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A Fund that Dodges Fads

Fund manager Mike Balkin fashions his investment philosophy on a maxim from hockey great Wayne Gretzky: Skate where the puck will be. For the co-manager of William Blair Small Cap Growth fund (WBSAX), this doesn't mean chasing the latest fad in the market. Balkin's first goal for any potential stock holding is for a company's expected earnings to grow at least 15% on a sustainable basis. Valuations are also important, says Balkin, who looks at a stock's price history because the market can overreact in both directions.

Balkin's gameplan has succeeded in this year's rally, and he has also held up better than most of his peers in recent years without assuming any more risk. This year through Sept. 18, the fund surged 47.1%, while the average small-cap growth fund rose 35.6%. For the three years through last year, the fund gained 11.7% on average, vs. a 17.6% drop for the peer group.

Based on risk and return characteristics, Standard & Poor's gives the portfolio its highest rank -- 5 Stars. Bill Gerdes of S&P's Fund Advisor recently spoke with Balkin about the fund's strategy. Edited excerpts from their conversation follow:

Q: What are the main features of your investment process?

A: We look for companies that can grow their earnings by 15% or better on a sustainable basis. We focus on superior performance, so we're more likely to pay for companies with this 15% earnings potential rather than chase the next fad. We also like strong management, because small companies often depend on the vision of a few key people. This is different from many large companies, where the CEO can step down and the company doesn't miss a beat.

Q: Do you consider valuations?

A: We don't believe you can be a growth manager and not pay attention to valuations. Everything has its price, so you have to consider risk-reward. Sometimes great companies don't make great stocks. As a result, we look at stocks relative to their historical valuations, their peers, and the overall market. Companies with the same growth characteristics can trade at very different multiples.

Q: What's your view of current market psychology?

A: There's a little bit of irrational exuberance right now. A lot of money is flowing into the market, especially into small-cap stocks. When we look at the market, we're aware that it can overreact in both directions. Right now, it's very favorable toward technology stocks. A lot of people are giving tech companies credit for normalized earnings before it's clear how that will play out.

Q: What are the fund's largest sectors?

A: We're underweight in technology. Historically, we've favored consumer-discretionary companies because we like many of the business models in that area. A lot of business-services companies, including education and gaming firms, have more predictable earnings growth.

Q: Why does your fund have solid long-term and short-term records?

A: We aren't willing to overpay, and we do our homework. In the early part of 2000, we were fairly aggressive in technology, and then later in that year we shifted to consumer and health care. Some of our biggest winners in the second quarter of this year were microcap companies. We've done a good job of identifying companies before Wall Street cozies up to them.

When people ask why we've been successful, I like to point to Wayne Gretzky, who said he tries to skate to where the puck will be. You need to be forward-looking -- we're always trying to look out the front windshield.

Q: You've also benefited from small-cap growth stocks' outperformance this year. Do you think that's likely to continue?

A: Small-cap growth is likely to outperform, but we're likely to see some correction, although it will probably be a short-term drop in a long-term uptrend.

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