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    Guest Interview:

   Pinnacle Associates LTD

    335 Madison Avenue, 11th Floor
    New York,NY 10017

    Telephone: (212) 652-3200
    Fax: (212) 949-2022


    Interview Quarter: 1Q2006

 Andrew Reitenbach

 Portfolio Manager/Analyst


Pinnacle Associates Ltd. provides U.S. and international equity investment management services to foundations, endowments, pension funds, family trusts, religious groups and public funds.

Mr. Andrew Reitenbach joined Pinnacle Associates Ltd. in 1997 as a Securities Analyst covering all non-U.S. companies. He soon began focusing exclusively on foreign small caps, initially as a Senior Securities Analyst and then took over as Lead Portfolio Manager in 1998. Before this, he worked as both a published Securities Analyst and Mutual Fund Analyst at Value Line, Inc. Mr. Reitenbach began his career in investments as a Portfolio Assistant with American Express Financial Advisors and earned his B.S. from Cornell University. Since inception in 1997, Mr. Reitenbach's International Small Cap Portfolio ranks as one of best performing international strategies on both an absolute and risk-adjusted basis.

Q: You have always been an advocate for investing in smaller companies overseas. Can you review for us some of the main benefits of international small caps?

A: Investors add more asset classes to their portfolio to improve the diversification and lower the overall risk, while increasing the potential for higher returns. International small caps have continued to demonstrate their attractiveness along these lines. This holds true particularly for investors who use U.S. large caps, for example the S&P 500 Index, as the core portion of a global asset allocation strategy. The earnings of large foreign companies have become more dependent on the strength of the U.S. economy, thereby significantly increasing the correlation between U.S. and non-U.S. large caps. By contrast, smaller foreign companies typically focus on their domestic markets and have fewer exports. This makes their revenues the least influenced by the external factors such as the U.S. economy, the value of the U.S. dollar, and major international developments. In fact, since we started our International Small Cap Portfolio in September 1997, the returns have a correlation of only 46% to the S&P 500. This compares to the S&P 500's correlation of 78.6% to the MSCI EAFE Index and 67.6% to the MSCI Emerging Markets Index, over the same time period.

The diversification also comes from the types of companies within the international small cap universe. For example, international small caps can be found in 134 industry groups compared to just 52 for large caps. Therefore, the sector weightings will also differ significantly according to market cap. Large caps are more weighted in Financials at 31.6% compared to a 19.1% weighting for small caps. Likewise, more foreign small caps can be found in the Industrials sector at 24.3%, which is 15.4% more than for large caps. And, Consumer Discretionary stocks have a 19.3% weighting for small caps, nearly twice as much as for large caps.

Q: What about the increased inefficiencies regarding valuations?

A: By nature, there will always be a greater number of mispriced companies in the smaller cap segment of the market, which provides the active investor more opportunities to generate alpha by identifying those companies that have not yet been recognized by the mainstream investment community. At this point, European small cap stocks are followed by an average of only 7 analysts, while European large caps are followed by an average of 17 analysts. In Asia, the ratio is similar with 4 analysts per small cap compared to 10 analysts for each large cap. As liquidity continues to improve and trading activity increases, research organizations are more willing to spend the time and money to publish reports on smaller foreign companies, which will help to increase transparency and raise the profile of small caps.

Q: Why should investors have a separate mandate for international small caps and what percent should it be of their asset allocation strategy?

A: First off, a separate allocation prevents style drift. It's the only way to fully capture the benefits of the asset class on an ongoing basis. Sometimes style drift is minor and may actually be beneficial as the manager reacts to market conditions, but the portfolio often becomes unbalanced and more volatile than originally expected. In fact, the most common form of style drift occurs with small cap funds. Secondly, a separate mandate allows the investor to gain access to the asset class by using an investment manager with specialized expertise. This strategy is much less risky and more efficient than a large cap manager attempting to cherry pick small caps.

A good rule of thumb is to assign 15% to 20% of your international investments into the small cap segment. This is roughly in line with the small cap universe as defined by companies less than $2 billion in market cap.

Q: Why are institutional investors finally changing their investment policies to include international small caps as part of their strategy?

A: The infrastructure and technology for institutions to invest in foreign small caps has been in place for many years now. Similar to what happened with the emerging market asset class, a major reason why plan sponsors are now more willing to participate in an international small cap strategy is due to the development of a more definitive benchmark. The introduction of the international small cap indices by MSCI and S&P/Citigroup in the late 90's were important steps in institutionalizing the asset class. U.S. pension plans have steadily increased their international investments over the last 20 years with the goal of diversifying away from an EAFE-based portfolio. Some of these new strategies include top-down/bottom-up investing, regional investing, value/growth investing, and small cap investing. The pressures on institutional investors for return, which are currently driving them towards hedge funds and private equity, are also leading them to international small caps. Remember, international small caps have outperformed international large caps over the last 15 years, not just recently.

Q: How has the heightened recognition of international small caps affected the industry?

A: In our International Small Cap Portfolio, for example, we've had 12 consecutive quarters of increasing assets under management, which is indicative of the asset class as a whole. On numerous occasions, I have seen public funds start new mandates for a dedicated international small cap portfolio as large as $250 to $500 million. The institutional investors are essentially giving the asset class a "stamp of approval." It's really just the tip of the iceberg. According to Intersec Research, out of a total $300 billion in international investments, U.S. pension plans only invest about 2.5% in dedicated international small cap strategies. Obviously there's going to be a lot more catch up here, which bodes well for the evolution and longevity of the asset class. The additional liquidity should continue to push up share prices and allow larger funds to make a sizeable enough allocation to have an effect on their overall investment portfolio.

Q: What else will help drive shares prices and valuations going forward?

A: Although the stocks have been strong performers, the dynamics of the asset class are changing, which will continue to make them attractive investments. The asset class has in part been a liquidity driven market, which helped in years like 1999, but then subsequently hurt in the following years. Going forward, however, the underlying improvements in corporate profitability and a prolonged period of low inflation and low interest rates will support rising valuations.

Besides U.S. institutions, another source of demand is coming from the local investors as they become more sophisticated and develop an equity culture similar to that in America. There is still a huge spread between the percent of equities in an American's portfolio with that of a European's, for example. And, the more they attempt to structure a truly diversified portfolio, the more small caps will benefit like they have in the U.S. over the last 10-15 years.

In addition, investors are not the only ones who see the value in small caps. The companies that have successfully built a business that may have synergies with another company often become acquisition targets. We've seen this trend pick up with the creation of the European Monetary Union and it's also becoming more apparent in Japan as the government continues to move forward with reform.

Q: How big is the international small cap investment universe?

A: The number of small caps outside of the U.S. keeps growing. Including Canada, there are more than 4,200 publicly traded foreign small caps, according to Citigroup's methodology, which accounts for the bottom 20% of each country ranked by available market cap. This is almost as many as the number for U.S. small caps, U.S. large caps and international large caps combined. We primarily target overseas companies below $2 billion in market cap, which is about 80% of all international stocks and totals roughly 3,500. This breaks down into approximately 40% Europe, 40% Japan, and 20% Asia ex-Japan. Moreover, if you exclude those companies that do not exhibit traditional growth characteristics, the final pool of names would be closer to 2,500. Once we filter out the companies that don't meet our valuation and sales/earnings growth criteria, as well as our current investment strategies, the end result is a more manageable group of 500 names that reflect the dominant investment themes and smaller emerging trends in the portfolio. This is where we spend the majority of our time doing research.

Q: What are some of the characteristics you look for in a small cap company?

A : Our goal is to find niche-oriented industry leaders with high visibility in future earnings growth, trading at reasonable valuations. We want our companies to be growing both sales and earnings at 15%-25% a year. We're looking for unique "pure-play" companies that offer exposure to one high growth segment of the market. Conglomerates tend to be harder to predict and often trade at a discount due to potentially dilutive divisions. Our companies should have the largest market share, providing them with competitive advantages such as barriers-to-entry, economies-of-scale and strong pricing power. This will also help to keep their operation margins stable or expanding. As growth investors, we also need catalysts for increasing revenues, such as new products, geographical expansion or the build out of additional capacity.

All of these characteristics are key questions we would raise when meeting with company managements. They should know their industry and competition and have clearly defined goals and strategies for future growth, with an emphasis on building shareholder value. Much of the techniques we use to analyze companies are based on what Michael Porter first wrote about 25 years ago in his book, "Competitive Strategy". His focus was on the competitive positioning of a company in order to maintain industry leadership. While Graham and Dodd are credited with creating a value style approach, Porter is known as being a pioneer of growth stock investing. Warren Buffett actually described himself as being somewhere in between the two styles.

Q: How do you find new ideas?

A: For every stock in the portfolio, we're always researching a few other names that may be added in the future. This keeps the portfolio invested in the companies with the greatest upside potential in the areas that we find the most attractive. What's somewhat unique about our process is that we're rigid in terms of the fundamentals we look for in a company, but we're flexible when searching for new opportunities for investment.

Looking for new ideas and following current holdings often overlap. We have the opportunity to meet with company managements on a daily basis. They are always trying to increase their shareholder base and U.S. investors are becoming a bigger percent of ownership. This gives us the chance to talk with management at length about the company's products, growth plans, the industry as a whole, as well as its competitors. These meeting also help to uncover emerging trends or broader themes that can provide longer term sustainable growth. Some examples of this include changing demographics, technological innovation, outsourcing and consolidation. Often times, it might be a couple quarters or a couple years before we buy a company since we first learned about it.

Sometimes it's the tail wagging the dog. What I mean by this is that we might find a great growth company that has implications for 10-15 other companies. If it is benefiting from an emerging trend, we now know these companies have the wind behind them and we will spend the time researching the fundamentals in depth. For example, as cell phone penetration continues to increase and PDAs become just as common, the downstream beneficiaries include the companies that are supplying the LCDs (liquid crystal displays), PCBs (printed circuit boards), plastic covers and the software for web navigation. During our meetings with Nokia, for example, we can learn more about industry trends and which companies are supplying parts to them.

Q: How do you structure the portfolios?

A: We typically hold 40-60 names and start new ideas at 1%-2% of assets. Sector and country weightings are primarily a result of our bottom-up stock picking and current investment themes. Each sector and country weighting is limited to 30% of assets and individual stocks restricted to 8% of assets.

Q: What would cause you to sell a stock?

A: As growth investors, the main reason we would sell a stock is if the company's sales and earnings growth were slowing down or did not meet expectations. This could be due to deteriorating fundamentals such as a lack of demand for the company's products/services, increasing competition or declining operating margins. Additionally, external factors like unfavorable industry regulations or adverse macroeconomic developments may hurt the company's competitive position or future growth plans. Lastly, if we find a better idea or our weighting limits are reached, we'll sell or trim a stock.

Q: How important is your analysis of global macroeconomics?

A: We spend nearly all of our time researching companies from the bottom up. Although we monitor the macroeconomic environment and track leading economic indicators, the company fundamentals will invariably reflect the overall economic strength or weakness. For example, our investments in Japanese retailers are posting excellent same-store-sales growth, which confirms the increase in consumer spending and healthy GDP growth. Likewise, the rising prices in our Japanese real estate companies reflect the reversal of deflation.

Q: Do you approach emerging markets differently from developed markets?

A: If there a compelling secular change occurring in an emerging market, we will opportunistically invest in the most attractive growth stories. Initially, we will spend more time determining the health of the economy and the political stability. These investments generally fit strategically into a broader growth theme that we are working with in the portfolio. With this being said, if we do invest in a company in an emerging market, it will usually be in a more established company in a well researched market.

Q: Is there any currency risk when investing in international small caps?

A: In developed markets, currency is less of an issue. As I mentioned earlier, smaller companies tend to be doing business only in their home market. If our investments do generate revenues in another country, or if their materials are sourced from another market, we will monitor the effects of a changing currency to determine the impact on earnings growth. We do not attempt to make currency calls by hedging. The biggest impact of a strengthening Euro or Yen, for example, is on our portfolio's performance because we report total returns in U.S. dollars. Therefore, a weakening U.S. dollar boosts our performance relative to a U.S. equities portfolio.

Q: What are some of the challenges you face as an international small cap manager?

A: Despite being at a smaller firm and based here in the U.S., there is never a lack of information flow and I always have access to company managements. The systematic approach we employ keeps the investment process extremely efficient in order to find new ideas and closely follow our current holdings. On the other hand, the biggest hurdle I'm up against is trying change the mindset of institutional investors and the consultant community to work with specialized managers at boutique firms. As more money flows into the asset class and they continue to search for alpha, we think the capacity issues and the advantages of a nimble manager will become more apparent in order to fully take advantage of the vast investment opportunities in international small caps.

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