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Small-cap value funds have been the darlings of Wall Street for the past few years, besting all other domestic stock categories over the past three years with an annualized return of 19.6%. And within that category, few funds have been better than the tate Street Research Aurora fund, managed by John Burbank since April of last year.

Value investors look for stocks that are trading below what they consider to be their true market value. But that's easier said than done, especially in the small-cap universe where there are so many stocks to choose from and many receive only limited coverage from Wall Street analysts.

But Burbank prides himself on being able to find stocks that are under the radar, and focuses on what a company would be valued at based on its enterprise value and cash flow. Given his penchant for "deep value" stocks, much of his fund is currently invested in industrial and service companies that have been out of favor in the weak economy.

According to Burbank, his investment strategy is essentially the same as that of former manager Rudy Kluiber, who led Aurora to one of the top spots on the small-cap leader board during his tenure. Prior to taking over the fund, Burbank worked with Kluiber on the fund as an analyst for more than three years. The fund's 23% five-year annualized return thumps the S&P 500 by more than 13 percentage points (unfortunately, the fund is largely closed to new investors, although it can still be bought through certain brokerage houses like Merrill Lynch).

Talking With:

John Burbank

Fund: tate Street Research Aurora
Managed Since: April 27, 2001
Assets: $3.6 billion
One Year Return: 25.3%/Trails 78% of Peers
Five-Year Return: 22.6%/Beats 98% of Peers
Expense Ratio: 1.40% (A shares)
Maximum Sales Charge: Closed
Top Holdings: International Game Technology,
Varian Semiconductor Equipment,
Source: Morningstar.
Returns through 4/4/02. Top holdings as of 12/31/01.

In the past year, the fund's performance relative to its peers has been only average, but Burbank attributes this largely to the effects of Sept. 11 and is confident the fund will return to its former glory.

To find out more about the fund and where Burbank is investing its dollars, read on.

1. What do you look for in a company before you go out and buy shares?

Market cap is the first cut. We've got to be within our relevant market cap universe. In terms of an inbound, or a buy decision, we like to look at capitalizations that are $1 billion or under. We'll make a few exceptions, but basically that's our cutoff point.

Within that universe, what we're looking for first is valuation. After valuation, then we go on and evaluate fundamentals and management and so on and so forth. Our preferred valuation metric is looking at enterprise value to operating cash flow or EBITDA, and where we can, we develop a benchmark that tells us what a strategic buyer would pay for that kind of company. The goal is to go in at a significant discount to that multiple -- preferably a 30%, 35% or 40% discount. That's our idea of deep value.

We'll look at other metrics too -- P/Es, price-to-sales, price-to-book -- and on those metrics, which tend not to be the metrics that strategic buyers use when making decisions, we compare those metrics to a stock's own history and to its peer group. We want to find numbers that are in the lower 25%, 35%, 40% of their historical level. After valuation we look at the cash flow statement -- we want to see free operating cash flow.

It gives us comfort to buy amid an adverse environment, and, as we typically do, buying early, buying a stock that's demonstrating poor relative performance. We've got to have free cash flow if we're going to be a player. The management of the company can deleverage a heavy balance sheet or buy back shares or whatever. Those are things that can help us be winners.

2. What is your sell discipline?

When we make the decision to buy the stock, we've identified value, free cash flow and secure fundamentals over the long term, so we know we have a survivor. Then we set a fair price target for that company. We take about a three-year horizon, and we like to see 100% upside potential over three years if we're going to play a name. But when we make those initial buys, we have already established a fair price for that stock. When it gets near that price, that's when we're going to start selling, hopefully into strength in the market.

3. I noticed that you have 264 equity holdings in your portfolio. Why so many stocks? Is that something related to the nature of a small-cap fund, or is it more your individual investment strategy?

It's all of the above. The fund right now has about $3.5 billion in assets, and we're dealing with small-caps. By nature they typically have, to one degree or another, trading liquidity constraints. So that argues for using a large number of names, but even if that weren't an issue, we'd still use a large number of names.

You have to look at the structure of the fund to understand where that comes from. Our top 10 names typically account for 25% to 30% of our assets. Every now and then it will drift below 25%, but that's a good central point. The top 70 names typically account for 70%-75% of assets.

When we open a position, it tends to be at a very small weighting in the fund --0.2%, 0.3%. Once we've initiated that position, we start a series of relatively frequent, very focused, short contacts with the company. The purpose being, No. 1, to get additional information. No. 2, to establish and enhance a communication relationship with the management players. Most of our day-to-day activity is involved with these "farm team" contacts.

We develop a relationship with the company and the executives over time. It can take us up to 12 months to get up to a full weight in a position. There have been cases where it's taken us up to 15 months to get a full position in place.

Catching Up
Aurora trounced its peers in 1999 and 2000 but has been in only the middle of the pack since then
Source: Morningstar. Returns through April 4.

Do you actually go out and kick the tires at these places?

Absolutely. We're on the road a lot. Sometimes we double up on companies on the road. One analyst that is dedicated to the fund is on the road today, meeting with companies on their turf. That's our daily routine, just one company after another. We accumulate knowledge on these contacts through time; we build the positions through time.

4. What are some of the names that you like right now?

One that I would cite that we have a pretty substantial position in that's just starting to work for us is Methanex ( MEOH - Get Report). It's a classic deep-value story. They are the largest producer of methanol, which is a basic commodity chemical that's used in a zillion ways.

Methanol is derived in the production process from natural gas. Methanex has under long-term contract, off-shore sources of natural gas priced at $1 per Mcf thousand cubic feet. The spot price of natural gas these days, the last time I looked, was between $3.30 and $3.40, so this company has got a massive built-in cost advantage vs. its competition. We like that.

As the price of natural gas rises, which we think is going to happen going forward as it has happened in recent weeks, the cost advantage of this company is enhanced. And the demand for methanol is likely to be rising with a recovery in the economy.

5. Looking at your portfolio, it seems to be weighted more in industrials and service companies. What do you see in these sectors that you like?

Well, because of our valuation focus on moderate- to deep-value situations we tend to have through time a modest bias toward cyclicals. When we enter a period of economic uncertainty, or slowing economic growth, that cyclical bias tends to get accentuated. We've just been through a period like that. We're picking off cyclical companies that are out of favor. It's valuation that draws us to that industrial sector.

As for the service area, our basic approach is to pick good value stocks on a company by company basis, and a lot of the service companies become negatively impacted in a slowing economy, as well as the industrial manufacturing part of the world, so that's how they get in there. You don't see a lot of consumer staple companies in the fund, and that's typically the case because you just can't find deep-value companies there. They're treated as fairly stable companies. They take a back seat during a cyclical recovery, but most of the time it's hard to find value in those areas.

6. Is there anything in technology that you're particularly fond of?

Yes. We started in the late third quarter, early fourth quarter in the year 2000 with the semiconductor capital equipment group, which was getting absolutely crushed in the marketplace. We mounted a field research campaign and saw a number of semis in the Northeast, Midwest, and San Jose Calif.. We made a selection of a number of them and built positions in that group. That's a group that still has significant upside. We're overweight and it's working for us.

7. What sort of impact has the Enron scandal and subsequent accounting scrutiny had on your fund's performance and small-cap funds as a whole?

That's a good question. In the small-cap world, we tend to be dealing primarily with domestically focused companies, and this might be a little too much of a generalization, but most of them are pretty simply defined and structured companies. They haven't become big complex organizations. I can't think of any situation that we've run into where there's any fancy off-balance-sheet stuff.

8. Are you planning on reopening the fund to new investors at some point?

We made the decision to partially close it, not completely close it. There are a handful of preferred brokers that still feed assets. Merrill Lynch, for instance, is one of our preferred brokerage relationships, and they can put new people in. There are three other big houses like that that can also.

9. The fund has outperformed nearly all of its peers on a five-year annualized basis, but this past year it's kind of settled into the middle of the pack. Are you finding that Rudy Kluiber's shoes are tough to fill?

Well, no. I will tell you that, with or without the change, the fund would have done the same thing. Our turnover is very low; that's the nature of the fund. We take these three-year horizon decision bets, or whatever you want to call them, and we simply don't have high turnover. Never have, never will. You can think of the structure of the fund changing through time at a very slow pace.

I had been working closely with Kluiber for three-plus years before I took over the fund. We cross-referenced all of our decisions, so there was no big structural change that was going to occur. He and I had almost identical investment philosophies, and there's been absolutely no change whatsoever in anything involving the selection process or the management of the fund on a day-to-day basis.

When the events of Sept. 11 occurred, we were overweight in four of the worst-performing groups in the market, and it hurt that year's performance. The good news is, as we came out of that event, the fund in the fourth quarter of 2001 was up 20% roughly. We ended up OK. Not a spectacular year, but we had one horrendous third quarter. That's just the way we were set up.

10. Does the timing of an economic recovery or any particular sector outlook play into your decision-making process at all?

We are very bottom-up focused. The economy is not something we focus on, and sectors have no relevance whatsoever to how we make investment decisions. We are focused on one stock at a time -- bottom-up, three-year horizon, going for deep value and free cash flow. What happens to the economy is just not in our decision-making process. We don't make sector-based decisions; it's one stock at a time.