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Mutual Fund Q&A: 
In Quest of Core and Catalysts
Author: Manish Shah
123jump.com
Last Update: 9:23 AM EST January 29 2008



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Ryan Crane
  “Our goal is to evolve a strategy that will enable us to invest in really great growth companies, like the 10-fold return type of investments, for our small cap and mid cap growth fund portfolios.”
Stephens Mid-Cap Growth Fund, Stephens Small-Cap Growth Fund

Identifying high return companies in the relatively volatile small-cap and mid-cap space requires considerable experience and expertise. Ryan Crane, portfolio manager of the Stephens Mid Cap Growth Fund and the Stephens Small Cap Growth Fund, and his research team employ a judicious combination of fundamental and quantitative analyses in their unique dual-approach strategy to make money from growth investments for their two funds.

 
Q:  What is your investment philosophy?

A: We are growth investors. Our ultimate goal is to evolve a strategy that will enable us to invest in growth companies where companies can grow multiples bigger in our small and mid-cap growth portfolios.

Our philosophy is pegged on two different approaches to growth investments. One, to look for core growth companies, the stable, predictable and consistent performers, and two, to invest in companies that are likely to improve their earnings in the near term.

Q:  Can you elaborate on these two approaches?

A: Growth is our keyword. One approach is to look for a core growth stock that is synonymous with stability in business, predictability in earnings and thus, consistency in stock performance. We are looking for unique business models that allow a company to enjoy outsized returns with lower risk and lower volatility to their financials, whether it is earnings, revenues or cash flows.

The second approach is to look for the earnings-catalyst type or the inflection point catalyst that can generate multiyear earnings growth. These stocks are at some inflection point - the business models have transitioned and there is some event or trend that is going to last for more than a few quarters, even multiple years, but the market does not catch up to that fast enough.

Sell and buy side analysts do not change their models fast enough so we get this long time period when the stocks are able to beat earnings expectations year after year. We get really outsized gains from such a stock as it grows faster than market expectations. Again, we get multiple expansions, as people are willing to pay more for a stock that is growing faster than in the past.

Q:  What is your investment process?

A: Our investment process is a combination of fundamental and quantitative analyses. Fundamental analysis helps identify and understand business models and the factors that drive them, and for the best of these we build an investment thesis on the stock. Additionally we have a disciplined quantitative process that helps in confirming any investment thesis we may have for a stock,or in some cases, a theme that is broader than just one stock. For example, a couple of stocks could fit into a theme. Our fundamental analysis can also help us identify a catalyst. Just because we believe one particular company is doing better because of certain factors that have changed, which we have identified, we need to verify our findings. That is where the quantitative analysis comes in.

Often, we do the fundamental work first followed by the quantitative analysis. Sometimes, however, the quantitative approach is our first line of offense and defense. For instance, the number of companies in our investment universe is vast and we cannot be doing fundamental analyses on all of them at the same time. Here, our quantitative analysis will first give us the inflection points that would imply the company might have this core growth-like characteristic and then we do the fundamental analysis.

We also do not set price targets on stocks because we believe such targets are often a sure way of excluding ourselves from some of the best growth ideas. Our goal is to capture rising earnings curve and benefit from the sharply higher valuations.

Q:  What are the differences in the strategies and research that you follow for your small-cap and mid-cap products?

A: The philosophical and stylistic kind of approach is almost identical for both products. However, there are differences arising from the different definitions accorded to small and mid cap stocks.

The small cap universe generally has more companies that would fall into the earnings catalyst type category. Most of these less than $500 million market cap companies are still growing and it is hard for them to already be at a point where they are exhibiting characteristics of a core growth, predictable, stable company. Therefore, our small cap fund tends to skew more towards the catalyst type companies.

Furthermore, we do not try to actively manage the ratio of core growth companies versus earnings catalyst companies in the two portfolios It is a part of the bottom up process that we let float back and forth. Therefore, in strong economic or market environments we will inherently be more focused on the catalyst type companies which tend to be higher growth rate, higher beta stocks. The fluctuation of the stocks between the two categories is a self-correcting mechanism in the portfolio in the sense that when the market is good we will lean towards more catalyst companies and when the market is weak and the economy is slow, we will inherently shift back more towards core stocks.

The difference is that this fluctuation is a little more dramatic in the case of our small-cap product than the mid-cap fund. Consequently, in terms of diversification, we feel we can take a little bit more risk and be more concentrated in the mid-cap portfolio because it has more seasoned companies.

In case of the small cap fund, the ideal investment for us is one that is relatively, on the smaller side of small-cap companies, having market caps of just a few hundred million dollars and not widely followed. Those are the ones that we can catch early and achieve outsized returns to investments.

The bittersweet moment for a small cap portfolio manager is when you find this great stock, invest in it, get huge returns and then it grows to be a mid-cap stock, and at some point you are forced to sell it to stay style pure. Actually, our mid cap product is, in part, a vehicle to leverage the information, themes and ideas that we have had success with in our small cap product. As these great growth stocks transition from small cap to mid cap we can continue to own them, albeit in a different product.

Q:  Can you describe your research process?

A: Ours is a team approach. Although all team members have sector–specific responsibilities, their expertise is not just confined to their allotted sector. Management meetings are very important and we have met with more than 90% of the managements of all the companies we own. These meetings help in confirming again our thesis and get a better understanding of the fundamental story and what metrics we need to look at in our quantitative analysis of a company.

The research process involves in-depth fundamental work, and using that information to fine-tune the quantitative aspects of the metrics that we look for regarding each company. Initially we scrutinize growth in revenue, earnings, and cash flow on individual companies. Different industries, sectors and stocks have different metrics that can be equally important and may actually be leading indicators for earnings. Identifying and monitoring these key metrics is an important part of our process.

We also have a thematic approach to investing. We are bottom-up investors and look at one stock at a time. However, sometimes, when we capture a compelling investment theme that may be broader than just one company, we will look for other securities that might fit into that theme. It might be an overarching trend that’s affecting multiple companies or an entire industry, and therefore from a research perspective, it’s a big part of our research process, as it allows us to leverage what we believe is proprietary information across more than one investment.

Q:  Can you give some examples of stock selections that illustrate your investment process?

A: One example is NVIDIA Corporation that provides graphics processors for computers. We bought this stock several years ago in our small cap fund when we first identified an important catalyst, which ultimately lead to the stock becoming a text book case for exploiting the biases that are commonly identified in the field of behavioral finance.

After suffering through a two-year period of no real growth due to a more robust competitor and unforeseen events, a meeting we had with the management team indicated that things were going better. Subsequent to this meeting, NVIDIA had a quarter where we identified an inflection point. It was the first time in 10 quarters that it had posted a year-over-year gain in earnings and beat the high end of earnings expectations.
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