Getting the Maximum from Micro Caps

Focusing on fundamentals rather than price keeps fund manager Robert Sullivan disciplined -- even if he has to sell star performers

Small companies have bigger potential in the market than their larger brethren, and their superior performance should continue longer than it has in the past, according to Robert J. Sullivan, manager of the Satuit Capital Micro Cap Fund (SATMX ). He bases this view on the diversity of small- and micro-cap stocks, their relative valuation, and the economic cycle.

Sullivan looks for stocks with market capitalization of $500 million or less, and fundamentals rather than price momentum drive his investing, he says. These were among the points Sullivan made in an investing chat presented Nov. 6 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: What's your forecast for small caps in general vs. larger stocks? Do you think small companies will outperform?


Yes, and I'll give you three themes as to why that'll happen. One is diversification. The second theme is relative valuations. The third theme is the economic cycle. Combining all these three leads me to believe that the small-cap outperformance cycle will last quite a long time.

Q: What's the fund's definition of micro vs. small, and do you have some of each?


The fund's definition of micro cap is $500 million of market cap or less. We have positions that have market capitalizations that are greater than $500 million due to the fact that they've appreciated in value since we bought them. In terms of market cap, we'll sell a position completely if its market cap hits $1 billion. That falls out of what I consider to be the framework for the fund. The median market cap is approximately $380 million.

Q: Bob, give us a few of your favorite or top holdings in your fund and why you like them.


In biotech, VI Technologies (VITX ). They develop products designed to improve the safety of the blood supply. They have a compound in Phase 3 trials that can identify viruses, bacteria, and parasites in red-blood cells. It's very important to be able to identify these types of pathogens in the blood supply before it's put into patients.

Another interesting name that we own in technology is August Technology (AUGT ). They design, develop, manufacture, and sell automated wafer-defect inspection systems. It's very important for semiconductor manufacturers to be able to detect wafer defects before spending the money trying to create the chip. VI Technologies and August are both in our top 10.

Q: What sectors are you betting on the most?


Our top three sector holdings are as follows: technology, at 19% of the portfolio; finance, which is 13%; and health care, 12%. As you can see, the portfolio is very diversified. Our technology holdings span everything from pure plays in the semiconductor-production rebound with investments like August Technology and then the recovery in info-tech spending by businesses through investments in Digitas (DTAS ) and PTEK Holdings (PTEK ).

Q: A few of the stocks in your fund seem to have had triple-digit returns so far this year. Are they your stars? And can that kind of performance last?


Unfortunately, we have sold some of the real stars in the portfolio probably too soon. One in particular that comes to mind is Ceradyne (CRDN ). J2 Communications (JCOM ) is another, and Central European Distributors (CEDC ) is one more. Those could be some of the stars you're talking about. My point is that we'll trim positions and sell them outright if the fundamentals really start to lag the stock price. We want to make sure that we're investing in fundamentals first and not in price momentum.

Q: We get questions regularly now about satellite radio -- Sirius Satellite Radio (SIRI ), XM Satellite Radio (XSMR ). Have you tuned into those names?


Tuned in? You betcha. A little bit too big for the fund, both with market caps of $2 billion-plus. Having said that, interesting technologies, interesting business models, and certainly two companies that you want to keep your eye on.

It's very important to understand the cash position of the companies because the capital markets will be very important to these two firms going forward in terms of financing. I can't say I really know enough about them to compare the two -- as I stated, they are too big for the fund.

Q: Do you like any retailers?


Yes, we do like the retailers. They had a tough month in October because the weather was probably a little bit nicer than we had expected, keeping folks out of the stores. Two that we like and that we own are Bombay (BBA ) and Mossimo (MOSS ). We also own Goody's (GDYS ), which sells discount clothing for the family.

Q: You're fairly big in financial services, which one might think of as a place for giants. What are some of your names there?


An interesting name that's a recent purchase is Ashford Hospitality Trust (AHT ), which is buying small motels and hotels on a very disciplined financial basis so that they can maximize capital returns.

Another interesting bank that we own is BankUnited Financial (BKUNA ). This is an example of a company that we bought originally with $350 million in market cap, and it has moved to $750 million. They provide a range of banking services in South Florida -- your classic bank that's in a growing area. Finally, another interesting name is ProAssurance (PRA ) -- one of the leaders in providing medical-malpractice insurance.

Edited by Jack Dierdorff

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