Specifically, Thinstall (now Thinapp) is a very lightweight OS package. On top of this is a virtual representation of the registry and other "critical" system files. The application doesn't know any better, and installs as though it was a full (in this case) Windows installation. Then when running, the virtualization layer translates all calls to the OS layer into a command to the actual machine it is plugged into/run on top of. It captures the needed installer files like mwb1100 stated. Why it is so small has to do primarily with which options were chosen at install time and what Word really needs (vs. the plethora of fonts, templates, etc that come with a regular install).
If you figure out a way to do this manually, I want to know how you did it. VMware starts with a 32MB customized Linux OS for their ESXi hypervisor, so to strip it out more than that should prove impressive. Thinstall (before VMware bought them) created their own OS from the ground up for this purpose. That said, if you can do something with the Xen Hypervisor (ESXi is proprietary), you might be able to do something like it - but I doubt it will be THAT small.