Quick Take: After three straight annual losses, the Armada Small-Cap Growth Fund/A (ASMGX) has rebounded. The fund, which has total assets of $224 million, was up 40.9% this year through October, compared with the average small-cap growth fund, which gained 39.1%.

Previously, the fund suffered because the growth stocks it leans towards were out of favor with investors, says Jon Scharlau, the fund’s lead portfolio manager.

Scharlau attributes the turnaround in part to a quantitative model his team began using for stock picking shortly before he came on board in February. The computer model screens for growing companies that have the financial strength to keep expanding for at least two years.

The managers also blend fundamental analysis into their research, and consider economic conditions in setting sector weights. Recently, 41% of the fund’s holdings were technology stocks.

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In picking stocks, the team that oversees the Armada Small-Cap Growth Fund starts with a quantitative model.

The computer program screens for companies for which analysts’ estimates are increasing and that beat those expectations. Stock price movements are tracked to see if they, too, are rising.

Balance sheets and related factors are analyzed to gauge a business’s financial strength and to get an idea of how long it can continue growing. The idea is to find companies that can expand for two years in a row. When it comes to bottom lines, the managers like to see them increase by at least 15% annually, Scharlau says. Two other key criteria are fairly heavy spending on research and development, and low debt.

In addition, the model takes into account valuations, like a stock’s price compared to a company’s earnings, sales and cash flow. “Cheaper is better,” Scharlau says of the multiples the managers hunt for. He adds, though, that “we’re not looking for cheap stocks.”

After crunching numbers, the team, which consists of four portfolio managers and an analyst, try to judge the health of the economy, as well as where individual companies are in their profit cycles, in order to determine what industries to invest in and how heavily.

Competitive advantages or leading market positions, and managements with successful track records, are other things Scharlau and his colleagues like to mark off on their check list, as are catalysts, such as new products, that can help boost a stock.

The 130-150 stocks packed into the portfolio have market caps ranging from $100 million to about $2 billion, Scharlau says.

The fund’s No. 1 holding at the end of September was semiconductor maker ON Semiconductor (ONNN). Chip companies look good Scharlau says, because they’re beginning to regain the power to raise prices. “In that scenario, this company has very substantial earnings leverage,” according to Scharlau.

Phoenix-based ON is attractive in particular because over the last few years it has been adding “higher value” products while cutting expenses, says Scharlau, who initially bought the stock in September.

Another stock that entered the fund within the past two months is RADWARE Ltd (RDWR), an Israeli manufacturer of software for managing traffic on the Internet. Scharlau says he was drawn to the company because it beat Wall Street estimates and raised its forecast in the third quarter this year.

Radware generated sales of $14 million in the three-month period, compared to $11 million in the 2002 quarter. Scharlau says that every $10 million increase in the company’s sales will translate into $0.60 in earnings.

Technology stocks like ON and Radware comprised 41% of the fund’s asset at the end of last month. The managers have been finding companies with the growth characteristics they prize in that sector, Scharlau explains.

A favorite of Scharlau’s in the group is Manugistics Group (MANU), which makes software for managing supply chains. Manugistics, the leader in its field, stands to benefit if corporate tech spending picks up, he says. Meanwhile, the stock trades at about two times projected 2004 sales, which Scharlau describes as “pretty reasonable.”

Many of the fund’s tech holdings have contributed significantly to the portfolio’s performance so far this year, Scharlau says. Among its winners, he cites Lexar Media (LEXR) and Silicon Storage Tech (SSTI), which make products for storing and retrieving digital images.

Outside the world of technology, Scharlau is fond of Aeropostale Inc (ARO), a retailer of low-priced apparel that targets young shoppers. The money manager thinks the chain can expand from its current 400 stores to 900 over the next five years, giving it a chance to fatten its operating margins. Also, although Aeropostale is increasing profits by about 25%, its stock carries a P/E multiple of only 18, Scharlau says.

Scharlau also likes Labor Ready (LRW), which provides temporary workers for companies. The stock entered the portfolio in the spring and was its third-largest holding at the end of September. Labor Ready stands to gain if the economic recovery strengthens and leads to increased hiring, says Scharlau, who believes the stock “has well over a dollar in earnings power.”