Quick Take: Just as the Brazos Micro Cap Portfolio/N (BMIAX) invests in small companies, its stock pickers like to keep the fund’s assets at a level they consider small enough to be manageable. Because of that, the fund, which reopened to new investors in July after being shut for two years, will close again when its assets, which now total about $250 million, reach $300 million, says co-manager Brian Gerber.

Gerber and fund’s ten other portfolio managers focus on companies with market caps of $600 million or less whose top and bottom lines are growing by 15% or more. However, they’re willing to bet on unprofitable companies if they envision them generating earnings soon. The team also favors companies that aren’t burdened by debt.

The fund was off 39.8% last year. Gerber attributes the loss partly to weakness in the overall stock market, which pressured the stocks the fund typically invests in. But the fund has recovered this year, with help, Gerber says, from its technology stocks that make up about a third of the portfolio’s assets.

Brazos Micro Cap’s class N shares posted a total return of 40.4% through the end of September, versus 27.5% by its peer small-cap blend funds. That version of the fund is too new to be ranked by Standard & Poor’s. The fund’s institutional class Y shares carry a 3-Star rank.

The Full Interview:

The Brazos Micro Cap Fund buys very small companies, but its list of holdings has been getting bigger.

The roster of stocks has risen to 87 from just under 50 at the end of 2002, says Brian Gerber, one of the fund’s 11 managers.

The three-year bear market made it difficult to find suitable investments, and as a result the fund became overly concentrated, leaving it vulnerable to potential blowups, he says. As stocks and the economy have rebounded, so have buying opportunities, he says.

“I think we’ve probably put in more new names this year than we’ve ever contributed to any portfolio in the history of the firm,” says Gerber, a principal and partner of John McStay Investment Counsel, Brazos Micro Cap’s investment advisor.

One of those names is NetFlix Inc (NFLX), an online film renter with a library of more than 15,000 titles that ships up to three DVDs at a time to customers and charges no late fees.

Its subscription base gives NetFlix and investors a good idea of what revenues will be like in a given period, Gerber says, adding that the company’s sales increased over 74% in this year’s second quarter. He sees profits rising more than 150% in 2004.

The fund bought a stake in the Los Gatos, Calif., company in June. Its average cost in the shares is in the low $20s, Gerber says. The stock closed at $43 today.

In August, handheld computer maker Palm Inc (PALM) entered the portfolio. Although the company currently is losing money, it has been generating “substantial” revenues, and features a well-known brand name, Gerber says. Following its acquisition of rival Handspring Inc (HAND), Gerber expects analysts to hike estimates for the combined entity, which he thinks will also get a boost from the introduction of new products.

The fund’s average cost for its Palm shares is in the mid-teens, Gerber says. The stock closed at $22.28 today.

Another recent addition to the fund is K-V Pharmaceutical Cl`A` (KV.A), a maker of brand name and generic drugs. The company’s top and bottom lines expanded by 21% in the June quarter, Gerber says, and he envisions it churning out similar results going forward.

The fund’s average cost for its K-V shares is in the low teens, Gerber says. The stock closed at $22.65 this afternoon.

In picking stocks, Gerber and his team trawl among companies with market caps of $600 million or less, fishing for those that grow earnings and revenues by 15% or more. They want to buy those companies when their stock price is equal to or slightly less than the company’s earnings growth rate.

The fund may also buy an unprofitable company if the managers think it will start start making money soon. Brazos Micro Cap’s investments often have higher than average returns on equity, Gerber notes, too. The managers also favor businesses with low or manageable debt.

Additionally, the team likes companies whose results top analysts’ estimates. While the managers don’t scan for stocks that aren’t widely followed by Wall Street, their ideal, Gerber says, is to spot those that are tracked by only a handful of smaller, regional brokers, because the shares can rise when main stream analysts began tracking and recommending them.

Also, the team prefers companies whose managers have had success elsewhere and who own a good part of their businesses. Gerber says he and his colleagues spend a considerable amount of time visiting companies. “Travel is our No. 2 expense behind payroll and bonuses,” he says.

Two companies are essentially tied for the No. 1 position in the portfolio: Nam Tai Electronics (NTE), a Hong Kong-based contract manufacturer of telecommunications and consumer electronics products; and Encore Acquisition (EAC), an energy concern.

Encore has been benefitting from above-average prices for natural gas, according to Gerber. The company increased earnings by 57% and revenues by 36% in the second quarter, and he expects it to post similar numbers over the next few quarters, Gerber says.

Nam Tai’s shares have appreciated to the point where some may have to be sold, Gerber says, explaining that positions are limited to no more than 4% of the fund’s assets.

The managers also will reduce their holding in a stock, or eliminate it from the portfolio, if a company’s financial fundamentals seem to be weakening.

For example, shares of LookSmart Ltd (LOOK), a provider of search listings, were banished from the portfolio last month, Gerber says, because at the time it appeared that the company would lose its largest customer, Microsoft Corp (MSFT). The software maker has since said it will not renew its LookSmart contract when the pact expires in January.

Stocks that reach the price targets the team sets for them, or whose cap size expands to $1 billion are sale candidates as well.

While investing can be fun for a stock picker, “I think the more difficult part of portfolio management is selling,” Gerber says. Money managers, he argues, may sometimes become so enamored of a stock that they are blinded to its potential problems and reluctant to part with it.

To guard against that, he points out, the Brazos fund is managed by a team, some of whose members compile a list of stocks that may be suspect because of technical or fundamental factors.

In rebounding from its loss in 2002, Brazos Micro Cap has been helped this year by the performance of its technology stocks, which account for about 30% of the fund’s assets, Gerber says. Besides Palm and Nam Tai, the fund’s tech investments include software maker Concord Communications (CCRD), and ManTech International`A` (MANT), which provides information technology services to the Defense Department and the federal government.

A favorite of Gerber’s in the sector is Microsemi Corp (MSCC), a manufacturer of analog and mixed-signal semiconductors. The company’s products tend to lack competitors, and it has good exposure to the laptop computer market, which has been enjoying a renaissance of late, Gerber says. Microsemi’s earnings rose 25% in the second quarter and are starting to accelerate, he adds.

Gerber says the fund also has benefitted this year from the renewed popularity of very small companies, even those that have not yet generated profits. Not long ago these companies were all but orphaned, he says.

Now, “I would expect to see that kind of low-quality rebound to broaden up the market cap chain,” Gerber says.