Quick Take: Adam Friedman describes the investment philosophy of the team that runs the Armada Small Cap Value Fund/A (AMRRX) as “good value, good news.”

First, Friedman and the fund’s three other managers scan for small companies with what they judge to be attractive multiples of price to sales, cash flow and book value. The second part of the investment formula, “good news,” refers to a catalyst that can get a stock moving.

Although the fund lost 10.8% in 2002, it beat its small-cap value fund peers, which fell 12.7%. But over the longer term, the portfolio has the edge. Armada Small Cap Value gained 6.6% annualized, versus 2.5% for its small-cap value peers, for the five-year period ended in January. The fund carries a 4-Star rank from Standard & Poor’s.

The Full Interview:

Adam Friedman says he and Dan Bandi, who help run the $808-million Armada Small Cap Value Fund, have seen their share of corporate book-keeping gimmicks, and they distance themselves from businesses that use them.

“If a company has complicated accounting, even if the stock looks good, we’ll most likely walk away from it,” says Friedman. “We’ve always been focused on reading [quarterly and annual reports] when many investors didn’t.”

At the same time, the managers aren’t fond of complex companies. For example, Friedman says they sold Chiquita Brands Intl (CQB) in December, in part because the distributor of fresh fruits and vegetables was difficult to analyze, given that it had assets around the globe.

Friedman says he also lost confidence in Chiquita at year end because while management said the company would meet Wall Street estimates, it offered nothing concrete to back up its words. The fund’s managers also thought banana prices had peaked, which would hurt the stock, Friedman adds.

In picking the fund’s 120-140 stocks, the managers initially look for companies with market caps of $100 million to $2 billion whose stock prices are inexpensive compared to the company’s cash flow, book value and sales. They exclude stocks with trading volume of less than $750,000 a day.

Next, the managers scan for a catalyst that can boost a stock, such as new product introductions, or improved outlooks by analysts.

Among the latest additions to the fund, portfolio manager Bryan Tinsley cited Hercules, Inc (HPC), which makes chemicals used by paper and paint producers. Tinsley sees the company benefitting if, as he expects, oil prices start declining. It should also be helped by rising prices in the paper industry, according to Tinsley.

Hercules yesterday reported a fourth quarter profit, up from breakeven a year ago, on higher revenues.

The managers began buying Hercules in early January and added more shares this month, paying $8.50-$9, on average. They closed at $8.09 today.

Another of the fund’s recent investments is software maker Progress Software (PRGS), which Friedman says he likes because it has a “huge” customer base of a couple of thousand users, and a “cash-rich balance sheet.” In addition, the Bedford, Mass.-based company derives about 50% of its profits from services, so its earnings tend to be predictable, he says.

The managers began buying buying Progress’s stock late last month at an average cost of $13.90. They closed today at $15.34.

The No. 1 stock in the fund at the end of last year was GrafTech Intl (GTI), formerly known as UCAR International Inc., which makes natural and synthetic graphite and carbon-based products. The stock has fallen this year because investors fear the company will be unable to raise prices due to the sluggish economy, Friedman says. However, he does not share those concerns and expects GrafTech to be profitable, provided the economy strengthens once problems stemming from the situation in Iraq are resolved.

The second-largest holding in the portfolio in December was Westinghouse Air Brake Technologies Corp., which does business as Wabtec Corp (WAB). The company, which provides equipment and services for maintaining locomotives and railroad cars, stands to gain as railroads increase their capital spending, Tinsley says.

Armada Small Cap Value’s major investments also included athletic footwear and apparel maker Reebok Intl (RBK), which the fund managers began buying after the terrorist attacks of September 11, when they thought it was attractively priced. The stock’s multiple of price to cash flow still looks good, says Friedman. However, the managers trimmed the position a few weeks ago because the stock had run up to about $32, he noted.

At the end of 2002 Friedman says the fund’s four managers were finding the kind of valuations they prefer among financial services companies, which accounted for about 25% of the fund’s assets. Investments in this sector included Odyssey Re Holdings (ORH), Affiliated Managers Grp (AMG), Everest Re Group (RE), and Phoenix Companies (PNX).

Friedman says he is optimistic about prospects for small-cap stocks this year. Their multiples and earnings growth look better than those for large companies, he argues.

Still, until investors have a clearer picture of what will happen in Iraq, small stocks could bounce around, and investors may seek safety in large-cap stocks, he acknowledges.

“With the geopolitical environment kind of touch and go, you might see small-caps be very volatile and underperform here as people are looking for more stability in their portfolios,” he says.