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Small-company investors typically limit their investible stock universe by market value. Brown Capital Management takes a different approach. The Baltimore-based small-company specialist defines “small” as businesses with revenues of $250 million or less. “It just makes more sense,” says Keith Lee, co-manager of the $3.1 billion Brown Capital Management Small Company fund (ticker: BCSIX).

Sales reveal more about a company’s growth prospects than market value does, Lee argues. Hot, new companies go public with lofty share prices and market caps, but still earn little to nothing. On the flip side, mega-caps that have fallen on hard times might make it into the small-cap universe by default.

Lee, 56, co-manager Kempton Ingersol, 49, and their team’s nuanced approach to evaluating small-caps doesn’t stop there. To address the changing nature of small companies, they use a 40-year valuation model. Price targets are beside the point. “It allows us the flexibility to review various scenarios and growth trajectories of companies’ cash flow using specific discount rates for each year,” explains Lee. “As arrogant as it sounds, we know what we are looking for.”

A little arrogance seems to go a long way. Over the past decade ended Sept. 30, the fund returned an annualized 13.7%—net of its steep 1.26% fee—soundly walloping the Standard & Poor’s 500 index’s 7.2% and 99% of its fund peers. (Its trailing-year return of 20%, versus the S&P 500’s 15%, is nothing to sniff at, either.)

Barrons.com recently spoke with Lee and Ingersol to make the case for some companies they think are small, but have the potential to get big.

Barrons.com: How do you define your investible universe?

Lee: We limit ourselves to companies with $250 million or less of revenue at the time of initial investment. Revenue is a better indicator of size and where a company might be in its growth cycle as opposed to market capitalization. In 1991, IBM (IBM) was in a downward pricing spiral and we argued then that if the stock price of IBM dropped far enough, it would start appearing in small-cap portfolios. In 2008-2009,General Motors (GM) had a market cap of $1 billion. A company with multiple billion dollars in assets and in revenues, we would argue, makes it anything but small. We want to invest in exceptional small companies that we think have the wherewithal to become exceptional large companies.

Ingersol: We also like companies that save time, lives, money, or headaches. If you look at our companies, there are a number that increase productivity or efficiency for other companies or make processes more fluid, whether they are business services, industrials, or medical. In the consumer space, we hold companies that have unique concepts or offer a good value proposition. We take early identification seriously.

Q: What’s an example of one you discovered early on?

Ingersol: We invested in Cheesecake Factory (CAKE) in 1993 when there were eight restaurants, all in California except for one. It was right when the company was about to start expanding nationally. We also invested in Panera Bread (PNRA) in 1997, when no one had heard of it.

Q: And how do you know when they’ve gotten too big?

Lee: All companies aren’t created equally, so it depends. Some companies will reach that level with revenues of $500 million; others might require revenues of $5 billion or $6 billion.

Q: Could you explain that with an example?

Ingersol: Pros Holdings (PRO) offers dynamic pricing for the airline industry. Passengers on planes pay different prices for their seats depending on where they purchased and at what time, and on capacity. Southwest Airlines (LUV) is a large customer. Airlines use Pros’ software to optimize pricing that then go up on their Websites or on Expedia (EXPE) or Orbitz. They have broadened out from that area to financial services firms and delivery companies such as FedEx (FDX) or United Parcel Service (UPS). Revenues are still below $200 million, but at $600 or $700 million, if it reaches its saturation point, we might deem it large at that point.

Q: Pros was in the red in terms of profits. Why?

Ingersol: Pros is in the midst of transitioning from a licensed software business model to more of a subscription model, so throughout this process some of the operating metrics will look worse before they look better. We have experienced this with a number of other companies in the past, and we believe that it is on track to emerge as a better positioned, more profitable company in the future, with a more stable stream of recurring revenue. While Pros shares have already more than doubled to $22 from a low earlier this year, we believe that it is still undervalued relative to its revenue and earnings growth potential.

Q: It seems you have virtually no exposure to financial services companies. Why is that?

Lee: Over 25 years, we’ve only invested in one financial services company. There have been a lot of banks over the years, but we do not invest in them because real growth comes from their loan portfolios, and we don’t have complete access to that information. From our perspective, better investments come with more information. The one financial services company that we owned years ago is T. Rowe Price Group (TROW), which we thought was the ultimate consumer company, because of its vast number of mutual funds.

Q: The fund also doesn’t seem to have any exposure to telecommunications, consumer staples, or real estate.

Lee: We usually build a portfolio of 40 to 65 names at no more than 6% of assets each. We are benchmark-agnostic. We don’t remotely build relative to the benchmark. We look at the world through six broadly defined areas: business services, consumer-related industry products and systems, industrials, information/knowledge management, and medical/health care, and if we can’t put a name in any of those areas, we put it in the all-encompassing “miscellaneous.” Our three most heavily weighted areas are business services, information/knowledge management, and medical/health care.

Q: What’s a company you’ve bought recently?

Ingersol: Ellie Mae (ELLI), a software company for the mortgage industry, is one we added a year or so ago. The mortgage process is one of the most inefficient, paper-intensive processes, but that’s been changing in recent years. Ellie Mae’s software helps streamline the process. If you are a banker or a mortgage originator, it helps you keep client information in one file and keep track of all the necessary documents. In terms of efficiency, instead of taking 45 days to process a mortgage, it can be done in a shorter amount of time.

Q: Is Ellie Mae a play on mortgage volumes?

Ingersol: When we first became aware of Ellie, mortgage volumes were declining, but Ellie’s revenue and earnings were rising. Increased adoption of their services helped, and clients are using more of their services. So even in a down mortgage market, there is a clear need and benefit to purchasing Ellie Mae software.

Q: Is that because of the tightening regulatory environment?

Ingersol: Ellie Mae’s software has a compliance component, helping clients stay on top of increasing and changing federal, state, and local regulations related to mortgages. This component is especially important, since requirements have gotten more complex in the years following the recent housing crisis.

Q: What do you like in your industrial bucket?

Lee: Cognex (CGNX) married a video camera with software used for various inspection needs across industries. Its software can read chip identification numbers and can be used to guide chips in place. The company recently expanded to luxury goods. It makes sure the face of a Rolex sits at the exact same location on every watch. The Food and Drug Administration also requires individual inspection for bottled water. Could you imagine a human sitting there inspecting tops all day long? Growth rate is 10% for the top line. Last year it had $450 million in sales and $187 million in net income. We continue to believe in Cognex’s ability to generate revenue and earnings growth as well as deliver long-term returns for shareholders.

Q: What about in medical/health care?

Ingersol: One added this year is Inogen(INGN). They actually developed oxygen concentrators. People with COPD (chronic obstructive pulmonary disease) or other breathing difficulties frequently have a stationary oxygen machine with the tubes to help breathing. Inogen developed self-generating units. The units are actually smaller and lighter than traditional oxygen canisters and are approved by the Federal Aviation Administration to be taken on planes. Inogen is the leader in portable oxygen concentrators. POCs have been gaining market share relative to the traditional oxygen machines for the last several years, but still only account for roughly 7% of the total market.

Q: And under “miscellaneous”?

Lee: Neogen (NEOG) develops and sells tests used to detect E. coli, salmonella, listeria, and other contaminants in the food supply. At the farm level they make rodenticides and a mix of different products. They also have partnerships in Brazil and China, where food safety is becoming a bigger concern, so it is a tremendous growth opportunity. Revenue last year was $321 million, and it continues to grow at a 12% clip.

Ingersol: They expanded their breadth of testing and identification where if you are out in the field, you can do a portable test right there on the spot, all the way to the food processor and distributors, where you could conduct a test at supermarket produce display or at a food-preparation area in a restaurant. Neogen has made advancements in terms of the speed of detection, too. Food safety in the country and in the world is not something that will be solved next year or in the next five years or 10 years. There will be a continuing need for Neogen’s products for years to come, which should be rewarding for shareholders.

Q: Thank you, gentlemen.

Ref: http://www.barrons.com/articles/finding-tomorrows-star-growth-stocks-today-1477995138?mod=BOL_hp_highlight_3