Quick Take: Chris Bonavico, co-manager of Transamerica Premier Growth Opportunities/A (TGOAX), likes high-quality companies with lots of free cash flow. Since they aren’t easy to come by in the small-cap space, the fund focuses on “smid” or small- to mid-cap companies.

Even so, Bonavico and co-manager Ken Broad find there aren’t many companies that meet their criteria. As a result, they run a concentrated portfolio of 20 to 30 stocks with low turnover. To limit volatility, the fund holds only one stock in a sector. The fund’s three-year standard deviation has been less than the average for small-cap growth funds.

The strategy has resulted in competitive performance. For the one-year period through July, the fund was up 18.4%, versus a 9.1% gain for small-cap growth funds. For the three-year period through July, the fund rose 5.5%, annualized, versus a 2.6% loss for its peers.

The Full Interview:

S&P: What is your basic investment philosophy?

BONAVICO: This fund focuses on companies with outstanding franchises among “smid” or small- to mid-cap companies. We follow a smid strategy to avoid the arbitrary small-cap ceilings that force you to sell succeeding businesses.

Our average weighted market cap is $3 billion. We want the very few businesses that can grow into large businesses because of their managements teams, business models, and opportunities. We take concentrated positions, holding about 20 to 30 stocks, with several positions at 5% to 6%.

S&P: What is your approach to growth investing?

BONAVICO: I only focus on businesses that can internally fund their growth since acquisitions are very risky. I also look for companies with favorable long-term trends. We’ll own any business as long as it has long-term secular growth opportunities, rising returns on capital, and good management. We also like companies generating excess cash. Unlike p/e ratios, which many investors follow, free cash flow tells what you, as a business owner, put in your pocket.

S&P: Do you have a difficult time finding growth companies that can fund their own growth?

BONAVICO: We think the common view that growth companies don’t produce excess cash is nonsense. We are especially attracted to companies with growing free cash flows. About 60% of our holdings pay dividends. These companies generate capital appreciation as well as dividend returns.

S&P: With your concentrated approach, how you cope with volatility?

BONAVICO: We control risk by diversifying with only one holding in a sector. By focusing on the quality companies’ business models, balance sheets, and cash flows, we can also avoid significant downsides.

S&P: When will you sell a holding?

BONAVICO: We’ll sell if we see a better investment idea. We also tend to sell a stock when it gets north of the $7 billion to $8 billion market-cap range.

S&P: Do you foresee limits to the size of your fund in view of your concentrated approach?

BONAVICO: We plan to close the fund. We have about $1.1 billion in assets, including mirrored products. We think we will take in about $1.5 billion in total and close the fund. If we took large positions in some of our small-cap holdings, we would own over 10% of the company, which would limit our flexibility.

S&P: Why has the fund’s long-term performance been attractive?

BONAVICO: We apply the same discipline over time by looking for secularly growing businesses trading at good valuations and run by honest managers.

S&P: Why was 2000 a difficult year for the fund? The portfolio lost 26.2%, versus a 9.1% loss for its peers.

BONAVICO: In 2000, we sold a lot of stocks when valuations were high, but we didn’t realize how many companies outside of technology had high valuations from the excess capital flowing through the economy. We didn’t own dot.coms. Since then, we’ve developed a system of keeping other ideas ready.

S&P: What have your purchased recently?

BONAVICO: Tuesday Morning (TUES), a unique retailer, is likely to have free cash flow growth of 15% for the next five plus years. It sells high-quality home furnishings at ten sales events a year to a loyal customer base.

Contact Bob Keane with questions or comments at:bkeane@investmentadvisor.com.