Morningstar's Small-Cap Superstars Portfolio

We believe that one of best and easiest ways to screen for new investment ideas is by monitoring the activity and holdings of successful fund managers. Chris Browne of famed money-manager Tweedy, Browne advocated such an approach. In The Little Book of Value Investing, Browne says:

"A savvy store owner will visit competitors to see what they stock on their shelves, what is selling well in their location, and what seems to be worthless inventory. ... We can do the same by observing what other value managers are doing."

And we, too, will do the same with our new Small-Cap Superstars Portfolio, which will track 25 of our favorite small-cap fund managers (see names in the second table below). We'll screen their holdings against the highest rated ideas of our fellow analysts.

Deciding what goes into our portfolio is simple: First, the stock must have a Morningstar Rating of 5 stars, and second, it must be held by a handful of the 25 small-cap fund managers on our watch list. We also consider the size of the holding in the respective funds as a way to further refine our selection process. But we primarily will rely on the group as a whole to guide our ship.

The Small-Cap Superstars Portfolio
After running our screens and analyzing the respective merits of the Superstars holdings, the first five positions in the portfolio are  American Reprographics (ARP),  Carter's (CRI),  Cimarex Energy ,  Navigant Consulting , and  Whiting Petroleum .  

Small-Cap Superstars Portfolio
	Morningstar Rating	Number of Funds Owning	Price/ Fair Value
Amer Reprographics (ARP)		5	0.64
Carter's (CRI)		7	0.65
Cimarex Energy		5	0.59
Navigant Consulting		7	0.50
Whiting Petroleum		7	0.74
Morningstar Rating and Price/Fair Value as of 09-26-07

See our analyst takes on these stocks below. If you'd like to get more frequent updates on our Small-Cap Superstars Portfolio, be sure to sign up for our free e-mail alerts.

American Reprographics
In spite of current concerns about the credit markets and their effects on the construction industry, Morningstar equity analyst Irina Logovinsky remains confident about American Reprographics' prospects. The company is the market leader in providing document management services to the construction industry but does not have a significant exposure to the residential market. Plus, its core commercial business is healthy. American is owned by five of the small-cap fund managers on our watch list.

Carter's
While Carter's is struggling with OshKosh (acquired in 2005), Morningstar equity analyst Michelle Chang believes that with time, management will be able to turn around this brand. Furthermore, the children's apparel manufacturer should continue to build off the strength of its core Carter's line, which is sold through its own retail stores, as well as department stores and mass channels. We would also highlight that seven of the small-cap fund managers on our watch list have a position in Carter's.

Cimarex
Cimarex had a challenging year with the drill in 2006, posting a far lower success rate than what the firm is accustomed to. The company also experienced some operational challenges. If the firm can improve its drilling success from 2006 levels sometime in the next three to five years, which Morningstar equity analyst Justin Perucki thinks it can, then the shares look cheap. Besides being held by five managers on our list, Cimarex is a high-conviction idea at  Diamond Hill Small Cap (DHSCX) and  Third Avenue Small-Cap Value (TASCX), since the stock represents at least 3.5% of assets at each respective fund. We also take comfort in the fact that Marty Whitman of  Third Avenue Value (TAVFX)--the flagship fund at Third Avenue Funds--has recently been buying Cimarex shares. Our colleague, Morningstar equity analyst Justin Fuller, tracks Whitman's positions for the Ultimate Stock-Picker's Portfolio.

Navigant Consulting
Navigant Consulting continues to see weakness in its core dispute and investigative business, as work related to stock option backdating rolls off. According to Morningstar equity analyst Brett Horn, this is the nature of Navigant's business. The firm, which has established relationships with 200 of the 250 largest law firms, typically moves from one legal issue to another to drive its results. The next driver doesn't look to be far away with the current mess in the housing industry, especially the subprime market. Horn believes this will be a solid revenue generator down the road. Seven of the fund managers on our list currently hold Navigant stock.

Whiting Petroleum
At first glance, Whiting looks pretty ugly: Returns on capital have been mediocre, oil and gas reserves declined in 2006, and Morningstar equity analyst Justin Perucki expects production to slide over 6% this year. However, the firm is undertaking a massive tertiary oil recovery that should improve returns, reserve growth, and production in the upcoming years. Whiting also has assets that are attractive to upstream master limited partnerships. MLPs are willing and able to pay top dollar for acquisitions, due to their lower assumed cost of capital. Shareholders stand to benefit if Whiting is able to sell these assets to an MLP. Whiting's shares are also held by seven of our fund managers.

Some of Our Favorite Small-Cap Fund Managers
All the fund managers that we selected primarily focus their efforts on the small-cap space, boast excellent track records, and generally perform a bottom-up analysis of individual stocks (that is, they don't blindly buy stocks without concern for the underlying valuation). Premium Members can learn more about these managers by reading Morningstar's Analyst Reports written by our mutual fund staff (just click on the fund name). If you're not a Premium Member, you can still read the reports by taking a free 14-day trial.

Manager List
Baron Growth (BGRFX)	Ronald Baron
Baron Small Cap (BSCFX)	Clifford Greenberg
Century Small Cap Select Inv (CSMVX)	Alexander L. Thorndike
Champlain Small Company Adv (CIPSX)	Scott T. Brayman
Columbia Acorn USA A	Robert A. Mohn
Diamond Hill Small Cap A (DHSCX)	Ric H. Dillon Jr., Thomas P. Schindler
FBR Small Cap (FBRVX)	Charles T. Akre Jr.
FPA Capital	Robert L. Rodriguez
Gabelli Small Cap Growth A (GCASX)	Mario J. Gabelli
ICM Small Company (ICSCX)	Robert D. McDorman Jr.
Janus Venture (JAVTX)	William H. Bales
Keeley Small Cap Value	John L. Keeley Jr.
Longleaf Partners Small-Cap (LLSCX)	G. Staley Cates, O. Mason Hawkins
Pennsylvania Mutual Inv (PENNX)	Charles M. Royce
Presidio	Kevin C. O'Boyle
�  Royce Select I Inv	Charles M. Royce, Lauren Romeo
Royce Special Equity Inv (RYSEX)	Charles R. Dreifus
Royce Value Service (RYVFX)	W. Whitney George, Jay S. Kaplan
Schneider Small Cap Value	Arnie Schneider III
T. Rowe Price New Horizons (PRNHX)	John H. Laporte
T. Rowe Price Small-Cap Value (PRSVX)	Preston G. Athey
Third Avenue Small-Cap Value (TASCX)	Curtis R. Jensen
Wasatch Small Cap Growth  (WAAEX)	Jeff Cardon
Wasatch Small Cap Value (WMCVX)	Jim Larkins, John Mazanec
William Blair Small Cap Growth N (WBSNX)	Karl W. Brewer

Small-Cap Superstars Portfolio Methodology
We will assume that almost $10,000 will be invested in each of our initial positions, based on the closing price of each holding on the eve of the publication in which we first recommended the stock. We will also assume that each of our transactions costs us $12.95, a standard online commission rate. In calculating our portfolio's total return, we will use a time-weighted calculation, which is a common performance methodology applied by mutual funds.

For news and updates on the Small-Cap Superstars Portfolio, be sure to sign up for our free e-mail alerts.

John Owens CFA, CPA, contributed to this article.