RS Investment Management fund manager James Callinan believes ruthlessness is the key to success in small-cap investing.

He ought to know. Over the past three years, practicing some strategic ruthlessness has propelled his $1.3 billion RS Emerging Growth Fund to a 40 percent annual return. That's No. 1 among 608 small-cap funds tracked by Bloomberg Fund Performance.

"You have to be ruthless in terms of weeding out companies that don't do well as a sign of being uncompetitive in the long run," Callinan explained. "You can't afford bankruptcies or delistings."

For the most part, small-cap fund managers are the cowboys of the mutual fund industry, investing in the frontiers of corporate America where the best new companies may appear, and in a flash disappear as well.

"Nasdaq delisted more companies than it listed last year," Callinan said. "You don't get press releases on the companies that delist. There are very few turnarounds in small-cap investing."

Callinan has had a remarkable record of picking winners. He bought Inc. when it had a market capitalization of $300 million. It's now at $21.3 billion. He bought Check Point Software Technologies Ltd. at $18, shortly after it first issued shares in 1996. It's now at $88.

Callinan finds these gems by setting five criteria his companies must invariably possess, and constantly searching for candidates. Each must have a sustained 20 percent revenue growth rate, for example, although his portfolio's average is now 35 percent, compared with the 22 percent average of the Russell 2000 stock index, which tracks many small-cap stocks.

Each must also have a "proprietary advantage," described by Callinan as "a unique something," which may be as tangible as a patent or Food and Drug Administration drug approval or as vague as a marketing advantage. They also must be gaining market share and boast high margins that confirm their proprietary advantage.

Finally, they must have "quality management," which Callinan said he confirms by on-site visits.

It's only when he starts to waver from these criteria that things begin to go bad. Vanstar Corp., a computer networking company, "looked like a really cheap company with great growth, but it was neither cheap nor great," said Callinan. "It was poorly positioned in a very competitive industry. I violated every rule. But you get it in your teeth. I lost money on it three times since 1996."

He learned a lesson, though: "You've got to take emotion out of your investing."

The one issue where Callinan is flexible is on the size of a small-cap. Picking winners often means companies that start off as small-caps--by his definition under $1.5 billion--and quickly rocket out of that category. That doesn't mean he'll sell them.

He's also not wedded to technology stocks, though his fund has 42 percent of its holdings in technology and Internet stocks, the highest since he began running it. The mix of technology stocks has never fallen below 33 percent.

Each quarter, Callinan and his staff screen about 600 companies and wind up holding fewer than a quarter of those. Through August the fund had a 118 percent turnover, and Callinan expects it will reach 200 percent by the end of the year.

Gemstar International Inc. was the only company among the fund's top 10 holdings on Dec. 31 that was still on that list on June 30.

Callinan is also very high on initial public offerings. "We skip about one of seven," he said. "But we don't flip. If we do the deal, we take our time."

The RS Emerging Growth Fund has consistently ranked at or near the top of small-cap funds, and within the top 1 percent of all 9,700 mutual funds since Callinan took over three years ago.

It has returned 59.61 percent so far this year and has yielded 125.55 percent over the past 12 months, according to Bloomberg Fund Performance. This has placed it No. 3 this year among small-cap funds, easily outperforming the average such fund, which has returned 9.89 percent.

Callinan was a running back for Harvard University's varsity football team. After earning a master's degree in accounting from New York University at night while working at Arthur Andersen during the day, he went for his MBA to Harvard Business School. He then joined Boston-based Putnam Investments, which he had audited while at Arthur Andersen.

That's when he began learning small-cap stocks, as part of a team that managed more than $45 billion of them. After seven years at Putnam as an analyst, Callinan said, he became a portfolio manager, taking the Putnam OTC Emerging Growth Fund from $200 million in assets in 1994 to $26 billion in 1996.

Then, seeking "elbow room," he jumped to RS, then known as Robertson Stephens, as a partner in 1996. "It paid to take a risk and leave the mother hen--you know, Boston, Harvard--and go west," he said.

Six months after he arrived at the San Francisco-based fund family, it was taken over by Bank of America Corp. He's run the Emerging Growth Fund since his arrival.

The expense ratio of the fund is 1.47 percent, compared with the average of 1.65 percent for small-cap equity funds, according to Morningstar Inc., the Chicago research company.