''We don't buy the cheapest stocks or the fastest-growing businesses. We buy the highest-quality companies.''

INVESTING WITH/Robert A. Schwarzkopf And Sandi L. Gleason; Kayne Anderson Rudnick Small-Mid Cap Fund
By CAROLE GOULD
Published: Sunday, June 17, 2001


AMERICA'S biggest blue-chip companies were once small businesses -- the kind that Robert A. Schwarzkopf and Sandi L. Gleason want for their $69.2 million Kayne Anderson Rudnick Small-Mid Cap fund.

''In an industry where most people classify themselves as growth or value investors, we decided to take another road,'' Mr. Schwarzkopf said from their offices in Century City in Los Angeles. ''We don't buy the cheapest stocks or the fastest-growing businesses. We buy the highest-quality companies in America.''

The companies' returns have been substantial. The fund rose 30.4 percent in the 12 months ended Thursday, compared with a 15.4 percent loss for the small-cap growth group and a 16.1 percent loss for the Standard & Poor's 500-stock index. For the three years ended Thursday, the fund gained 14.8 percent a year, on average, versus 10.4 percent for its group and 4.9 percent for the S.& P.

Mr. Schwarzkopf, 52, and Ms. Gleason, 36, also manage $2 billion for institutions and individuals for Kayne Anderson Rudnick Investment Management, the fund's adviser.

To find businesses with sustainable competitive advantages, the managers screen 8,000 United States companies for consistent earnings and revenue growth. They look for growth rates that have exceeded the industry average over 10 years.

The portfolio companies have a weighted average market capitalization of $2 billion, comparable to that of the benchmark Russell 2500 index.

The analysts look for rising free cash flow and low debt levels. ''Companies that have lots of cash and little debt are less financially risky,'' Mr. Schwarzkopf said, ''and they can take advantage of opportunities during difficult times, when other companies are struggling.''

The managers trim the pool to 250 companies by eliminating those whose management does not seem focused on building shareholder value, and those that do not dominate their markets. Further research helps them choose the 25 to 35 stocks in the fund. ''We want to find the best businesses, understand what makes them great so we can assess how long they will stay great companies, and determine how much we should pay for them,'' Mr. Schwarzkopf said.

The managers work with sector analysts and visit the companies. ''We want to understand how a company differentiates itself from competition,'' Ms. Gleason said, ''how it creates value for customers, and how it does that in a way that excludes competition.''

To reduce risk, they aim for a diversified portfolio that roughly replicates the Russell 2500 index.

They call their strategy ''quality at a reasonable price.'' The managers prefer companies with above-average return on equity and profit margins, but with below-average valuations based on price-to-sales and price-to-book ratios. Those correlations ''give you a good sense of how your company is valued relative to its industry,'' Ms. Gleason said.

They also review ranges of price-to-earnings multiples over 5 or 10 years. ''You get a P/E band range around which the stock trades,'' Ms. Gleason said. ''You can apply the high and low multiple to target earnings for each of five years to get a target price.''

They trim positions in stocks that reach their target price, and companies whose market capitalization grows too large or that cannot sustain their target growth rates.

IN March, the managers bought shares of the Black Box Corporation of Lawrence, Pa., at $43.42. Black Box, a global marketer of cable, networking and other communications equipment, has carved out a market niche by basing its selling primarily on service, not price, Mr. Schwarzkopf said. It offers technical service 365 days a year in 132 countries. In its last fiscal year, 99.2 percent of calls were answered within 20 seconds, according to the company.

The strategy has let Black Box generate double-digit net profit margins, he said, adding that it avoids economic cycles because it concentrates on the aftermarket, not infrastructure building. He expects 20 percent annual growth in earnings over the next three years.

On Friday, the stock closed at $62.94, compared with their 12-month target price of $75.

Another favorite is the Catalina Marketing Corporation of St. Petersburg, Fla., a leader in customized electronic coupons generated at checkout counters. The company's systems are used in about 15,000 supermarkets, she added, and it has annual and multiyear contracts with major consumer goods companies. It is also expanding into health care advertising linked to drug purchases. She expects earnings per share to grow 22 percent in each of the next three years.

The fund bought shares in March 2000 at a split-adjusted price of $30.14; they now trade at $31.68, compared with the managers' price target of $49.

The managers also like C. H. Robinson Worldwide, a transportation company based in Eden Prairie, Minn. The company dominates a domestic market, Mr. Schwarzkopf said, by using its data processing systems to match small local trucking companies with the needs of large packaged-goods companies.

''They serve as a marketing and information technology department for thousands of small truckers,'' he said.

Unlike most companies in the transportation industry, he added, it carries no debt on its balance sheet. And because it specializes in the food industry, he said, the company can continue growing during bad economic times. He projects annual earnings growth of 20 percent over the next three years.

The managers first bought shares in January 2000 at a split-adjusted price of $19.70. The stock closed at $28.26 on Friday; their price target is $34 within 12 months.

Photo: For their fund, Sandi L. Gleason and Robert A. Schwarzkopf buy small stocks that he calls ''the highest-quality companies in America.'' (Kim Kulish/Saba, for The New York Times) Chart: ''Kayne Anderson Rudnick Small-Mid Cap'' Category: Small growth Net assets: $69 million Inception: October 1996 Managers: Robert A. Schwarzkopf and Sandi L. Gleason Minimum purchase: $2,000 ($1,000 I.R.A.) Portfolio turnover: 50% 3-year annualized return through Thursday: 14.8% Category average: 10.4% SECTOR BREAKDOWN Financial services: 11% Other: 57% Banks: 10% Computers: 9% Medical information systems: 7% Drugs/hospital supplies: 6% FEES Front-end load: None Deferred load: None 12b-1 fee: None Expense ratio: 1.29% (Sources: Morningstar Inc.; company reports)

http://www.nytimes.com/2001/06/17/business/investing-with-robert-schwarzkopf-sandi-l-gleason-kayne-anderson-rudnick-small.html