Philip Tasho, manager of Aston/TAMRO Small Cap N (ATASX), looks for small companies with attractive valuations and a catalyst that could push the stock price higher. Those catalysts normally fall into at least one of three categories: consolidation, restructuring or new products.

Consolidators, which normally make up 50 to 60 percent of Aston/TAMRO Small Cap’s portfolio, are “best in class” leaders of their industries, often because they are the low-cost producer or provide an enhanced product or service. Such companies are gaining market share and making it increasingly difficult for competitors to do so.

Restructuring plays typically account for 20 percent to a third of the fund’s assets. These companies may have performed poorly in recent quarters or years but still have strong market positions. In such cases, “new or reinvigorated” management stands a good chance of boosting profit margins and significantly increasing earnings.

Companies with new products, which account for the rest of the portfolio, can provide unexpectedly large boosts to earnings in a short period of time. Tasho is especially fond of companies that sow the seeds for future innovation by investing regularly in research and development.

To identify potential investments, Tasho applies quantitative screens to a universe of about 1,100 companies, using traditional valuation criteria such as price-to-earnings (PE), price-to-book value and price-to-sales ratios, relative to the company’s own four-year history; PE-to-earnings-growth ratio (a good way to find restructuring plays); and increases in analysts’ earnings estimates. The screens sort companies into deciles, and Tasho and his analysts scrutinize the top third.

They then compare that list with the results of industry research. For each industry, all stocks are compared based on 12 factors; the analysis is then printed out on a color-coded sheet that allows Tasho to quickly identify leaders and laggards in each group. Attractive companies are then subjected to fundamental analysis of financial statements, balance sheets, business plans and management quality.

For each stock Tasho and his team estimate upside potential and downside risk, taking into account historical assessments and some macroeconomic assumptions (e.g., about interest and growth rates). To be considered for purchase, a stock’s upside potential must be at least three times its downside risk.

The 40 to 60 most attractive stocks make it into the fund. To further reduce risk, Tasho diversifies the fund by major sectors and limits a single stock to no more than 5 percent of the fund’s assets.

Tasho sells a stock if the company’s earnings growth slows, he loses confidence in management, or if the stock’s valuation becomes excessively high or its market cap hits $5 billion. He also will bump the portfolio holding with the least-attractive upside/downside calculus if a more compelling new stock is waiting in the wings.

That adds up to a surprising well-diversified fund, even if it has just 63 holdings. However, he’s currently overweight on software companies and business-services outfits, holdings names like Quality Systems (NSDQ: QSII), L-1 Identity Solutions (NYSE: ID) and Corinthian Colleges (NSDQ: COCO).

Tasho’s unique approach has propelled the fund into the top 18 percent of its category on both an annualized three- and five-year basis, though 2008 was a bit rough as the fund lost more than 33 percent of its value. But even that performance kept the fund in the top third of its category, a testament to its quality control measures.

This year has been kind to the fund. Thus far it’s returned over 17 percent, slightly under-pacing the small-cap category–a consequence of its value-sensitive approach. Falling squarely in the GARP camp, these funds don’t always outperform in rallies but rarely underperform when the bears take control.

That’s not to suggest the fund is without its risks. Tasho likes to dip into micro-caps where there can be substantial uncertainty about a company’s future in even the best of times. But with his disciplined portfolio strategy, it would take several blowups to dent the fund’s returns.

While there’s always some risk, a disciplined buy and sell strategy makes this fund an attractive option for long-term investors. Despite a 22 percent run-up in small-cap growth funds this year, this is one of the best ways to play small caps.