This Fund's China Connection Pays Off

Armada's Jon Scharlau says one-third of his holdings are in U.S. companies with exposure to the Asian giant. The rest are doing pretty well, too

By Eric Wahlgren

Thirteen years ago, when portfolio manager Jon Scharlau was a college student studying abroad in Beijing, most residents got around on bicycles. These days, the Mandarin speaker notes, a striking number of Chinese are tooling around the sprawling city in late-model automobiles. It's the kind of rapid economic transformation in the world's most populous nation that inspires the Armada Small Cap Growth Fund's (ASMIX ) investment philosophy: to seek U.S. companies that have exposure to the white-hot China market, where growth could top 8% in 2003.

The fund, which Cleveland-based Scharlau took over in February, 2003, was badly in need of a new direction. The portfolio had underperformed most of its peers over the last four years. These mainly bear-market years were admittedly lousy for small-cap companies, as the small fry tend to be less diversified than larger corporations. But fund-tracker Morningstar blamed the fund's especially poor returns in the past on a heavy reliance on volatile technology and health-care stocks.

So far, looking East seems to be working for Scharlau. The fund is up 40.03% year-to-date, slightly besting its peers and smoking the Standard & Poor's 500-stock index by 19.65 points. Of course, performance like this hasn't been too tough to achieve, given that this year's rally has largely been led by the small caps. The real test will come as the stock market rally broadens to other asset classes.

Scharlau says his fund will not disappoint, contending that the small-cap companies his team has selected are well-positioned to benefit from a global economic recovery. His arguments appear to be resonating with investors. Money is flowing to the fund, with assets now totaling about $230 million, up from $170 million at the end of last year. In a recent chat with BusinessWeek Online Reporter Eric Wahlgren, Scharlau discussed his stock picks and investing philosophy. Edited excerpts of their conversation follow:

Q: Why does your fund looks for U.S.-based companies with exposure to China.

A:

In college, I took Mandarin Chinese and studied in China, so I'm familiar with the region. You might not think that there's that much overlap between investing in small-cap stocks and China, but you can't ignore China. It has the best growth prospects over the next decade. Companies are moving operations to China.

Companies in the small-cap space tend to be component suppliers to larger companies. It's extremely important that small-cap companies have a China strategy, or can address that huge market, or can move operations to China, to take advantage of that lower cost structure.

About a third of our investments have a China connection. One company that comes to mind is ChipPAC (CHPC ). It's a back-end semiconductor-equipment company that packages and tests semiconductors. They have substantial operations in Shanghai. They see customers moving testing there because the cost structure is lower, so they wanted to be there.

Another company is Merix (MERX ), which makes components used in sophisticated electronics like computer servers. They moved their more commoditized business to China because of the lower cost structure. What they've retained in the U.S. is their fast lead-time manufacturing operations.

It's a lot easier to do business in China than it was in the past. Overall, we believe that companies that have an effective China strategy will have a lower cost structure and a higher growth rate.

Q: What are some of the other stocks you like?

A:

On the retail side, we like Aeropostale (ARO ), a teen retailer. They've differentiated themselves by addressing the lower end of the market. They've shown nice increasing sales trends at stores open at least one year. They had a successful back-to-school season, which historically points to a good holiday season.

It's expected to grow earnings per share 25% over the next three to five years. The chain currently has 400 stores. We think it can grow to 800 or 900 stores. They're also building brand awareness. It's trading at under 20 times 2004 fiscal year earnings, which is very reasonable.

Another company we like is Manugistics (MANU ), the leading provider of supply-chain management software. They should do much better in an economic upturn. Industrial companies will come back and spend money. What many other companies will focus on is improving their supply chains. They're very leveraged to the recovery, and their valuation is still very reasonable. It's trading under two times price to 2004 sales, which is on the low end for software companies.

And there's Radware (RDWR ), which makes Internet switches. This company has beaten estimates for the last three quarters. When corporate spending increases, they'll see a more dramatic increase. They have a reasonable valuation. We've found that a change in $10 million in revenues would yield an extra 60 cents in earnings per share, which is pretty strong. By Eric Wahlgren

Q: Your fund has had a nice run this year. But market strategists are talking about an eventual rotation into large caps from small caps. What would this mean for your fund's performance?

A:

If past is prologue, we have some excellent years ahead of us. There's a ton of upside in small-cap growth companies. The rally we're seeing now is on par with the rally we saw in 1991. Small caps led that rally. But even in the following years, 1992 and 1993, small caps outperformed large caps -- they were up 36% in that two-year period, vs. 18% for the large caps.

Fundamentally, small-cap growth companies don't do well in tougher times. We're now in a situation that's much more favorable for them. They benefit from good valuation and good earnings leverage.

Q: Before 2003, the fund underperformed its peers for the previous four years. What happened?

A:

It was a very difficult environment. If you look back at the late 1990s, it was not an environment when people cared about valuation, and the fund stayed true to valuation. Also, some of our peers moved into value stocks when we remained focused on growth stocks, so our relative performance was affected.

I was brought on this year. I have 11 years of small-cap experience. We have a lot better process for picking stocks, and we should have more consistent results.

Q: How do you pick stocks?

A:

We look for companies in the $100 million to $3 billion range. We're inherently growth investors. We believe that earnings growth translates into higher stock prices. We're looking for companies that can grow their revenues and their earnings. Typically, we look for companies growing earnings at a 15% to 20% annual rate. On top of that, we look for companies that can sustain growth over a period of time.

We also want to see that they're addressing a large market opportunity or a niche product area. Our companies tend to be No. 1 or No. 2 in their markets. They have a competitive advantage. Most importantly, they reinvest in the business.

Another important consideration is valuation. We look at earnings over the next two years and look for stocks with reasonable price-to-earnings multiples. When we like a company, we evaluate its risk vs. its reward. Small-cap companies are one-product companies. They're volatile. We want to make sure there is more potential upside than potential downside.

Q: Your top holding, tech company ON Semiconductor (ONNN ), doesn't seem to meet your criteria. It has lost money for the last two years. What gives?

A:

I'm not so interested in what it has done over the last year. I'm looking to the future. We're looking to companies that are leveraged to the economic recovery.

ON Semicon was a spin-off to Motorola (MOT ). The company makes semiconductors that are used in a variety of industries. In the last couple of years, new management has slashed costs and reinvested in new products. What we think we have going forward is a newer company with higher-margin products. In an economic recovery, they will have a very, very nice earnings ramp.

Q: Part of the fund's past underperformance was blamed on your technology and health-care holdings. Have they changed?

A:

Technology has helped this year. When I look forward, a lot of the companies that are the most leveraged to the recovery are technology companies. On a relative basis, we like software companies. We think we'll see more corporate spending next year. We are underweight health-care services. We found better growth elsewhere. But we're modestly overweight in biotech companies.

Q: Are there other areas in which you are overweight?

A:

We're also overweight in business services. When you look at the recovery in business spending, information-technology companies will do well. The staffing companies will do better, too.

We have a position in Gartner Group (IT ). It has a very good business model. They take their research on technology content and spread it out over a lot of different distribution channels. When you think of corporate spending increasing, it's hard to imagine Gartner's business not improving.

On the staffing side, we like Labor Ready (LRW ). They do low-end, all-purpose day labor. Historically, it has seen growth come back the earliest. The company did very well in the downturn. They maintained their national offices. They're in construction, landscaping, and light-industrial work. The services they offer are low-wage positions that companies can't afford to fill themselves. We bought the stock in the spring at around $6 a share, and now it's at around $12 a share.

Wahlgren covers the markets for BusinessWeek Online in New York

Edited by Beth Belton

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