Paul Graham and David Wabnik of UBS U.S. Small Cap

WABNIK: We use a very disciplined investment process based on proprietary quantitative screens and in-depth fundamental research. Our process is about 50% quantitative and 50% fundamental research. We initially consider about 6,000 companies with market caps greater than $100 million and less than $1.5 billion. We screen for companies with earnings growth in the top 40% of the small-cap universe and trading volume of at least $15 million per month.

S&P: How does individual judgement figure in your process?

GRAHAM: A small-cap growth stock is a lot like a dove: It’s beautiful and soars to the sky, but then something clips its wings and it falls like a turkey. We try to understand what’s likely to clip the wings of a small-cap growth stock.

We look to see if a company’s numbers are real. A lot of times, there’s Wall Street hype behind a stock, so we ask if a company’s earnings growth is sustainable. Where is a company in its product cycle? What’s its competitive position?

S&P: The fund’s literature says you look for companies with strong business franchises and attractive competitive positions. How do you find these companies?

WABNIK: Strong small-cap companies tend to have niche positions. Often, a company will come up with a novel idea that changes the dynamics of an industry or sector. For example, Cytyc Corp. (CYTC) developed a replacement for the traditional pap smear a few years ago and has since gained significant market share from traditional pap smears.

S&P: The fund is less volatile than most of its peers. How do you reduce risk?

GRAHAM: It’s very easy to get stuck in illiquid positions during difficult conditions and watch your holding vaporize. We tend to be more diversified than the average small-cap growth fund over a market cycle. No one position makes or breaks us. We never buy a position that would be more than 1.5% of the portfolio, and we automatically trim it when it reaches 4% of the fund. We hold between 50 and 100 names, averaging about 80.

We’re also fairly well diversified at a sector level. We won’t hold more than a 15% overweight in technology, health care, or consumer goods, which are the major small-cap growth sectors. In the smaller sectors, we won’t go more than a triple overweight. As of March 31, our largest underweight was technology at 24.7% versus 29.1% for the Russell 2000 Growth Index, our benchmark.

S&P: Do you sell a holding when it reaches a maximum market cap?

GRAHAM: We’ll purchase a stock with market caps of up to $1.5 billion and typically sell out when its market cap reaches about $5 billion. We try to keep our average market cap well within the small-cap growth universe. Our average market cap was $1.375 billion, as of March 31, and the average for the Russell 2000 Growth Index was $888 million. We don’t own the smallest market-cap stocks in the Russell index, and we let our winners run.