Morningstar Advisor - Spring 2007 - 43

How To… Spot Small Caps Scott Brayman searches for high-quality small-cap stocks with minimal business and valuation risks. You can create your own universe of worthy small caps in Advisor Workstation and Principia Stocks. Start with this screen: Market Cap in Mil AND ( Business Risk OR Business Risk 2000 Average Below Average ) 4 what ruefully that “by being in companies that others would covet, we expose ourselves to take-outs. We don’t target take-out candidates, but if we can’t realistically think of a strategic buyer, we won’t buy a stock. We don’t want our only exit strategy to be a ‘greater fool.’” It is frustrating to lose a great company that still has plenty of kick in it, given the substantial research invested in each pick. That’s why Champlain recently started a mid-cap product, co-managed by Harissis, in order to continue to profit from stocks that simply outgrew the small-cap strategy. (This portfolio is not yet available to mutual fund investors, but likely will be.) The mid-cap portfolio has about half the names of the small-cap because business risk decreases as market-cap increases—but also, Brayman points out, because there are “fewer bona fide good values” in this more efficient marketplace. Investors who are as excited about small-cap opportunities as Brayman is might consider buying into Champlain Small Company sooner than later: Although it has little more than $100 million in assets, it will close to new small-cap investors when Champlain’s total small-cap portfolio, including private accounts, reaches $1.5 billion. Brayman’s desire to keep assets down to a manageable size is reassuring, but there are some drawbacks to investing with a fund company this small. For one thing, the fund’s 1.4% expense ratio is on the high side, even after a partial voluntary fee waiver. What’s more, just one analyst departure would hit this small team hard. Brayman calls his co-workers “courageous” in their willingness to both buck market opinion and disagree with the boss, and he is committed to keeping the tight-knit team together: “Judy and I would rather own a modest percentage of something that is harmonious than a lot of something that is dysfunctional, so we err on the side of being generous.” He and O’Connell made everyone on the investing side an equity partner, and all have signed long-term employment contracts and non-compete agreements. It is telling that the group was willing to leave secure positions with an established investment company to embark on a new venture. Brayman does not take their confidence for granted. “I consider myself incredibly fortunate to be here, in this business, with this team. I’m very thankful.” K Laura Lallos is a former Morningstar analyst and editor. She also was a senior writer for Money magazine. She recently finished law school and is studying for the Illinois Bar Exam. AND Morningstar Overall Rating is a classic razor/razor blades story: Customers buy a machine, and then come back for more modeling material. That’s not to gloss over the risks of either company. An economic downturn that resulted in Wall Street layoffs would hurt FactSet—though it would also create a great buying opportunity, Brayman says. And Butler, the firm’s tech analyst, warns that a significant portion of Stratasys’ business comes from its high-end, high-price products, so that a loss of even one order in a quarter might jar the stock. That’s why this micro-cap position is one of the portfolio’s smallest. Hard Sell Discipline While the team will hold patiently when highquality picks go through a rough patch, their “strict sell discipline sets them apart,” says Morningstar’s Kathman. “Most managers would tell you they have a sell discipline, but in a lot of cases, it’s squishy.” Brayman and company are quick to admit mistakes like Timberland, but also to sell when a stock becomes overvalued or when its market cap exceeds $3 billion. That discipline led to unusually high turnover last year, as holdings hit market-cap and valuation ceilings in the small-cap run. Turnover was also driven by acquisitions of some of the team’s favorite names, including Sybron Dental, a highly profitable dental supplier. Brayman notes some- MorningstarAdvisor.com 43

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Morningstar Advisor - Spring 2007

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