Quiet, Please!

Focus, discipline, and the ability to “turn everything off and just ignore the noise.” These are the qualities that Philip Tasho, chief executive officer and chief information officer at Alexandria, Virginia-based TAMRO Capital Partners, believes are essential for money managers hoping to make their way through the current financial market and economic mess.

After 28 years in the investment management business, Tasho–who founded TAMRO Capital Partners in June 2000–has enough savoir faire and confidence to stick to his guns, tune out the din, and focus on what he does best: Picking best-of-class stocks in the small-cap space. The Tamro Small Cap Fund, which has about $1.185 billion in assets under management, has been a consistent top performer in its class, and even at a time when mutual funds across the board are down, the portfolio has not suffered as deeply performance-wise as its peers.

Tasho credits the success of the fund to the rigorous investment strategy TAMRO follows, one that screens small-cap stocks in a multi-pronged, meticulous manner to gauge their competitive advantage.

At a time when the credit crisis has revealed itself to be systemic and stocks in all sectors have been beaten up beyond imagination, Tasho believes there are still more than enough gems for savvy managers to choose from, particularly in the small-cap space. TAMRO Capital’s mission is to find them.

Tasho is the architect of TAMRO’s investment philosophy and process. The small-cap product benchmarks against the Russell 2000 and there are about 52 stocks in the portfolio: “the lower limit,” Tasho says. “We usually run between 50 and 70 names.”

TAMRO Capital also manages around $75 million in an all-cap portfolio.

We are in the one of the worst financial messes of all time and things don’t seem to be getting any better [the interview took place October 30, 2008]. Do you think the crisis is going to change the way in which managers like yourself invest?

I have been doing this for 28 years and the one thing I have learned is that you need discipline. Experience is also very important. When people ask me how many years I’ve been in this business, I say, “Never enough.” Our rule of thumb is that whenever the markets provide us with an opportunity, we focus on buying best-of-class companies. That is the basis of our strategy. We only invest in companies with a sustainable business advantage. They have to have built a sufficient competitive moat, they need to have the managerial talent, and we look for stability. We also look for financial flexibility, for companies that are able to manipulate their way around.

But do you think there are companies that have those characteristics at this time?

There are always companies that meet those characteristics.

How do you find them?

Our investment process starts with idea generation through a stock screening process. We’re screening stocks for favorable characteristics that will identify attractive value based on accelerating earnings, relative valuation, and confidence of earnings. Everything is then ranked by deciles, and the top third is the most attractive. The total universe is 1,000 companies and we rank them based on sectors, because part of our risk profile is broad diversification and we believe that there are opportunities across the entire market. Within the top one-third, most attractive decile, we then see if the companies are leading in their industry or lagging their group. For stocks that score well, we run an industry matrix which includes multiyear trends for such variables as total return, revenue growth, earnings growth, return on equity, cash flow, debt to equity, and R&D spending. These factors are used to compare a company within its peer group and to identify the leaders and laggards of a group. Leaders have historically produced outsized returns, but could be experiencing short-term difficulties; laggards have failed to generate value over time as evidenced by poor trends relative to their peer group, but could benefit from a restructuring as long as there is a core business where they have a leading market share.

How do you determine that?

We look at companies historically to determine their competitive advantage. We look to see if they have a leading product, or if they offer a service where they are number one or two in market share. We want to know if the management team is highly incentivized; whether the board is capable, independent, and incentivized; whether the company possesses a superior balance sheet relative to its peers; whether excess capital can be returned to shareholders, and so on. This will assess the business profile of a company. Lastly, we look at the valuation of the underlying stock, based on not only historical facts, but also on best estimates going forward. We also look at the downside risk in case things don’t come to pass as we had hoped.

Based on your strategy, which industry sectors have done well by you this year?

Well (laughs), nothing has done well this year. Everything is doing what it’s doing, I suppose. But we have been successful in understanding what have been the best investments for us, particularly energy at the beginning of year. For all the reasons we have to buy a stock, the inverse is true for selling it. We look for three times the upside versus the downside, and once that becomes neutral, we will sell the stock and say, “It’s becoming expensive.” We would also sell stocks if they are not quite doing what we want. Our universe of small-cap stocks includes those companies with a market cap range of $200 million to $2.75 billion. Our sell discipline is based on valuation (we will sell if the stock gets expensive relative to our target price), whether fundamental execution is poor relative to our expectation, or the stock’s market cap hits $5 billion.