It's All About Change At First Investors

Fund manager John Walthausen aims to keep a portfolio of 60 to 70 names focused in small caps, although he's free to buy any size company.

"We buy companies with proven management, strong cash flows and sustainable business models," Walthausen said. "While many of our selections could be characterized as conservative, we are willing to take risk. We look to moderate that risk by evaluating event-driven uncertainty and attempting to diversify away any of those risks."

For him controlling risk involves buying high-quality names that are trading at low prices.

"In general a stock must sell at a discount to its peer group, have a creditable management team with a clear plan for building value and we must find good evidence that management is effectively executing that plan," he said.

He pours 1.5% of the fund's money into new positions. And he cuts back strictly when a holding grows to 2% of assets.

"This ongoing rebalancing is a key factor in reducing volatility and maintaining consistent performance," he explains.

He also sells when the price gets too high or believes the management's business plan has gone bad.

Walthausen buys with a three-year outlook but annual portfolio turnover is running in at 48%. That implies an average holding period of a little over two years.

The fund gained 4.77% for the year going into Tuesday vs. 0.23% for small-cap blend funds tracked by Morningstar and 4.57% for the S&P 500. For the past three years, the fund cranked out an average annual return of 19.09% vs. 15.40% for its peers and 13.39% for the S&P 500.

New Buys

Walthausen bought USA Mobility (NasdaqGS: - ), the largest U.S. provider of paging services, and industrial manufacturer Pentair (NYSE: - ) three quarters ago.

Aside from pagers, USA Mobility also makes devices to track goods and read utility meters from a distance. Cell phones made pagers obsolete, but they're still used by people working in emergency response fields, health care and government.

Sales dropped between 16% and 21% year over year the past five quarters while earnings were sporadic.

"The moderate declines in the top line have hidden the awesome free cash flows and low valuation," he said. Last year's cash flow of $4.24 a share was nearly three times earnings per share of $1.46.

"Our patience was tested by declines in the stock price, but our analysis suggests that this is an unusual value," he added.

The stock is down 31% from its July 17 peak and 13% from its Dec. 31 close. But even if he's wrong, at less than 2% of assets the stock can't do that much damage to fund performance.

Pentair's EPS growth went flat the past four quarters, but analysts expect 15% to 53% year-over-year growth the next four quarters. Sales are expected to climb 4% to 9% over that period.

Walthausen is optimistic about its water business, the company's largest unit.

"Pentair's management has a history of building value," he said. "And we believed that their strategy of building a water technologies group was working, and the value of this strategy had not been fully reflected in the stock price."

Walthausen sold winners such as MEMC Electronic Materials (NYSE: - ), Jacobs Engineering (NYSE: - ), Wab-tec (NYSE: - ) and Denbury Resources (NYSE: - ) because they went up too high.

"This generally takes courage because in rising markets, good performing stocks tend to keep working," he said. "However, we do trim positions and then sell stocks that are appreciating rapidly because as the valuations get larger, volatility and risk tend to increase."

Walthausen continued to track these stocks in case prices dropped into his buy range. He bought back Denbury Resources when it did just that.