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Afraid of flying? You’d better get over it if you want to pick stocks the way Virginia Au does.

Earlier this year, she returned from a six-month research trip to Asia, where she took factory tours and grilled CEOs.

Au, vice president and portfolio manager at Trimark Investments in Toronto, has a passion for stock picking in the small-cap space.

“Only a handful of sell-side analysts cover many of the companies we own,” she says. “Compare that to the 50-plus teams watching a firm like Apple. With so much coverage, it’s very difficult to get a unique outlook.”

She adds, “Larger-cap firms often find it difficult to outpace GDP growth. Smaller companies are nimbler—they can develop a niche market and grow exponentially.”

What’s your investment process?

We’re not stock-price speculators. For us, buying a stock means investing in a business, and that requires understanding its fundamentals.

We’re looking for three main things:

  • sustainable competitive advantage
  • high-quality management
  • attractive valuations

01 Sustainable competitive  advantage

This is a company that has the ability to keep its competition at bay. For instance, it has patents that prevent others from copying its products. High switching costs are another advantage. This means it’s expensive and a major hassle for customers to switch to an alternative supplier.

02 High-quality management

Management should act in the interests of shareholders. The best way to ensure this is for top decision-makers to own a lot of stock. And it’s difficult to measure, so we judge each company case by case.

We also stress compensation. Less than half should be based on short-term (one-year) performance; the majority should be based on long-term (three-to-five-year) metrics, such as total shareholder return and profit growth.

Top managers at small-cap firms are more accessible than their large-cap counterparts. We have extensive discussions, but we’re careful to filter out the spin.

The key is to question them based on track records. For example, if they spent 20 times revenue on purchasing and acquisitions, we press them on what it’s accomplished two or three years later. When you hit them with hard data, it’s difficult to spin the story.

We also attend industry conferences, including the consumer electronics and telecom tradeshows in Las Vegas. We speak with competitors and if we get divergent stories, it’s necessary to dig deeper. Sometimes we discover the competitor is a better buy and invest in it instead. In one case, we were considering a Taiwanese computer touch-screen component company, but invested in U.S.-based Synaptics instead.

03 Attractive valuations

Strong competitive advantage and management don’t mean much if the stock’s expensive. We buy a company when it’s undervalued, which means below its long-term intrinsic value.

Our time horizon is about five years. This allows us to overlook short-term fluctuations. The market tends to latch on to what happens in the next quarter and often overreacts. Our patient approach allows us to focus on the value a company can generate over the long term.

Where are you finding opportunities?

Over the last three years, many companies have cut costs and restructured operations. Others have taken advantage of low rates to refinance debt. Both steps have put balance sheets in good shape.

The problem is valuations. The market has shot up, which means equities are at or near full value. So, compared to 12-18 months ago, it’s much harder to find high-quality companies at cheap prices because stocks have had such a strong run.But some good buys still fit the characteristics in our investment process, including industrial automation and tech services.

Industrial automation:

Hollysys Automation Technologies Ltd is a U.S.-listed Chinese company, which puts off many investors. This is a mistake because it has great potential. With wages in China increasing, factories need to find ways to improve productivity. Major foreign players, such as ABB, Emerson and Siemens, hold 70% to 80% of the industrial automation market share. Hollysys is the largest domestic player, and while it lags foreign firms in technology, its product is 30% cheaper.

Think of big foreign firms as the Ferrari of industrial automation. Hollysys is presenting itself as a Toyota—an alternative a lot of companies want. This is one reason we think it has long-term growth potential. Hollysys also makes signalling systems for high-speed trains. In 2011, there was a major accident in China and the government put all high-speed rail projects on hold. (Hollysys was not the signalling system provider for the crashed train.) But in the last few months, the government has relaunched many of these projects and that means another growth opportunity for Hollysys. Despite its potential, the company’s trading at a mere 12 times earnings.

Tech services:

The tech sector also has opportunities. When people think tech, big names like Apple get the most attention. But the sector also includes software and services firms.

A good example is Global Payments Inc., which processes credit and debit transactions. Switching costs are an advantage for the company, along with low costs for adding new customers. Scale grows exponentially with every new client. Global Payments is a top-10 firm in the U.S., and second-largest in Canada. It also has a strong presence in the U.K. and Asia. The key growth opportunity is entering countries with lower card-payment penetration, such as Spain, Russia and China.

What risks do you see?

The U.S. government is a major concern. Even though the shutdown was over politics in Washington, it made market players nervous. Sequestration has meant an 8% to 10% across-the-board cut on defence, which is having a major impact on a lot of companies.

What advice do you have for advisors?

Advisors should ensure fund managers practice what they preach. Many say they’re bottom-up investors doing deep fundamental analysis. But their holdings sometimes tell a different tale.

If there are 100 names in the portfolio, it shows there’s no conviction behind the manager’s picks, since each has an average weight of only 1%. We aim to have 25 to 35 names because it shows we’re confident in our stock-picking ability.

Another thing to look at is turnover. Many managers are at 100%. A portfolio with 100 names and 100% turnover means each year it goes through 200 stocks. A team can’t analyze that many companies in depth. We try to keep turnover at about 25%. It fluctuates, but never gets higher than 50%.

Advisors should also evaluate managers on a three- to five-year horizon because that’s how long it takes for a bottom-up strategy to bear fruit. You also can’t discount luck, which may be behind short-term spikes in performance.

Keep in mind that active managers can only add value if they deviate from their benchmarks. This is why I include my funds’ active share figures in my presentations to advisors. Funds with low active share don’t deviate enough from the index to make the extra fees worth it; clients would be better served with ETFs. There’s a place in client portfolios for active and passive strategies. Just ensure their active funds are truly active and not managed by closet indexers.

Dean DiSpalatro is senior editor of Advisor Group.

Originally published in Advisor's Edge Report

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