FOR ROBERT SULLIVAN, WHO RUNS THE $76 MILLION Satuit Capital Micro Cap Fund, investing is a bit like riding a powerful steed. If you don't pay attention, you can get thrown, with painful consequences.

During the second and third quarters of 2006, Sullivan, who has been riding horses off and on for most of his 48 years, suffered losses of 7% and 1.41%, respectively. "I felt like I had fallen off my horse and didn't know how to get back on," he recalls. "It's the only time in the eight-year history of our fund that I started to question our investment philosophy and process."

The more he thought about it, Sullivan says, the more he became convinced that he temporarily had deviated from his standard practice of evaluating companies on their revenue growth, margin expansion, balance-sheet strength and cash flow. "We lost sight of the fundamentals and picked some losers," he recalls. "It was like being thrown off my horse" on one of his rides on the land around his Johns Island, S.C., headquarters. Fortunately, the portfolio manager was able to brush himself off, remount and get back on the trail that he'd successfully followed before.

BY QUICKLY REFOCUSING ON back into the black the next quarter, posting a 7.32% return. He ended 2006 with a full-year gain of 5.65%.

Through the end of August 2009, Satuit Capital Micro Cap's one-, three- and five-year returns of a negative 8.87%, minus 2.70% and plus 5.66%, respectively, outstripped the Russell 2000's by 12.42, 3.38 and 3.45 percentage points.

"Morningstar data tells us we outperformed 98%, 88% and 94% of small-cap growth funds during those periods," Sullivan says. "And in 2007 and 2008, arguably the two worst years in recent memory, we outperformed 86% and 80%, respectively, of our competition in our category, according to Morningstar data."

This year, Micro Cap has continued to sizzle. Through August, the fund, which is rated four stars by Morningstar, was up 29.85%, versus a 15.75% gain in the Russell index. It outpaced 90% of all small-cap growth funds. Sullivan attributes the strong showing to the lessons he learned in 2006, especially the importance of strong fundamentals.

This year's performance has been bolstered by the returns of a number of key holdings, including Chinese insurance intermediary CNinsure (CISG), semicondutor maker NetLogic Microsystems (NETL), and specialty retailer hhgregg (HGG), up 88%, 100% and 99%, respectively, through August.

Most of the 87 companies in the fund's portfolio have stock-market values of less than $500 million. The holdings generally turn over about twice a year. The fund is no-load, but has a somewhat pricey expense ratio of 1.95%.

WHAT DOES SULLIVAN SEE AHEAD? "With respect to the current market, we are cautiously optimistic," he says. "It feels as though the path of least resistance is higher. We have had a tremendous run off the March lows. We are seeing 'green shoots' [signs of recovery] all over the globe. The question for the U.S. economy is not how long the recession will continue, but what the shape of the recovery will look like. But the opportunities are there."

Micro- and small-cap stocks historically have led the economy out of recessions and bear markets, the investment manager says. "It's frustrating to read Wall Street strategists and the financial press drone on about how large-cap is better than small-cap," he adds.

As of the end of August, the Russell 2000 had returned 15.75%, while the Russell Micro Cap index was up 20%. "We don't see much difference there, and when you factor in the growth opportunities for smaller companies in a recovering economy, the return outlook for smaller names is much better," Sullivan contends.

Right now, Sullivan sees opportunities in the fund's main investment areas. Those are the high-tech and industrial sectors, accounting for about half of assets; financial and consumer-discretionary issues, representing about a third; and energy, health-care and materials stocks, which, with a small amount of cash, make up the rest of Micro Cap's holdings.

"Our guiding principle is the concept of searching for 'diamonds in the rough,"' Sullivan explains. "We're like miners looking for something sparkling in the coal dust. We get our hands dirty."

One unappreciated diamond that Sullivan's senior equity analyst, Ed Moore, discovered in November 2008 was Stec (STEC), a solid-state disk-drive maker that the fund bought for $3.80 a share. The stock subsequently skyrocketed, reaching $40 by the end of August, endowing the company with a market capitalization around $2 billion. "The stock may have more legs, but it became too big for a micro cap and we have had to sell our position," Sullivan says.

Similary, Bob Johnson, an analyst at Satuit, saw what he believed was a solid buying opportunity in materials manufacturer Solutia (SOA) . It was changing hands around $2 in late March, not long after the stock market had bottomed.

"The company recently improved its growth profile by selling its nylon business," Sullivan says.

Solutia currently trades near $11, and is expected to earn 75 cents a share this year and 90 cents in '10. "That's solid growth, but the valuation had become rich, and we recently exited the position," he says.

CONSUMER NAMES THAT Sullivan still likes include Steve Madden (SHOO), which designs and sells footwear for men, women and children, and is posting solid results. Despite a weak retail environment, the company recently posted quarterly earnings of 66 cents a share, easily surpassing the 49-cent consensus estimate. "We've been patient holders since we initiated a position around 23 in September of 2008 and it has paid off," he says, noting the stock now trades in the low 30s. "We continue to see catalysts to help drive the stock higher." His 12-month price target: 40.

Perhaps Sullivan's favorite consumer issue is Denny's (DENN), the family-style restaurant chain. With about 1,500 restaurants across the U.S. and annual systemwide sales exceeding $2.4 billion, Denny's "may be finally able to serve up some real returns for investors," Sullivan says. The stock recently fetched around $2.75, about 9.9 times this year's expected earnings of 27 cents a share and 8.2 times next year's expected 33 cents a share. "Customer traffic will pick up as the economy recovers," predicts the fund manager, who sees the stock going as high as $3.50 within a year.

Industrial plays that Sullivan and his team like include offshore drilling-equipment supplier Boots & Coots (WEL), which is trading at seven times 2010 earnings estimates of 39 cents a share (it is likely to make 26 cents a share this year), and is growing profits at a 50% pace; and the construction company Sterling (STRL), which is expected to earn $1.54 a share this year and $1.39 in 2010. It could benefit from increased funding in the U.S. for infrastructure spending.

Sullivan also favors semiconductor-equipment manufacturer Semitool (SMTL), which has strong niche positions in its markets, and Measurement Specialities (MEAS), which is generating higher sales and earnings on increasing demand for sensors from the automotive, medical, aerospace and consumer industries.

All have the strong fundamentals that Sullivan finds crucial. Says the fund chief: "We've stayed focused on revenue, margins, balance sheets and cash flows. It's kept us in the saddle and on the horse."