From the August 2003 issue of Investment Advisor • Subscribe!

Small Packages

Kevin Callahan and Lanny Thorndike use an exhaustive research system to pick their high-performing Century Small Cap value stocks

When it comes to running a mutual fund, every manager has an angle. Some may focus on an arcane logarithm, while others highlight a specific performance number that makes them stand out. But then there are those managers who keep it simple. Case in point: Kevin Callahan, of Century Capital Management, Inc, who, when asked to describe his and his co-manager's investment process, simply says, "It isn't rocket science, but a process."

Callahan and Alexander "Lanny" Thorndike manage the Century Small Cap Select Investor Fund (CSMVX), which has been awarded five stars from both Morningstar and S&P. The three-and-a-half-year-old fund is on its way to a fourth consecutive year of positive returns, and its return numbers for the three-year period ended June 30 place the fund 12th within the universe of 327 small-cap value funds, according to Standard & Poor's. "We describe ourselves as growth investors in value industries, or value investors in growth industries," says Thorndike. "The earnings and the revenue growth rates of our companies tend to be a little bit faster than their peer group in the overall market."

Looking to invest in each position for at least two years, Callahan notes that a potential investment must go through an initial filtering and then an additional six-step screening process before it is even considered for the portfolio. At each of the six steps, both managers and analysts must sign off before a company can move on to the next step. "We try to break up the S&P or the Russell by different industries and sectors and have Lanny, myself, and our analysts focus on different sectors so we can leverage that knowledge and not have too many people focusing on the same thing," Callahan says. If one person isn't happy with a company, then "we have to research it further" to answer that person's reservations, he says.

The approach seems to be working. For the three-year period ended June 30, 2003, CSMVX had an average annualized return of 18.4%, versus a total return of -11.2% for the S&P 500 and 8.7% for all small-cap value funds. "With small-cap stocks, especially in this market, you are seeing a return to fundamental investing, and that requires a fair amount of homework," says Thorndike. "It was easy for a fair amount of time to just go on earnings growth to be a successful investor." But now investors have to look at "balance sheets and cash flow, which is something they have ignored for a long time."

We spoke to Thorndike and Callahan in July about their fund.

How do you work together in managing this fund? Thorndike: Kevin and I have been working together just shy of two years. I joined Century in the beginning of 1999, and at that point we only had a large-cap fund, a small-cap limited partnership, and a large separate account that we managed for a large pension fund. It was at that point that we decided to bulk up our resources. We added to our analyst core, and then almost two years ago we brought Kevin on board to be director of research. We kind of play yin and yang [when it comes to managing this fund]. We break out by sectors [to cover more ground]. Although I am the lead manager, we very much follow a consensus-oriented investment style and a six-step investment program.

Callahan: Lanny is more of the chief investment officer type and I am more focused on research responsibilities.

Do you rely more on the numbers alone to help you identify well-run companies that are undervalued? Thorndike: We follow our six steps but there is an initial screening process that is very much quantitative. We do a lot of research, but we can't look at 8,000 stocks, so we have a filtering process that narrows them down to a manageable number of buy and sell ideas. Then we are able to go into due diligence. But it is the top of that funnel that allows us to get there.

Callahan: Step 1 is new idea generation. We sort through 3,500 to 4,000 companies and we emphasize first, return on equity; second, valuation; and finally, growth. Going through this screen generates anywhere from 60 to 80 new companies and ideas a month. Then each of the analysts--including Lanny and myself--take those companies and we look at two or three each week and do what we call a "quick and dirty" on the company. Here we find out all sorts of data and discuss the companies as a group. We take a quantitative approach: How do the hard numbers look? Do they look reasonable, including valuation? We weigh those factors and then make a judgment as to whether one of us should delve deeper into the company. When we look to sell, we need to have new ideas coming into the fund and we [always] look at the same characteristics.

Step 2 is due diligence. Here we build income statement models and look at the balance sheet, cash flow, etc. If we know of a competitor, we try and meet them and get some qualitative feedback. This is where we get a sense of the management. Do they manage ethically? All those little tidbits of information from their competitors and suppliers add [to the picture]. It is amazing how much you can learn from a competitor.

Step 3 is to rank the holding and put it on a watch list. If we like the company, we'll start with a small position and build it over time.

Step 4 is an in-depth presentation. We will come back together and [present all of the information to the group]. There have been situations where one of us did not like the company but everyone else did, so in that situation we could not just stop. We have to research it further to answer everyone's questions.

Step 5 is portfolio construction. When we add a company to our portfolio, it goes through three stages. At first, it's the new position, meaning it's less than 1% of the portfolio. Second are the secondary positions: only 1% to 3%. Third are core holdings, at 3% to 5%.

Step 6 is paranoid investing. That entails following up on any changing events that may hit a company.

The fund invests in companies that are "capable of growing revenues and earnings faster than industry averages over an extended period of time." Do you look at companies that are already growing their revenues, or do you forecast that they will grow? Thorndike: We want companies that are already growing. It is easier to believe in a story that has already demonstrated evidence of growth than one that is promising growth in the future. The earnings and the revenue growth rates of our companies tend to be a little bit faster than their peer group in the overall market. The average P/E multiple currently is about 12 times earnings. That gives us a favorable risk/reward profile in the types of companies we look at. In fact, the P/E multiple on next year's earnings is about 15.5 times and the earnings growth rate is about 18 times. We look at companies that can grow return on equity and book value above 15% over rolling three- and five-year periods. We think return on equity is the one metric that ties the income statement to the balance sheet. Companies that manage their capital well have fairly high returns on the amount of equity that shareholders have given them. [Finding] that prudent type of management is how we differentiate ourselves as investors. We are more singles and doubles hitters looking for predictable boring stories than we are looking for fast-growing stories.

So you don't jump on the investment du jour? Thorndike: Because what we do is a little bit different, it takes us a fair amount of time to research. The down side of our process is that it may take us three or four or five weeks to get comfortable with a story before we add it to the portfolio. I wouldn't describe us as momentum or nimble investors, we tend to be more thoughtful and do much more due diligence.

Callahan: Our style is sensitive to valuation. We buy above-average companies with high ROEs, but we want to get them at below-average valuations and we will ride them for a single or double, and occasionally get a triple or home run out of them. But in doing so we will buy them cheap, and as they move up, we will sell into some of that strength and move on to new names that are more attractively valued. We are also focused on cash flows. We like companies with strong cash flow that can cover their capital expenditures. It's a very positive sign when a company has a healthy free cash flow over a number of years.

Thorndike: Companies that do generate cash flow even in a trough period of earnings like the last 24 months are able to reinvest in their business at a faster and hopefully more effective rate than their more poorly placed competitors. That enables them to be placed in an even stronger competitive position coming out of a recession.

Do you limit yourself to a certain cap size? Callahan: Our small-cap stocks are under $2 billion, or basically the top end of the Russell 2000. Our sweet spot, though, is companies in the $300 million to $800 million range. Below $300 million we find it hard to do the amount of due diligence we would like to do or get the amount of information we need to get to make a recommendation. Once we get up over a billion, we may have a harder time getting access to competitors, vendors, clients, or the company may not let us talk to the junior tier of management. We like to be able to talk to that second-tier management because that's where strategies actually get implemented; it's that next level down that is going to determine whether the company can make it to the next stage of growth. We want to make sure that the depth of management is more than just one or two people.

Do you worry about style drift, if you have to sell these small-cap value companies that show improvement in their bottom lines and grow out of the small-cap category? Thorndike: We tend to do a fair amount of work on our stocks and we often get accused of selling them a little early as they reach our price targets. One of the problems with small-cap stocks is if they are very good, they eventually become mid-cap stocks and we have to let go of them. But we don't sell them once they get to $2 billion; we are allowed to hold them. In general, once they reach our price target we are either trimming or reassessing the [holding].

Your turnover rate appears to be rather high--123% versus an average 69.96% for your peers. Thorndike: The portfolio turnover rate has averaged about 50% to 60% over the last three years. It spiked last year to 123% because the denominator in the calculation is based on the lower of new purchases or redemptions into the fund by shareholders, and we had very few shareholders redeem. In 2002, turnover was above our normal levels simply because a relatively large number of the stocks we owned reached or exceeded our price targets. The Russell 2000 rallied in the fourth quarter of 2002, which resulted in above average trading for us.

Callahan: In an ideal world, we would love to own a stock for two, three, and five years out. What we end up doing is establishing price targets when we buy a stock. We try to remain disciplined in setting targets and trimming a stock when it gets close to that price target. We can adjust price targets, but that happens very infrequently. When we set the targets, we are looking to set them 12 months out.

Have you always focused on services companies, or is that where you happen to see value at this point in time? Thorndike: We have always had a bias. For instance, when you have turmoil in a market like we have had in the last three years, you get things overbought and oversold. Within the first six months of 2003 we spent a lot more time on technology and retail stocks than we had in a while because there was so much downdraft in valuation that they came onto our valuation screens for the first time in years. That created an opportunity for us. Now technology is maybe 12% of the fund [11.6% as of June 30], and was less than 2% nine months ago. In general, we are always going to have a bias to service-based industries because they tend to deliver more predictable, higher growth in book value and ROE.

At the end of March, your largest exposure was in the financials sector. Is that still the case? Callahan: We are actually underweighted in financials relative to the benchmark. We are about 15.5% in financials, healthcare is 25%, business services is 17%, energy is 4%, producer durables is about 3%, materials processing is 2%, and technology right now is about 11.6%.

What was the catalyst to decrease your financial exposure? Thorndike: Valuation. We had a tremendous run-up in financials. Bank stocks moved up, and they are now selling, on average, at three times book value. Financials had such a good run that they were at their cyclical peak of valuation and we saw growth from beginning to end.

Callahan : Financials tend to perform well when rates are down, and that has been the case with us.

What index do you benchmark against, and how closely do you manage to the index? Thorndike: Our index is the Russell 2000 Growth, but we have very little correlation to it. In general we are stock pickers and not sector pickers, and we view ourselves as fundamental, bottom-up investors. But we try not to be more than two times overweighted or two times underweighted in a particular sector. Over the last three-and-a-half years we have been up each year and we think it has been because of stock picking, not just sector picking.

Small-cap value funds tend to be more volatile than those that invest in larger companies. How do you see this fund fitting into someone's portfolio? Thorndike: I think in terms of small caps, the typical allocation seems to be anywhere from 5% to 15%. We have a lower risk/return ratio than some higher-octane funds. We [like] consistent, steady, predictable growers that can deliver steady performance in good markets and in bad. We are trying to find those stable growers that aren't susceptible to the risks of higher volatility. Now, you can't always do that, and in small-caps you are bound to find names that move in either direction more than you anticipated.

Is this fund a core holding? Probably, yes, for someone who has a moderate to aggressive growth outlook. For the conservative retiree, it is probably not a good allocation for anything other than that small part of their portfolio that has a higher risk tolerance.

Callahan: We do tend to have a lower risk, but part of that is we are sensitive to valuation. It should be noted that in a momentum market we are going to trail to some degree the performance of that period because we are not going to buy a stock just because it is performing well. We like higher quality companies with a high percentage of recurring revenue, and we like to buy them when they are reasonably or cheaply valued.

Thorndike: We describe ourselves as buying leaders at laggard prices. The best management teams do deliver higher returns over long periods of time, and typically a couple of times in the economic cycle you are able to get these leaders at valuations lower than the overall market. It requires patience and sometimes you get it wrong but if you do your homework, you'll be around and ready when the stocks finally do meet your criteria.

Do you make a lot of sales through the advisor channel? What share classes do you have and what is their expense ratio? Thorndike: Probably 50% of our sales are through the advisor channel. We have an investor class below $250,000 that carries a 12(b)1 fee--that's really the only difference between the two. We are now at the level where we are below our expense cap, so the expense ratio should be dropping. We are at about $55 million in assets, and as we get closer to $60 million, the 180 basis points in expenses for the investor class should drop considerably and the 145 bps for the institutional class should drop as well.

How much of your own money do you have invested in this fund? Thorndike: The vast majority of my liquid net worth is in our fund. I feel we are owners and managers at the same time. Callahan: I have been here for almost two years and my strategy is to liquidate all my stock holdings and put them in the fund. Over the next year, most of my liquid assets will be in the fund as well.

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