at a Reasonable Price, though it has a growth bias.

Laming’s top-down approach generally leads him to the growth-oriented parts of the market, and the portfolio’s sector weightings tend to be more in line with the growth benchmark. While there is definitely a growth emphasis, we feel that there are a number of characteristics that push Laming over into the GARP category. First, he is conservative in his assumptions. We discussed several portfolio holdings with Laming, and there was a clear consistency of using conservative estimates when it came to selecting forward-looking inputs in the regression model. Second, Laming is more valuation sensitive than most growth investors we follow. His valuation methodology ensures that he does not overpay for growth, and he will not own stocks if he thinks the future growth expectations are reflected in a stock’s price. His valuation process also leads him to own the cheaper stocks within his universe. For example, if there are a handful of stocks that he believes will benefit from a trend, he will own the stock(s) that appear most undervalued. This valuation requirement will take the fund out of the hottest-performing sectors prior to a market peak, and could cause it to underperform a growth benchmark during those periods (e.g., the late 1990s).

Performance Analysis
Laming’s track record at TrendStar begins in August 2003, which is a relatively short track record to evaluate. In looking for a longer track record to analyze, we assessed the “transferability” of Laming’s record from Buffalo Small-Cap, which he co-managed since 1998.
We came away confident that Laming was the lead architect of investment philosophy and process used to run the Buffalo mutual funds, and that he is using the same process to run TrendStar Small-Cap. However, we are only comfortable looking at the Buffalo Small Cap record beginning in 2001 for the following reason: In examining historical portfolio holdings for Buffalo Small Cap, we noticed a number of holdings that were not consistent with the long-term trend strategy that Laming uses at TrendStar. For example, energy was a meaningful percentage of the Buffalo Small Cap portfolio prior to 2001. We know that Laming will not own energy stocks because of his focus on long-term predictable trends, as guessing the price of oil is not something he’s going to attempt to forecast. There is also evidence of other stocks not fitting Laming’s current-day thematic process. Our analysis indicates that Buffalo Small Cap was initially managed using a broader Kornitzer Capital strategy (one that was used to run the firm’s separate accounts and was not confined by trends) to Laming’s current-day philosophy and process. So given that there was not a hard-start date for when Laming’s trend-based process went into effect for Buffalo Small Cap, we are only comfortable looking back to 2001. But while we believe this portion of the Buffalo Small Cap record is relevant, we put the most weight on his TrendStar record.

Since 2001, Laming’s annualized return (through November) is 11.7%, compared to 9.7% for the Russell 2000 Index iShares. This outperformance can be traced to 2001, when the fund gained 31.2% compared to 2% for the benchmark. This staggering outperformance was due to strong-performing positions in consumer staples, consumer discretionary, and financial stocks, and a lack of declining technology and energy stocks. In subsequent years, performance is mixed and Laming’s short- to medium-term numbers are trailing the benchmark due mostly to a relatively poor 2006. Looking at rolling 12-month periods, Laming has beaten the benchmark in 67% of the periods. But this number improves to 94% when looking at rolling three-year periods. We expect Laming to be out of sync with the benchmark over shorter time periods given his long-term focus.

Litman/Gregory Opinion
After numerous conversations with Laming and McBride, and internal discussions among our research team, we have gained the necessary confidence to add TrendStar Small-Cap to our short list of Recommended funds in the Smaller-Cap Growth-at-a-Reasonable-Price category. Adding the fund to our Recommended list reflects our confidence that the fund will outperform the benchmark over the long term. Below we lay out the reasons supporting our positive opinion of the fund.

On the qualitative side, Laming employs a clear discipline for investing in long-term trends and identifying companies that stand to benefit from these trends. Laming and McBride apply their process very consistently and are rigorous in how they measure trends to ensure they can persist. Laming is also very patient and he will not invest until he is highly confident that he’ll get paid over time. He is extremely thoughtful in his trend analysis, and we believe this constitutes a large part of his investment edge. Our impression is that he knows his industries as well as, if not better than, the competition. We also think he does an excellent job at the company level where he considers factors such as companies’ competitive advantages, the threat of potential new entrants or substitute products, and bargaining power with suppliers/buyers. We also have no reason to believe that Laming is missing attractive trends. We discussed a number of possible trends with Laming, but he had clear reasons for not investing in those areas. He is currently invested in 19 trends.

Laming strikes us as a very intelligent and thoughtful investor. He has clearly thought out his process and he is always looking for ways to improve the valuation model, or at the very least, understand the model’s shortcoming so that he can factor that into his qualitative decisions. He freely admits mistakes and figures out where he went wrong in an attempt to avoid them in the future.

Laming does not attempt to chase performance or pick any given year’s best-performing sector. When to buy and sell stocks is determined exclusively by the valuation methodology. Laming has clearly developed this methodology over the years. While this is noteworthy on its own, his adherence to valuation is equally important. Ultimately, owning the less-expensive stocks in his universe and carefully monitoring risks should help reduce downside.

Another positive is Laming’s shareholder orientation. For starters, he is very committed to managing asset growth. Current assets in the strategy total $390 million, of which $260 million is in the fund. Laming estimates that total small-cap capacity is between $1 billion and $1.5 billion. But, he plans to close the fund to new shareholders when assets reach $400 million. In fact, he has written this closing level in the fund’s prospectus. We applaud this decision, as capping assets is an important element in preserving managers’ ability to maintain their investment process. This is especially true for small-cap managers where asset growth can hurt performance in the form of the dilution of best ideas because they are forced to own more names, higher transaction costs, as well as higher market-impact costs from moving larger blocks of stocks. Laming is clearly not an empire builder. Another plus is the fund’s reasonable expense ratio. Considering the fund’s small asset base, fund expenses (1.39%) are quite reasonable. This is made possible by a very low (for a capacity-constrained small-cap fund) management fee of 0.7%, which means expenses have more room to decline as assets grow. Laming is also the largest shareholder of both TrendStar funds, aligning his interests with shareholders’. Laming is also tax-conscious and pays attention to tax lots, short-term and long-term holding periods to minimize tax liabilities.

We do not have any major concerns with the fund. We did question how well Laming and McBride could stay on top of their universe of stocks that they have identified as beneficiaries of trends, evaluate competitive threats, and generate new ideas. We came away confident that they are not stretched too thin, due in part to their strict discipline of only buying stocks that are beneficiaries of long-term trends, which includes significant up-front analysis that enables them to know companies within that industry very well prior to investing. They also use the valuation methodology as a prioritization tool, and have a process for reviewing portfolio holdings on a consistent basis.

While there is a clear emphasis on growth, we feel that TrendStar Small-Cap is best categorized in the Growth-at-a-Reasonable-Price (GARP) category. Investors interested in using this fund should keep Laming’s long-term orientation in mind, as there will undoubtedly be periods when his focus on long-term results is out of favor. As always, we will continue to stay in touch with Laming and provide ongoing updates.

—Jack Chee

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

A Worthy Small Cap and Mini Cap Manager

Forward Small Cap and Mini Cap Funds are both funds I use in some investment portfolios in my practice. Irene Hoover does a great job of managing risk while generating a great return. Her strength is in her firms ability to find stocks that no one else is following. This knack is more prevelent in her Mini Cap fund, which is the fund I use the most. Here is research report on her Small Cap fund which will give you some insight into her investment management style. Enjoy!

The Financial Pragmatist
Libby Mihalka


DUE DILIGENCE: Forward Hoover Small Cap Fund (FFHIX, Inst’l)

Category: Smaller-Cap Growth-at-a-Reasonable-Price Manager: Irene Hoover

We’ve recently completed our due diligence on Forward Hoover Small Cap Fund. Our research consisted of several face-to-face meetings with portfolio manager Irene Hoover both in our office and in her San Francisco office, where we also met with the team’s five analysts. As a result of our research, we are adding the fund’s institutional share class to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category. Below we provide an overview of Hoover’s investment philosophy and process, the investment team, and the reasons for our favorable opinion. We should note that because the fund is Approved, we have gone into less detail in this due diligence report than we would for a Recommended fund.

Investment Philosophy and Process
Hoover’s overriding objective for the fund is to generate high rates of return, but with low volatility and risk. In a nutshell, she wants to preserve capital and provide superior risk-adjusted returns over time. Her philosophy is somewhat contrarian in that she emphasizes businesses in out-of-favor industries, with minimal Wall Street coverage.

The bulk of investment ideas come from quantitative screens that highlight underperforming industries, but ideas also come from bottom-up research, sell-side contacts, and the identification of themes. Although Hoover looks for cheap stocks (those with at least a 25% upside), she emphasizes that she only wants to own profitable and growing businesses. To be considered for purchase, companies must have a growth catalyst (e.g., new product introduction, geographic expansion, or new management, etc.) that will lead to higher earnings and/or higher market multiples that result from increased investor recognition in order to achieve her upside target. Although Hoover looks for out-of-favor names, she avoids deep-value stocks and tries to avoid buying a name too early. In Hoover’s words, “We want to be the last value buyer.”

Growing stocks in out-of-favor industries are candidates for fundamental analysis. An initial step in this process is to run a stock through the team’s “risk checklist,” a list of potential problems that is based on their past mistakes. The list ensures that they consider business risks such as turnarounds that rely on difficult-to-predict macro factors, threats of a larger competitor entering the market, high customer concentration, and legal or environmental issues. It also covers organizational risks such as aggressive revenue-recognition policies, as well as valuation risk, to mention a few factors. The risk checklist helps emphasize predictability and minimize the risk of losing money.

Because the focus is on companies in out-of-favor industries, further fundamental analysis focuses on whether stocks are down because of issues that are permanent or temporary. As part of this analysis, the analysts study industry trends, companies’ operating histories, and financial statements. The team will sometimes meet with suppliers, customers, and competitors to gauge demand for the company’s product or services, as well as its competitive advantage. Management evaluation is also important. The team typically meets with companies to assess operations and whether management’s goals are achievable.

When buying stocks, Hoover is looking for at least a 25% upside over an 18- to 24-month horizon. Price targets are based on a P/E multiple, which is based on their earnings-growth expectations for the next 18 months. For example, if they think earnings will grow at 20% over the next 18 months, they will put a 20x multiple on the earnings 18 months out. However, price targets are dynamic and change with the fundamentals of the company. It’s very important for Hoover’s internal earnings estimate to be above Wall Street consensus as they’re looking to capture earnings growth and P/E-multiple expansion. Assessing a stock’s downside risk is also important, as Hoover won’t buy stocks with huge downside potential, regardless of the upside potential.

Hoover sells when a stock has hit the team’s price target, to raise money for better opportunities, if they see a deterioration of fundamentals, or when the stock has “run ahead” of improving fundamentals.

The portfolio typically holds 60 to 80 names, but that number can occasionally be higher because of “transition holdings,” i.e., holdings that she is still buying or selling. During periods of market uncertainty/volatility, Hoover will slightly increase the number of holdings to lessen stock-specific risk. Sector weightings are a byproduct of where the team is finding ideas, and Hoover spends very little time thinking about the portfolio’s weightings versus the index. Initial position size is a function of conviction and liquidity. Positions typically start out between 1% and 1.5%, although Hoover will occasionally establish a larger position in a high-conviction idea. But larger holdings are usually a function of price appreciation and tend to top out at 2%. The fund is usually fully invested.

Team and Team Interactions
Hoover Investment Management was formed in 1997 by Irene Hoover, who is portfolio manager and chief investment officer. Hoover has almost 30 years of investment experience. Prior to forming Hoover Investment Management, Hoover was at Jurika & Voyles (1991-1997), where she was a director of research and also managed Jurika & Voyles Mini Cap Fund. In 1999, Hoover teamed up with Forward Management, who is the advisor, and provides marketing and client services for the fund. Forward Funds does not have an ownership stake in Hoover Investment Management.

Today, Hoover heads a six-member investment team, and the analysts are all generalists though each has a specific sector emphasis. Once a security is selected for purchase, Hoover and the analyst work together to determine portfolio weightings and target sell prices, however, Hoover is the final decision maker. The team meets weekly in a comprehensive investment-strategy meeting to discuss economic policy, monetary and fiscal policy, as well as news events and trend analysis as they relate to portfolio holdings.

Style Analysis
When evaluating a fund’s investment style, we examine both quantitative and qualitative factors. Quantitatively, we consider a portfolio’s valuation statistics, sector weightings, performance history and correlations with various benchmarks, etc. Qualitatively, we consider a manager’s valuation methodology and the aggressiveness of assumptions used in their analysis. Based on our assessment of these factors for Hoover, we are categorizing the fund as Smaller-Cap Growth-at-a-Reasonable-Price. We should note that some fund-rating firms categorize the fund as a growth fund, which we disagree with.

Touching on some quantitative measures, the portfolio’s valuation and sector weighting statistics tend to be more in line with the GARP category over time. Performance also tends to correlate best with the GARP index. Qualitatively, we think Hoover’s valuation methodology–deriving price targets based on the team’s forward earnings estimate–falls between GARP and Growth. Many pure growth investors pay little (if any) attention to valuation, while value investors typically require a much steeper discount than Hoover is looking for. Hoover falls between Value and Growth. As for modeling assumptions, the analysts seems to strike a balance of assessing what a company can reasonably do, while not giving much, if any credence to “what-if” scenarios (which is more typical of growth investors). As for the timing of investments, while Hoover is looking for out-of-favor stocks, she also wants to be “the last value buyer” in an effort to minimize the opportunity cost of waiting for a stock to appreciate. This differs from pure value investors who are typically more patient and are willing to hold stocks for years before realizing a stock’s value. Hoover has a shorter investment timeframe that is evident in the portfolio’s turnover, which is relatively high at 150-200%. A lot of the turnover is due to trimming and adding to names, as opposed to a complete turnover of names. Meanwhile, Hoover runs a fully invested portfolio, as she says there are always stocks that are moving up, regardless of the market environment. This is in contrast to many pure-value investors who are willing to let cash build in times when they consider the market expensive and opportunities limited.

As for performance expectations, Hoover invests in a risk-averse manner. Our expectation is that the fund will underperform when speculative stocks are leading the market, and outperform in more “normal” markets where companies with sound fundamentals are being rewarded. We also expect the fund to outperform during steep market corrections where speculative stocks perform proportionately worse, as the team avoids this type of company. Since the fund’s inception in September 1998, the fund has a compounded annual return of 11% versus 10% for the Russell 2000 iShares. As for risk parameters, the fund’s worst 12-month return is a 24% loss compared to 27% loss for the benchmark. Meanwhile the standard deviation of three-month returns is 17.7, which is much lower than 21.3 for the Russell 2000 iShares.

Litman/Gregory Opinion
As a result of our research, we are comfortable adding Forward Hoover Small Cap to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category. Our favorable opinion of the fund is based not a single edge, but rather on several things that we think they do very well that collectively constitute an edge. The positives are as follows.

We believe the investment philosophy and investment process are consistently applied across the team. We have observed a systematic framework for identifying new investment ideas, clearly laid out criteria for buys and how these criteria are weighted, and the analysis seems very thoughtful. The research process is very fundamentally driven, and the team is clearly looking for catalysts that will drive a company’s future growth. They try to benefit from the excitement of strong earnings growth but they also want to measure it very carefully by understanding what the risks are to achieving that growth. As for information gathering, analysis is not built off of numerous third-party checks, but it is clear that the analysts gather the necessary information to make informed decisions. This research includes meeting with company management and talking to suppliers, customers, and competitors. There are also tools in place (e.g., quantitative screens and the risk checklist) to ensure that the team brings specific types of companies to Hoover for inclusion to the portfolio.

There are also positives at the investment-team level. One plus is the team’s investment experience. Hoover has been in the business for over 25 years, while the analysts each have several years of investment experience. As for the quality of the research, we have generally been impressed with the team’s stock discussions, where they walked us through their fundamental analysis. They seem to know their industry/sectors and stocks very well, and strike us as independent thinkers who are enthusiastic about their work. Another positive is that the team has minimal non-research responsibilities, which allows them to focus on investing. The team has also been cohesive, and most of the team members have worked together for about five or more years. Hoover seems to think a lot about retention of analysts, e.g., sharing equity in the firm and handing off some decision-making autonomy, which reduces the odds of personnel departures. There has been no turnover of investment personnel in the past few years. Hoover has also implemented a compensation structure that we think encourages analysts to identify their best long-term ideas, as well as aligns the team’s interests with shareholders’ interest.

The asset base in the strategy is closing in on $1.5 billion and Hoover is starting to think very seriously about closing institutional accounts, although she plans to leave the fund open to new shareholders. The fund currently has about $500 million in assets. Hoover does not strike us as an empire builder, and seems to genuinely want to do well for shareholders. The fund is not marketed very heavily and because of the relationship with Forward Funds, she has very minimal client-service responsibilities on the mutual fund side of the business. Hoover is responsible for handling client-service responsibilities for institutional clients. As for running the business, Hoover has an internal staff that handles the majority of business decisions, compliance, and client servicing.

As for why the fund is not Recommended, we don’t have any major concerns, but there are a few areas of the investment process that we were not able to fully get our arms around, despite discussing them with Hoover. For example, during times of perceived market uncertainty or highly volatile markets, Hoover will diversify the portfolio by increasing the number of names. Related to this are questions we have around Hoover’s sell discipline. Hoover says that selling is where she makes most of her mistakes because she gets nervous when she loses money on a stock. The source of her nervousness seems to be losing clients’ money, as we discussed a number of examples where Hoover sold a stock because it was down, and ultimately missed an upside move, despite analysts suggesting to buy more. On the flip side, Hoover has also sold names and avoided further losses.

The potential risk is that Hoover makes decision errors or gets whipsawed if she makes a bad call when it comes to timing of these decisions, which involve a considerable amount of subjectivity and don’t exhibit the same level of discipline we see elsewhere in the process. After discussing these issues with Hoover, our impression is that these issues seem to be done at the margin, where the goal is to protect shareholder capital. We wouldn’t call these issues concerns, but because we are not clear about her decision-making framework for these aspects of portfolio management, we are currently not comfortable with Recommended. Perhaps over time, if we come to better understand the framework of Hoover’s thinking when it comes to portfolio construction we could raise our opinion.

One area we plan to watch going forward is the structure of the investment team. Our sense is that the analysts may have a larger role in portfolio management of the fund in the future and we plan on monitoring this to see how things play out.

At this time, only the institutional shares meet our 1.5% expense threshold for domestic small-cap funds (the retail shares currently have a 1.69% expense ratio). After discussing this issue with Forward Funds and after doing some back-of-the-envelope math, we doubt retail share expenses will get to 1.5%, so our Approved rating extends only to the higher-minimum institutional shares.

—Jack Chee
Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.