Jan. 18, 2005 — The managers of LKCM Small-Cap Equity Fund (LKSCX) are willing to own growing companies, as well as shares they judge to be undervalued.

Of greater importance to them, however, is whether a company has some kind of competitive edge, says Steven Purvis, who runs the fund with J. Luther King Jr.

The $344-million fund has had a leg up on its competitors of late and over the long run. The institutional version of the fund (it also offers retail shares) rose 22.1% last year, topping its small-cap blend fund peers, which gained 18.2%. The LKCM fund generated returns of 11.7% and 14.5% on average for the five and ten years ended in December, compared to its peers’ averages of 8.8% and 13.3%, respectively.

The fund also tends to be less volatile than similar offerings, based on characteristics like its standard deviation, which measures how much its returns vary. LKCM’s reading clocked in at 14.49 last year, compared to its peer group’s 17.69 average.

Because they scan for companies with unique products or something else that provides an advantage over others in the same field, the businesses he and King invest in tend to have high or increasing returns on invested capital and sound balance sheets, Purvis says.

In picking stocks, the pair of investors prefer profitable companies with strong cash flows. They hunt for investments among companies with market caps of $200 million to $2 billion, and typically put 80-90 names into their portfolio.

In October, the fund invested in Pantry Inc. (PTRY), which operates a chain of combination gasoline stations and convenience stores in ten states. Pantry’s net margins are low, but rising, and its return on equity is in the low 20s, according to Purvis, who feels both numbers can “continue to grow dramatically over the next couple of years.”

Another stock the managers took a stake in late last year is Argonaut Group Inc. (AGII), which provides specialty insurance products. Although the company’s bottom line has been expanding, its stock trades at about book value, Purvis says, but he expects that multiple to improve as Argonaut’s new managers clean up some bad business that had been carried on its books.

Purvis cites P.F. Chang`s China Bistro Inc. (PFCB), a restaurant chain, as an example of the kind of company the fund invests in. The managers initially bought the stock in early 2004 and added to the position during the summer.

The company’s China Bistro and Pei Wei Asian Diner units have been posting “strong results,” Purvis says. Also, “they’ve got lots of unit growth opportunities ahead of them over the next five to ten years,” he says. Purvis thinks the company can grow its earnings by 20%-25% over the next two to three years.

The fund’s No. 1 stock at the end of December was Kirby Corp. (KEX), which operates barges on inland waterways and provides repair services for diesel engines. Kirby stands out because it has been able to use its cash from operations to buy competitors cheaply, thus enabling it to expand capacity, Purvis says.

Another of LKCM Small-Cap’s major holdings at the end of last year was Texas Regional Bancshares Inc. (TRBS), a holding company that operates banks in south Texas. The company, which the fund has owned since 1997, has consistently churned out “significantly above average” earnings over the last 15-20 years, Purvis says.

The fund’s biggest winners last year, he says, included SBA Communications Corp. (SBAC), an operator of towers for wireless telecommunications whose stock jumped 146%; and Penn National Gaming Inc. (PENN), a casino and racetrack operator, whose shares climbed 161%.

The fund also got large contributions from trucker Landstar System Inc. (LSTR) and EGL Inc. (EAGL), an air and ocean freight transportation company, whose stock prices rose 93% and 70%, respectively, Purvis says.

When it comes to selling, the managers will cut back on companies when their market caps exceed $3 billion and eliminate them from the portfolio when the cap tops $5 billion.

Companies will also be banished from the fund if their stocks get too pricey, or their financial fundamentals deteriorate. The latter reason led the managers to sell insurer Bristol West Holdings Inc. (BRW) in late 2004, Purvis says.

“We just kind of gave up on that one,” he says of the company, which the fund had owned for about a year. “We just felt like the opportunity wasn’t as great going forward.”

As a rule, though, the managers plan to own stocks for the long haul, Purvis says. The fund’s turnover rate bears that out. It was 52% last year, compared to its peer group’s 82% average.

The fund’s expense ratio (0.97%) is also lower than that of similar funds (1.34%).

Looking at small-cap stocks, Purvis is optimistic about their prospects this year. He expects small companies to do well if the economy keeps growing, even if the pace is slower than a year ago.

“I don’t think the outsize gains that we’ve seen historically, or at least over the last five years, will continue,” he says. But in a battle with larger companies, “I expect small-cap stocks to win,” he adds.

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

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