Quick Take: To cope with the great variety of small-cap stocks, George Henning avoids a ‘one size fits all’ approach when managing Pacific Advisors: Small-Cap Fund/A (PASMX). Henning considers different investment criteria for stocks in different industries, along with top-down trends and technical analysis.

Recently, Henning has been focusing on the rising economy, particularly energy and transportation stocks. Going forward, he expects the consumer product and industrial sectors will gain, followed by financial services.

The portfolio has generated stellar gains lately. For the one-year period through May, it rose 84.4%, versus a 30.8% increase for small-cap value funds. Over longer periods, the fund has outperformed its peers, though not as dramatically. For the three-year period through April, it gained 12.4%, on average, versus a 10.3% rise for its peers.

However, the Pacific fund’s volatility is far above the category norm based on three-year standard deviation — 25.8% versus 18.18%. Henning says if you feel strongly about a holding, you shouldn’t limit your potential gains. Indeed, the manager prefers bigger stock weightings than his peers. The fund is very concentrated, holding about 40 small-cap companies.

Another thing to keep in mind is that the portfolio currently charges very high expenses of 4.44%, almost three times as high as its peers, making it much more expensive to own for small-cap exposure. However, fees should decline as the fund continues to gather assets. A-class shares carry a 5.75% front end load.

The Full Interview:

S&P: What is the fund’s investment strategy?

HENNING: We look for undervalued companies with catalysts for growth. We measure companies differently based on the industries they’re in. It doesn’t make sense to only consider price/earnings ratios when industries have different average p/e ratios. Over the years, I’ve found debt may be good for one company, while zero debt may be best for other companies. That’s why talking to company management is important, especially for small-cap stocks.

I try to keep a small number of holdings since following a lot of companies is difficult in the small-cap market. Right now, we have about 40 companies, which is higher than what we typically have.

S&P: How do you compare stocks in different industries?

HENNING: I make judgments based on a number of things. I tend to look at companies for awhile, sometimes for more than two years, before I invest in them. Information about small-cap companies is often limited, so it can take a fair amount of time to understand a company.

S&P: Do you consider any top-down criteria in picking stocks?

HENNING: I pay attention to technical analysis to see which sectors are performing well. This helps to measure how companies stack up against each other. It also helps to decide which positions to add to. Usually, I add to existing positions rather than start new positions.

S&P: Which areas of the market currently look attractive?

HENNING: The economy is growing, but I don’t think it will overheat. The industrial and energy areas look good, as does consumer products. Right now, I’m looking at manufacturing, because of steel shortages, the dollar’s valuations, and rising energy costs. When the market pulled back about six weeks ago, I bought Titan International (TWI), a wheel and tire producer.

S&P: Do you think any other market areas will be attractive in the future?

HENNING: Opportunities may develop in the financial area when the Federal Reserve raises interest rates. Overall, I’ll probably stay with the same themes as now, although I may make some adjustments.

S&P: What are the fund’s largest sector weightings?

HENNING: Energy and manufacturing are big holdings, as are, to a lesser extent, technology and financials. In finance, I’ve focused on niche banks, such as East West Bancorp (EWBC), and some pawn shops, such as First Cash Financial Services (FCFS). In the small-cap area, technology valuations tend to be high.

S&P: Based on standard deviation, the fund is more volatile than its peers. What is your approach to market volatility?

HENNING: You can keep volatility down by spreading risk, but if you feel strongly about something, you don’t want to limit your potential gains. Many of our holdings are about 4% positions.

S&P: Why was the fund’s one-year performance so strong?

HENNING: I’ve been a big advocate of a strong economy, so I’ve felt energy would be a good area. I also went aggressively into transportation, including Frozen Food Express (FFEX), a temperature-controlled trucking company. When the economy gets better, transportation is often one of the first areas to gain. I try to look ahead for six to 12 months, because it may take 12 months for a stock to go up.

S&P: What are the fund’s largest holdings?

HENNING: They include Intervoice Inc. (INTV), America Service Group (ASGR), RailAmerica Inc. (RRA), and Titan International. I’ve owned RailAmerica for several years. They’ve been a good acquirer of short-line railroads.

S&P: Do you have a favorite stock?

HENNING: I’ve owned East West Bancorp for four to five years. They’ve made strategic acquisitions, and they’re likely to continue to grow.

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.