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Three Steps to Small-Cap Winners

Small-cap stocks are the market's darlings right now, with the Standard & Poor's 600 SmallCap index gaining nearly 19% over the last 12 months, vs. a 4% decline in the large-cap S&P 500-stock index. In fact, small-caps have outperformed large-caps coming out of the last five recessions, says Juliet Ellis of JP Morgan Small Cap Equity Fund (VSEAX). In light of her forecast for a modest economic recovery and continued strength in consumer spending, Ellis has raised her fund's average weighting in retail, cyclicals, and consumer-staples companies.

Ellis has been outpacing her small-cap growth peers by using a three-step approach to stock selection that leaves a lot of the risk behind. Ellis looks for a great business with good management that's attractively valued. But if she also sees that the stock's technicals are deteriorating, she won't buy it.

For the one-year period ending in February, JP Morgan Small Cap Equity returned 4.4%, vs. a 13.3% loss for the average small-cap growth fund. For the three years ending in February, the fund rose 11.3% annualized, vs. 5.6% for its peers. Ellis keeps the portfolio fully invested, never letting cash exceed 5%. The fund's beta (a measure of volatility) is a relatively low 0.75.

Rick Micchelli of S&P's FundAdvisor recently spoke with Ellis about the fund's investing strategy, top holdings, and recent portfolio moves. Edited excerpts of their conversation follow:

Q: How would you describe your investment approach?

A: We start with the index that best matches the asset class. In this case, our benchmark is the S&P 600. We align ourselves with the benchmark in terms of sector weights.

Q: How do you select stocks?

A: The process is based on three steps: fundamental analysis, valuation analysis, and timeliness analysis. I have three equity analysts who work with me. The first step is to identify good businesses. he second two steps involve finding a good stock.

Q: In your search for good businesses, how do you go about looking at the fundamentals?

A: We develop detailed earnings models for every company that we investigate. We go back eight quarters, and we go forward eight quarters. We break down sales to the finest level of detail. We are modeling as much information as we possibly can about the business. Also, we're in contact with the management team for every company that we look at.

We look for revenue growth, which is a primary driver. Factors that drive revenue growth that we look for include product cycles, pricing flexibility, market-share gains, and consolidation.

Q: Once you have identified a good business, how do you discern whether it is a good stock?

A: We look for a reasonable valuation in the second step. In the valuation analysis we use the price-earnings-to-growth ratio. The significance of this is the metrics are our own. We have our own forecasted growth rate and earnings. We have a target multiple relative to the growth rate that we place on earnings 18 months out. That becomes our target price. We need at least 25% upside from today to make it a viable stock.

We then do what I call a reality check on the valuation. We model the income statement and an abbreviated balance sheet and cash-flow statement for every company. We are evaluating what type of enterprise value (EV) to EBIDTA [earnings before interest, depreciation, taxes, and amortization] multiple we need to reach our target price for each company. If the EV-to-EBIDTA multiple is in line with what we think is reasonable, relative to growth and the return, and it lines up with our p-e, then it becomes a viable stock.

Q: What are you looking for in the third step?

A: This final step is what I call timeliness of the idea. You may have a great business, and a cheap stock, but it is not the right time to buy it.

We look at the technicals of the company for any signs of deterioration. I consider this a kind of risk control measure. With a great business and a cheap stock, we are looking for what I call a benign chart, i.e. one that is showing no signs of deterioration. Relative strength isn't falling. The stock is not closing at the low on volume. The stock is performing in line with the industry.

If I have a stock that is showing signs of deterioration, but it is a great business and it is cheap, I still won't buy it. This final screen will keep it out of the portfolio, since we make the assumption that we missed something. A stock typically goes through this kind of rigorous analysis. If it passes all three steps then it becomes a viable idea. We typically take roughly a one percent position. I have 115 stocks in the portfolio now.

Q: Judging from the stock selection process, your bias is toward growth.

A: We definitely have a bias toward growth. It is really a function of trying to find good businesses. A good business, in our mind, is one that can grow revenue and grow earnings over a sustainable period of time.

Q: How do your sectors break down at the moment?

A: The largest sectors are consumer cyclical, industrial cyclical, retail, health services, and semiconductors. There has been a fairly significant change in the complexion of the portfolio over the last 12 months, with a tilt toward the cyclical side. It is influenced by the dynamics of what's going on in the world on a top-down basis. Areas where we have raised the average weight in the portfolio include retail, consumer cyclical, industrial cyclical, and consumer staples. There has been a reduction in the overall weight in health care and finance.

Q: Which companies currently fall into your top 10?

A: Chico's FAS (CHS), Province Healthcare (PRHC), Alliant Techsystems (ATK), Performance Food Group (PFGC), CACI International (CACI), EMCOR Group (EME), Pier 1 Imports (PIR), Brooks Automation (BRKS), Iron Mountain (IRM), and Cooper Cos. (COO).

Since we are a small-cap fund, the top holdings are not always a significant commentary on the portfolio. Currently the top 10 make up probably 15% of the fund.

Q: Given that, could you single out any one of your positions and illustrate why you find it attractive?

A: Too Inc. (TOO) is a retailer in a niche market. They are a dominant player in the girls fashion in the 'tween market, which is older than a young child, but younger than a teenager.

I have a fairly strong view on the consumer, and it is fairly bullish, so we have made an effort to focus in that area. The bottom-up part is finding a unique, growing retailer that can do well even if our broad thesis is wrong. Too is, absolutely, one of these.

The Limited (LTD) made an investment in this company, then took it public in 1999. Too's products are private-label, so they have good margins. They are very fashion aware and have a large design team. They have a very strong management team and a great opportunity to expand their store base.

On the fundamental side, we also have revenue growth that is being driven by positive same-store comparisons, since the company is taking market share. You also have revenue growth driven by store expansion.

Q: What about your second two steps, valuation and timeliness. How does Too Inc. weigh in there?

A: From a valuation side, we are looking for roughly $1.70 for next calendar year. We have a target price multiple of about 22 times, which gives us a $37 target price. That is 23% upside from here.

The stock's chart does not look extended. It looks very reasonable. There are no signs of deterioration. The enterprise value-to-EBITDA multiple that we need to get to get our valuation price is 11 times, which we are comfortable with for this kind of business. We bought it lower than here, but on today's price we still have the upside. It meets all our criteria.

Q: What is your outlook for the market going forward?

A: I think we have strong evidence that we are coming out of a recession. I think that we have a good solid six to nine months before the Fed would start to raise rates. We have this unique opportunity here, where you are not faced with a rising-rate environment.

From an economic perspective, I have more conviction about the consumer than I do the broad economy. I don't think we are going to have this huge recovery. I think we are going to have a modest recovery, but I think the consumer stays strong.

I think the wealth effect of real estate has been underestimated vis-a-vis the consumer. While the market has been down for two years in a row, real estate prices, on average, have risen about 9%. The bulk of the consumers' assets are not in equity, but real estate. I have a lot of conviction about the strength of the consumer.

As for small caps, they have outperformed large caps coming out of a recession five times out of the last five recessions.

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