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Tony Featherstone is a Morningstar contributor and a former managing editor of BRW and Shares magazines.

Led by its chief investment officer, Frank Villante, the Celeste Australian Small Companies Fund [6419] takes long-term positions in undervalued small stocks.

The fund had total assets under management of $130 million at 23 May 2012. Celeste Funds Management managed $514 million in total.

The Celeste Australian Small Companies Fund returned 1.47 per cent over one year to 30 April (after fees), compared to a 6.98 per cent fall in the S&P ASX Small Ordinaries Accumulation Index.

Over three years, the fund has returned an average 20.56 per cent per annum and outperformed the Small Ord's 12.7 per cent annualised return over that period.

Over five years, the fund returned an average annual 2.52 per cent, compared to a 4.97 per cent loss for the Small Ords.

Since inception in May 1998, the fund has returned an average 17.37 per cent each year after fees.

Here is an overview of the fund's investment approach and top holdings.

Tony Featherstone: Frank, why does the Celeste Australian Small Companies Fund favour a "style-neutral" approach?

Frank Villante: It's dangerous to be too dogmatic with any one particular investment style when researching small-cap companies. The reality is, today's small-cap "value" stock can become tomorrow's small-cap growth stock, and vice versa.

We focus first on the fund's performance objective [the Celeste Australian Small Companies Fund aims to outperform the Small Ordinaries Accumulation Index by 5 per cent each year after fees, over a rolling three-year period] and decide how best to achieve that goal, within the fund's constraints.

Our investment process spends much time assessing a company's reward and risk equation, before allocating portfolio capital. We continually ask, what happens if our view is wrong and how much could the stock fall?

It's easy to focus on the potential capital reward and lose sight of risk, when the aim should be to find stocks with strong upside and limited downside.

Featherstone: Why does your fund have a bias towards industrial companies?

Villante: We do consider mining stocks in the Small Ords Index or outside it. But mining companies must have certain attributes before we invest: a defined resource; a reasonably long mine life; a position in the bottom quartile of the cost curve; good funding; producing cash or close to being cash generative; operating in areas that do not have excessive geopolitical risk; and, of course, good management.

Small and mid-cap stocks, such as Western Areas (WSA) and Independence Group (IGO), have some or all these attributes, in our view. But the majority of small resource stocks do not.