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The £56m Legg Mason US Smaller Companies fund is the current star of the sector stable. Cumulative returns of 41.7 per cent over three years to 28 April rank it top of the small but very mixed IMA North American Smaller Companies sector, which averaged growth of just 22.5 per cent. It achieved this at below-average volatility – 4.8 per cent for the period, compared with a sector mean of 5 per cent.

Jack Fockler, managing director of Royce & Associates, the sub-advisory company that manages the fund for Legg Mason Investments, attributes this success to the investment house’s exclusive focus on small and mid-cap stocks.

“The smaller companies universe is very large in the US. There are about 7800 companies, which is 90 per cent of the stock market in number terms and 10 per cent in market capitalisation. We spend all our time and energy looking into that market. That’s a big advantage, because the sector can be quirky from a research standpoint,” he says.

The other quality that sets Royce & Associates apart from its competitors, according to Mr Fockler, is an emphasis on limiting risk rather than maximising return. “Most practitioners in this space look at the small-cap universe as a place to gather better long-term returns, but with much higher volatility. Most organisations focus on the return side of the equation.

“We take the opposite tack. We think return takes care of itself. It’s the risk portion that can really get you into trouble. If we can do better than our competitors in the downturns, we can compound our upturns that much faster,” he explains. The fund’s performance over the volatile year up to 28 April substantiate Mr Fockler’s claim: it lost only 1 per cent, relative to average losses of 8.8 per cent in the sector as a whole.

But Mr Fockler is dismissive of the short term. “In a one-year timeframe what we are doing may not show up. We know this and we don’t care. This is one of our strengths,” he says, suggesting a typical holding period of three to five years.

Royce’s buying discipline is highly structured around a value philosophy of buying financially sound companies with higher than average profitability at substantial discounts. This may sound too good to be true, but Mr Fockler insists that within the vast and heterogeneous universe of US smaller companies, opportunities can always be identified, even in the sunniest of bull markets. "If everything is going up we are probably net sellers. But there is always something to look at, even if opportunities are not as plentiful as in a broader downturn," he says.

The first variable in the magic equation is leverage: Mr Fockler and his colleagues screen for companies that have a shareholder equity ratio of 2:1 or less – in other words, companies whose debts do not exceed half the value of their assets. “This screens down the universe very quickly,” he says.

The second variable is earnings potential. “We then look at the past record of success the company has had in generating returns on capital. We look for return on assets of at least 7 or 8 per cent,” he says, pointing out this is a tall order in the Russell 2000 universe, which has an average ROA of 5-5.5 per cent. It even compares favourably with the large-cap sector: the S&P 500 averages ROA of 6-6.5 per cent.

The final element is valuation. Royce likes to buy companies for 30-50 per cent less than their perceived intrinsic worth, as defined by the leverage and earnings potential. “If a company is trading at that kind of discount, there is something wrong – the fund management industry is voting against the company or against the sector in which it is operating,” he explains.

Mr Fockler cites consumer discretionary as a sector currently ripe for value stock picking. “Retailers, restaurants and so on have fallen 50 per cent since the credit crunch began. There are some really good companies trading at huge discounts. We’re going to start buying. We won’t expect returns in the next year or so, but within the three to five-year cycle we would expect valuations to return to normal levels.”

Mr Fockler estimates that in reality, about two-thirds of buys follow this pattern and are sold at the original target price or slightly above. A minority of stocks are deemed either mistakes or "tweeners". Mistakes are holdings subject to a change in circumstances. "Our valuation assumptions sometimes change, either because we have made a mistake or, more commonly, because something has happened within the industry or company beyond our control," he explains.

Tweeners, meanwhile, are stocks that neither fall nor rise convincingly. "These are the hardest to judge," he says. "They just linger. We're probably too patient with tweeners and we sometimes hold them too long."

The Royce team pays no attention to the fund's sector weigthings against the index. "We are picking stocks rather than industries," says Mr Fockler. "That said, when you find a stock that looks appealing, there's normally another one in the sector. We're also going to look at the competitors. Sector themes do emerge."