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Examination Techniques

The Northern Small Cap Core Fund Strives to Meet its Growth Objective in Part by Spotting Tenuous Corporate Fundamentals in Advance of Trouble

Like a microbiologist examining human DNA for early warning signs of physical decline, Northern Small Cap Core Fund manager Robert Bergson puts thousands of corporate “organisms” under the microscope as well, sleuthing for hints of problems down the road.

“There are markers that often foreshadow a stock’s underperformance,” said Bergson. “Companies that exhibit those unhealthy traits are the ones we want to avoid.”

Bergson also tries to avoid style drift, adhering strictly to the Fund’s small-cap mandate.

Prior knowledge
An experienced small-cap manager, Bergson thinks that benefitting from the “small-cap effect” — the perceived tendency of smaller stocks to best their larger cousins during long periods — requires limiting exposure to businesses that do not appear reliably positioned for future growth.

Of course, no advance warning system is 100% accurate. Still, Bergson said certain characteristics tend to be associated with disappointing stock performance.

“Not all earnings are equal,” Bergson said. “We look very closely at the quality of a company’s earnings, not just at the reported numbers.”

Specifically, Bergson aims to avoid businesses that derive too much of their profits from accounting machinations that he views as non repeatable. Flatlining revenue growth is another red flag, as is falling return on assets and minimal free cash flow.

“We want to buy small U.S. companies that we believe are growing organically,” he said.

Large capacity
According to Bergson, there are hundreds of those companies remaining, even after weeding out potential laggards.

Starting from a small-cap universe of about 3,500 stocks, Bergson strives to own as many of the names that survive his early detection system as can be traded in a cost-efficient manner.

“Diversification on that scale,” he said, “has its advantages.”

“It means that we can let the market come to us when we need to trade, because we can be patient and more flexible regarding when and what we trade,” he said. “We want to leave as small a footprint in the market as possible.”

Such stealth could be especially important in declining markets, when liquidity usually is reduced. Indeed, Bergson compares selling a big piece of a small company in a weak market to trying to unload a used car that nobody wants.

Bergson likes the current environment for smaller companies, which generally derive a higher percentage of revenue in the United States than from abroad.

“We think we’re in the right place on the capitalization spectrum,” he said, “and our shareholders can be confident that we’re doing our best to stay there.”

Past performance is no guarantee of future results.

Diversification does not guarantee a profit nor protect against a loss.

Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.

Small Cap Risk: Small-capitalization funds typically carry additional risks since smaller companies generally have a higher risk of failure. Their stocks are subject to a greater degree of volatility, trade in lower volume and may be less liquid.

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