Small-cap stocks are notoriously volatile. Although small caps can lead the market during bull runs, they can also plunge dramatically during downturns. That makes the small-cap arena fertile hunting ground for stock pickers, particularly growth-oriented investors. We recently spoke with Ken Salmon, who co-manages BMO Small-Cap Growth (MRSCX, 800-236-3683), about his strategy for successfully selecting small-cap stocks. According to Morningstar, the fund is one of the top-performing small-cap growth funds on a three-, five- and 10-year basis.

Please describe your investment process.

As a small-cap growth fund, we focus on companies with market capitalizations ranging from $200 million to $3.5 billion. However, we don’t have many holdings with market caps below $500 million because their stocks usually don’t offer sufficient liquidity.

We define a growth stock quite liberally, so we don’t limit ourselves to certain thresholds for earnings or revenue growth.

We take a fundamental approach to security selection. Anything can happen to equities in the short term. But long-term stock performance is closely correlated to changes in the fundamentals of the underlying business. Once we understand a company’s fundamentals, we have a better sense of where its stock is headed over the long term.

Additionally, the market systematically underestimates both the duration and magnitude of changing fundamentals. When a business has deteriorating fundamentals, for example, that change is likely to be both worse than anticipated and last longer than anticipated. And that means the company’s stock will drop further than investors expect.

We look for three things when examining possible additions to our portfolio: Fundamentals have to be improving; we have to be able to explain why those fundamentals are improving; and we have to be able to reasonably project that the improvement will be sustainable over several quarters.

We avoid or sell companies with deteriorating fundamentals.

What type of catalysts for improvement do you look for in a stock?

The most common catalyst is a new product or new product cycle. That’s especially apparent in the technology and health care sectors, whether the product is a new drug or medical device or new semiconductors or software. The main difference between the two sectors is that product cycles can be quite short in technology and quite long in health care. Our investment rationale for many of our portfolio holdings in those two sectors is tied to a new product cycle.

In other sectors, catalysts such as a change in the management team come into play. New management teams often pursue cost-cutting measures that liberate excess cash flow. That allows management to return capital to shareholders or invest in the company to further improve growth rates.

Acquisitions are another positive catalyst, whether it’s transformative for a company or involves industry consolidation.

There can also be cyclical or structural developments within an industry that can change the number of competitors, the pricing structure of products and services, or even demand.

What would cause you to sell a stock?

The easiest trigger is if our thesis is wrong. If the fundamentals deteriorate or if they don’t improve as we anticipated and there’s some kind of negative surprise, we’re very like to sell the stock. We take that approach because, as I mentioned earlier, a negative situation tends to persist longer than most investors expect. We prefer not to have our capital tied up in such a company when numerous other opportunities abound in the small-cap universe.

We also have a valuation discipline. We rarely liquidate entire positions based solely on valuation, but we will incrementally adjust the size of our positions based on our valuation analysis.

How did small caps perform in 2011 and what is your expectation for 2012?

We actually don’t pay that much attention to what the market’s doing; we’re not market forecasters, so we don’t know how the market will perform in the future.

Small caps suffered downside volatility during the third quarter. But they recovered during the fourth quarter, with the Russell 2000 Growth Index finishing the year down about 3 percent.

Our fund lost about 4 percent for the year, which was a little bit worse than our peer group and our benchmark for that period.

The numerous macroeconomic headwinds–ranging from the European sovereign-debt crisis to the slowdown in China–have had a huge impact on volatility. It’s been a frustrating market.

But it sounds like you can still find opportunities if you focus on fundamentally strong companies.

Small caps are a stock pickers market. Whatever happens to the broad market tends to be magnified in the small-cap area. When stocks rise, small caps typically enjoy greater gains than their larger-cap peers. Conversely, when stock prices decline, small-cap stocks tend to suffer even greater drops in value than the broad market.

We construct a diversified portfolio of liquid stocks whose underlying businesses aren’t dependent on the macroeconomic environment. That approach helps our portfolio outperform the market in most economic scenarios.

Unfortunately, there’s not much small-cap investors can do to weather a financial crisis, such as the one that unfolded in 2008. But an improving economy offers the best opportunity for stock picking among small caps.

In what sectors are you seeing the best opportunities for investors?

Because of our fundamental approach, we don’t target a specific sector allocation versus our benchmark or peer group. Instead, we select individual companies that offer compelling growth.

For that reason, we’re currently overweight in energy. We largely focus on exploration and production (E&P) companies that can grow their production consistently and rapidly and do so with efficient use of capital. We prefer companies that don’t have to keep tapping the market for funds to grow production.

We tend to avoid the financial, consumer discretionary and consumer staples sectors. The materials sector is also difficult to navigate in the small-cap space. The mining and metals companies in this sector are volatile and capital-intensive businesses. By contrast, health care, industrials and information technology offer better opportunities for growth stock selection among small caps.

Please tell us about two of your favorite names.

Energy XXI (NSDQ: EXXI) performs shallow water oil and gas drilling in the Gulf of Mexico. It’s grown production for eight consecutive quarters at a strong rate and we think that growth is sustainable. Its E&P program has generated organic production growth of about 20 percent to 25 percent. The company funds that growth internally with its cash flow.

Even if the price of oil suddenly drops and the company’s stock takes a hit, we’d still add to our position because Energy XXI is growing production rapidly—that’s what ultimately determines the value of the company. We also like its ability to replace and grow reserves.

The company’s stock declined following the BP (NYSE: BP) oil spill simply because Energy XXI happened to operate in the Gulf of Mexico. But Energy XXI is a shallow water driller, so the US government’s moratorium on deepwater drilling didn’t affect its operations. This is a prime example of how the energy sector is periodically roiled by commodity price volatility or negative news flow. If we’re still comfortable with the long-term growth rate of a company’s production, we’ll use that temporary weakness as a buying opportunity.

Zoll Medical (NSDQ: ZOLL) is best known for the portable defibrillators used to treat sudden cardiac arrest that are seen in hospitals and office buildings. Although that product is an important component of Zoll Medical’s business, the company boasts a diverse product line that is changing the trajectory of its earnings and revenue growth.

Zoll Medical’s business slowed in 2009 because budget cuts in the public sector reduced demand for defibrillators from non-profit hospitals and municipalities’ emergency services. But the company caught our attention when its business started to recover. During our research process, we discovered new products, such as the LifeVest, that were starting to drive growth.

The LifeVest is an external defibrillator that a patient wears. When a patient with a heart condition requires a pacemaker, there’s usually a lag between when that determination is made and when the device is actually implanted in the patient’s body. This interim period is extremely risky for patients, and consequently the LifeVest can be prescribed to them until they receive their pacemaker.

The LifeVest has an excellent safety and efficacy record. This product has helped accelerate the company’s growth and improve its margins.

But in mid-2011, the Centers for Medicaid & Medicare Services (CMS) decided to revisit its reimbursement policies for the product, as well as the indications for which it was being reimbursed. With some degree of precision, investors can determine how much revenue a company will lose if CMS eliminates reimbursement for an indication of one of its products. In this case, such an outcome would have weighed heavily on Zoll Medical’s earnings, so that action roughly halved the price of the stock in a span of just a few weeks.

But the LifeVest is such a well-regarded product that doctors, hospitals and medical associations, including the American Heart Association, advocated for the product with CMS.

In mid-December, CMS decided to maintain its existing reimbursement policies. Since then, the stock has largely recovered and its prospects for growth remain strong. Last year, Zoll Medical’s earnings per share (EPS) grew 60 percent and we believe that 35 percent to 40 percent EPS growth is reasonable for this fiscal year, with high potential for it to continue into next year as well.

What is your best advice for investors?

Stick with domestic stocks. The emerging markets have disappointed and there’s still a great deal of uncertainty facing foreign stocks because of the European sovereign-debt crisis. By contrast, the US economy and stock market should continue to improve.