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Seeking Exceptional Small Companies

Janet Yang, CFA

Janet Yang: Hi, I'm Janet Yang, a fund analyst at Morningstar. Today Morningstar announced its Fund Manager of the Year Awards for 2015. The Domestic equity award winners were the team members from Brown Capital Management Small Company. They are Keith Lee, Bob Hall, Kempton Ingersol, Damien Davis, and Andrew Fones.

Today I have with me Bob Hall and Keith Lee. Gentlemen, thank you for joining us and congratulations on the award.

Keith Lee: Thank you for having us and thank you for honoring us with your Manager of the Year Award. We are extremely pleased and honored to be selected and to be here with you this morning.

Robert Hall: And also be with such fine competitors.

Yang: It was a great year for you all. You easily won the award.

In 2015 the fund gained almost 9% in a year when most of your competitors actually lost money. Before we get into the drivers of 2015, I think it makes sense to lay the groundwork for how you got there.

This fund is pretty unique on a few levels. One of those is the companies that you're looking at. You make a distinction between small company versus small-cap stock. What does that mean to you?

Lee: This year we will be celebrating our 25th anniversary. From the beginning, we thought it was important to differentiate between a small cap and what we call a small-company portfolio. The significant difference is that we define smallness in terms of operating revenues as opposed to market capitalization. We think that's a much better indicator of size.

For example, in 1991 if you go back and look, IBM was in a downward market spiral, and we said that if the stock price of IBM drops far enough, it's conceivable that IBM will start appearing in small-cap portfolios. We argued then, as we would today, a company with multi-billion dollars of revenues, multi-billion dollars of assets, hundreds of thousands of people is anything but small.

We get our jollies by going out, identifying companies early on in their life cycle. And it's arbitrary. We set a limit at $250 million or less at the time of initial investment. [This is] a long-winded way of answering your question, Janet, but we think revenues are a better indicator of size of a company than market capitalization.

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Hall: From the very beginning, the objective was to clarify what we were trying to do and simplify the process by which to get there: long-term investing, value creation over time. Why not start small with those companies that have the wherewithal, as Keith mentioned, that have the resources, commitment, products and services, save time, lives, money and headaches. That revenue generation really builds growth.

We have a little concept which we call transaction to mutual benefit. We want to invest in companies where the product and the service meets the needs of the provider and also the needs of the consumer. That's a magic formula for growth over time. We find companies, small companies, that really have outstanding characteristics. The ability to generate products over time that build value. It's as simple as that.

Lee: When you talk about 2015, that is really at the core of what we do. We're fundamentalist, bottom-up investors. We don't do sector rotation into names. And we're benchmark agnostic, so we don't remotely build or manage our portfolios relative to a benchmark. We go out, unearth, and invest in exceptional small companies that we think have the wherewithal of becoming exceptional larger companies.

We do that with very low turnover, and the turnover is not low because we sit back wringing our hands not knowing what to do. But it takes companies that have what we think is a sustainable growth plan, management that's able to implement that plan, and time for that usually to happen. We give these companies time to do what we expect them to do.

Hall: And they do it. A good example is Tyler Technologies, which is a company that provides software services for functions by small, local communities. Their clientele is roughly now about 13,000-14,000 communities, and there may be 55,000 in the whole industry. Here is a company that provides the software for state governments and local governments to do budgeting, to do forecasting, to run the court system, to run the 911 system, to run the real estate appraisal system. They become really critical resources for any state and local [government] who is trying to run in an efficient manner.

That is a company we've owned for many, many years, early 2000, 2006, 2007. It's grown from maybe $100 million at the time to almost $600 million at this point in time, and that's just a classic example. It's a company that is a real model of data-management systems that you can embed into the workflow of an organization, whether it's serving the local governments or the pharmaceutical industry, or even the private sector through a company called Blackbaud, which provides services to people who are trying to raise money for their endowments, for their universities and for civic causes.

Lee: Another company that did well, talking about the long-term nature of our portfolio, during 2015 is Manhattan Associates. A long time ago, we realized, or we believed, that supply-chain management was a very sustainable, necessary concept. There are different aspects of supply-chain management, and we invested in different companies in that area. But Manhattan Associates has probably been in the portfolio 15 years or longer, and their focus is on warehouse management of supply-chain management.

Hall: Very prosaic, moving boxes from here to there.

Lee: But they do it extremely efficiently, extremely well. This is a company that we invested in when the revenues were probably $60-$70 million; today revenues are around $500 million, and the company continues to grow, continues to innovate with their technology.

Hall: With a stable of real competitors as well.

Yang: Manhattan Associates was a big winner last year. I see a gain of 63% in 2015, but even before that, in 2012 it gained 49%. In 2013 it gained 95%. 2014 it gained 39%. It seems like it takes some bravery to keep holding on even after those kind of numbers.

Hall: This isn't for sissies.

Lee: It's interesting. When we invest in a company. We do not go into that thinking that this company will grow 10%, 15%, 60%. We invest in the company thinking that this company can be multiples in terms of its revenues today. Unfortunately it's not a 45 degree angle or higher for these companies to get there. Oftentimes, they hit bumps, holes in the road, and sometimes they fall off into craters.

But … we look to the future, not to the past, and we are always asking questions: Is this growth sustainable? Do they have the ability through their R&D, through their positioning, their salesforce or whatever their competitive advantage is to sustain that? You gave three years where this company has done exceedingly well, and we still believe that its future is in front of it. So we continue to hold it.

Now, does that mean that next year, Manhattan Associates is going to be up over 50%? We hope so, but it may not, and it may be down. It's really interesting when you look at our portfolio over time. Companies [may be] the largest detractor for any quarter, six months, a year or longer, but they can hit their stride, and over the next couple of years, like you indicated with Manhattan Associates, they can really start performing in ways that we expect them to. And that's what we do. We sit, and then we hold on and enjoy the ride, but we don't stop analyzing the companies to determine where the next inflection point is for them. It can be either up or it can be down, but we want to know that.

Hall: Our leader is always saying, words are important, and they are. We have to know what we mean to say and say what we mean to say, and companies change. So one of the important things we look at in a company is, does it have the ability to respond to the change? Can they keep up with the times and can they reinvent themselves if necessary? That's an important aspect of any company that's going to have a durable, long period of growth. And that's, of course, one way of saying, when the time is up. So we want to start young and stay late, but not too late.

Lee: Again, I would be remiss to say, Bob and I have the opportunity to be here talking with you today, but this is truly a team effort with Kempton, Damien, and Andrew, and the rest of our colleagues at Brown Capital. It really is a dynamic team. We know what we're looking for and we go out and continue to find them. That's the fun part of what we do.

Hall: And we do it with confidence and enthusiasm.

Yang: Now, understanding that it's a very long-term-oriented team. I am going to ask you a short-term question anyway. January 2016 has been pretty tough start to the year…

Hall: Pretty bad.

Lee: [joking] Was there something happening in the markets that we don't know about?

Yang: What's the mood like in the office.

Lee: That's the great thing about what we do. Our CEO and founder Eddie Brown, and this guy here, Bob. If you walked in the office, markets down 15%-20%, it's up 30%-40%. I am an analyst so we're the ultimate optimists. You notice the upside is always much higher than the downside. But the mood is the same, because we're not short-term investors. We focus on those things that we can control or at least we think we can control. And that's doing the analysis of the companies that are either in our portfolio or that are on our radar screen, and that's how we spend our time. We don't get caught up in the day-to-day volatility of the markets.

Yang: Unfortunately, for most investors, the fund is closed, but that's of course good for investors who are already in the fund. But for the rest of us, could you leave us with maybe one or two of your favorite ideas in the portfolio today.

Lee: Janet, I always hate that question, because we don't think in that way: What's your favorite idea? We have a portfolio of companies, and quite frankly, they are there because we think that, with the exception of seven or eight that are on our challenge list, most of them will do well over the long term.

But the other thing, when you ask that question, I don't know the time frame that you're talking about. I also don't know what your investment program is about. But recognizing that you and your viewers want some examples, let me give you a couple. Bob, do you want to talk about Veeva. Veeva is a company that we just put in the portfolio.

Hall: In healthcare. It's peas in a pod. You start with patients, you have producers, you have products, you have providers, you have payers, and you have protectors--regulatory. That whole chain of events is very complicated and getting more and more complicated.

We found a number of companies that are part of that chain, in the process of data management of clinical trials, many data solutions, which is really, in our judgment, transforming the way clinical trials are being conducted.

Veeva is another company that does a lot of software management on the customer relationship management aspect, the sales management aspect in pharmaceuticals, which is a profound change with new kinds of orphan drugs and specialty drugs. Learning how to sell those and how to give those to the right patients and deliver them at the right time is becoming a much more difficult assignment than it was years ago when the drug rep was trying to get the doc to talk about their favorite therapeutic. And they save lives, time, money, and headaches. They're a classic content-management, data-management companies that solve\ problems and can establish durable revenue and earnings streams.

Lee: Another long-term holding is Abaxis. Abaxis is a point-of-care blood analysis. We see that it's done exceedingly well, but we think, again, the future is in front of it. A company like Cognex, which has been in the portfolio a very long time. Cognex married video camera with software. It's used on the floor for factory automation, quality control. That's not disappearing any time soon.

Hall: And that's interesting because that feeds into supply-chain management and warehouse management, because they use these devices to read barcodes and so forth and so on.

Lee: Does that answer your question and give you a few names?

Yang: Absolutely. Gentlemen, thank you so much for joining us and congratulations again on the award.

Hall: Thank you.

Lee: Thank you.