Long/Short Hedge Strategy for Smaller Cap Stocks

by: The Wall Street Transcript

The Wall Street Transcript recently interviewed James A. Bitzer, CFA, Senior Managing Director and Portfolio Manager at Falcon Point Capital, LLC. Key excerpts follow:

TWST: Where are you finding the shorts and where are you putting the longs?

Mr. Bitzer: The shorts are in some of those areas that we talked about, which includes highly leveraged companies in many sectors; it includes technology and industrial stocks and some material stocks. To give you an idea on the technology area, in the last three to four weeks we've heard about the terrible earnings guidance from Cisco (NASDAQ:CSCO), Nokia (NYSE:NOK) and Intel (NASDAQ:INTC), three big bellwethers in networking, cell phones and semiconductors. This is just the beginning of the poor guidance we are about to witness. Technology stocks are going to have a very tough next six to 12 months.

Despite the recent economic turmoil, there are a few areas where we have found earnings growth and we do have some long positions. However, most of the positive returns in the last 12 to 18 months have come from the short side. Our net exposure today is about 20% net long. We have about 60% gross long and about 40% short exposure. So the longs that we will talk about in a minute are part of the 60% long exposure. This is less than the fund typically runs. In today's market, the two types of stocks we're looking for on the long side, given that we think the US is entering a very severe recession, are a) companies that we think can grow their earnings next year, and this may be a much tougher task given the macroeconomic environment, and b) super cheap stocks of high quality companies, despite the fact that earnings may be down next year.

On this second category, the stock needs to be significantly undervalued, have positive cash flow and a good balance sheet. Those are the two threshold criteria that we're applying to longs at this time.

Areas that we like today, where we see growth, are education, deep discount retailers, health care and a few select business service stocks. Education is one of our favorite areas. We own four companies in this industry as they tend to be counter-cyclical. A weakening economy and job market is providing a tailwind to student enrollment growth. In a bad economy, people tend to go back to school to learn a new trade or further their education. In addition, with fewer jobs available right out of school, particularly jobs where training is needed, more high school graduates are electing to go to college or trade school. These for-profit education companies have relatively fixed cost structures, so when enrollment improves, much of the incremental revenue falls to the bottom line. Most also have excellent balance sheets and throw off significant free cash flow.

The four names we own are Apollo Group (NASDAQ:APOL), DeVry (NYSE:DV), ITT Educational (NYSE:ESI), and a small position in Universal Technical Institute (NYSE:UTI). These names have various characteristics we like, but the key has really been enrollment growth. New student starts have been accelerating across the board recently. Higher student enrollment will lead to higher earnings in 2009 for most of these companies.

For instance, so far in 2008, DeVry has grown its revenues by about 20% and earnings close to 30%. New student enrollment growth was 12% in the most recent quarter and the stock is up 7% in 2008 in a 40% down market. We expect new student enrollment growth will accelerate this quarter. We've owned the stock for a little over a year now, purchasing it in the high $30 range. It is a high quality company with top-notch management. They offer BA degrees in various areas, including business, accounting and technology. DeVry has a nursing school as well as a medical and veterinarian school. However, there is still plenty of appreciation potential remaining. At $55 per share, it trades at just 18 times our estimate for the next calendar year. DeVry will grow earnings by over 20% in the next several years. We think the stock will appreciate to $75 a share or 25 times our CY2009 earnings estimate of just over $3 a share during the next six to 12 months.

Apollo Group is another stock we like a lot and it operates the University of Phoenix, which has the largest online enrollment in the country. They offer both Associate degrees, BAs and Master's programs. The Associate degrees are through its Axia College. The average age of their BA or Master's students is over 30 years old while the AA program caters to a younger student. All of its programs will be beneficiaries of the enrollment trends I have talked about.

The stock is up a bit in 2008 and it's outperforming the market significantly. It is one of the bellwether stocks in private education, yet is currently one of the cheapest names in the group. Given the large size of its enrollment (over 360,000 students), it takes more students to move the total enrollment growth so it is perceived as slower growing. However, student retention is improving and the cost of advertising for new students continues to fall. These positive dynamics will drive low double-digit top-line growth and mid- to high-teens bottom-line growth over the next few years. Apollo is a 17% to 20% earnings growth story, with a pretty high certainty of achieving that growth, currently trading for only 17 times our CY estimate of nearly $4 share. Given the scarcity of companies that will achieve earnings growth in 2009, it is likely that multiples for companies that can achieve earnings growth will expand. Our price target, applying a 20 to 25 times multiple to our $3.90 of earnings is $80-$90. As we ultimately roll into 2010 earnings by the end of 2009, we see Apollo hitting $100 per share.

The other education stocks we own are ESI and UTI and without going into detail, both are performing well and should continue to grow their earnings during the tough recession. ESI students require more company financial aid and a thawing out of the private student loan market would benefit them next year. UTI is a turnaround play in the sector. Its curriculum is focused on auto and motorcycle repair. The stock has appreciated by over 50% since our purchase price and is very near our price target at this point. All these stocks performed well during the last recession. So the education sector would be one of our favorite areas probably for the next eight to 12 months or longer if the economy continues to tumble.

TWST: Do they have international operations?

Mr. Bitzer: Most of these are all domestic. Apollo has some very small international operations, but they are looking to expand further globally. Greg Cappelli, one of their executives, is in charge of expanding their international presence and they're doing that in conjunction with a private equity firm that has experience there as well. International revenues are less than 2% of the company's business today, but you'll probably see that grow over time. There is plenty of domestic enrollment growth available. The average enrollment growth across the education space in recent quarters has been close to 15%. This compares to 8% to 9% over the last three years.

Another positive attribute of these businesses is pricing power. With the umbrella of continually rising state school tuition, these for-profit schools typically raise tuition by 4% to 6% per year. Combining accelerating enrollment with a little tuition increase provides nice earnings leverage across the sector.

The other area we like and where we have owned a few names is the deep discount retailers. Companies that we still currently own are Dollar Tree (NASDAQ:DLTR) and Family Dollar Stores (NYSE:FDO). Retail is a tough space right now, but the deep discounters are doing pretty well as strained consumers trade down to the stores that offer the best values. Wal-Mart (NYSE:WMT) is the king of everyday low value prices and its stock has performed well this year, up about 10%.

Of course, that's too large a market cap for us. DLTR and FDO are smaller sisters of Wal-Mart with everyday low pricing. They offer great values on many everyday necessities such as food, clothing, and household products. All the dollar stores have been performing pretty well during these trying times and are likely to continue to outperform in 2009. Family Dollar, for instance, is a $3.7 billion market cap deep discount retailer that operates over 6,000 neighborhood discount stores that sell basic goods at everyday low prices. The average ticket is around $7 to $8 and shoppers return frequently. For the most recent quarter, the company grew sales by 10%, earnings by 20% and at $26 it trades at just 15 times our $1.70 estimate for 2008 and 13 times the $1.90 we think they will earn next year. Their balance sheet is rock solid with over $1 per share in cash and minimal leverage. It's an excellent business that generates a 19% ROE on an underleveraged balance sheet.

Dollar Tree is a similar concept that we own. It's a little smaller with 3,500 stores and it operates at a dollar price point or less for all the goods in the stores. Historically inflation can be a problem for these single price point retailers, but this management team has managed it well, and we actually see inflationary pressures turning to deflationary worries, which should be a tailwind for the single price point stores like Dollar Tree. The stock is actually up 48% this year. It's one of the best performers in the market but it still was recently valued at $38 and it trades for 12.6 times our 2009 earning estimates of just under $3 a share.

We previously owned 99 Cents Only Stores (NYSE:NDN), which is another dollar store concept in the midst of a turnaround. Its stock rallied by 42% this year and it hit our price target. Its p/e was approaching 26 times the $0.45 we think they will earn next year, so we elected to take our profits on this one. Another discount retailer that we sold earlier in 2008 is Ross Stores (NASDAQ:ROST), which is a discount clothing merchandiser that performed admirably during the last recession. That stock had approached our price target earlier in the year and we exited near $40 but it is back down in the mid $20's now and we are currently evaluating whether we should repurchase this stock. It has an excellent management team and one of its biggest competitors (Mervyn's) is liquidating. This may hurt near-term results but should be a positive for them next year. I would say those two sectors, as well as health care, are our favorite areas for long ideas today. These are some of the areas where we expect earnings growth in 2009.

TWST: Where in health care are you finding growth?

Mr. Bitzer: The names that we like are some of the emerging pharma and biotech names, as well as a few healthcare service stocks. While there is always the risk of government price cuts or policy changes in health care, that's true whether you're in good times or bad. Health care is an area where we can find some exciting growth stories whose business should not be affected by the rapidly deteriorating macro environment. Some of our favorite names here include Gilead Sciences (NASDAQ:GILD), Cephalon (NASDAQ:CEPH) and ICON Plc (NASDAQ:ICLR). I'll briefly touch on these.

We've owned Gilead for three years and the business remains very strong. They have built the dominant franchise for AIDS drugs in the US, are expanding it globally, and have a growing franchise in Hepatitis drugs. In their key HIV segment, the company continues to take market share from competitors with its two main drugs, Atripla and Truvada. Some of the competing drugs have recently been found to have more severe side effects, which have helped the company expand its share. In addition, Atripla has only just been approved in Europe and the company is rapidly gaining market share over there. These rapidly growing chronic disease markets, combined with geographic expansion and market share gains are driving solid revenue and earnings growth. Revenues will be up about 25% in 2008 and earnings will grow close to 20% as they continue to invest in new drug therapies, some of them outside their core HIV franchise. Despite its recent pullback in this difficult market, the stock has held up very well this year. At $46, the stock trades at 18 times the $2.50 estimate we have for 2009. GILD will be an excellent stock to own during these turbulent times and should grow its earnings irrespective of what happens to the economy in 2009.

Cephalon is another one I'll touch on briefly. CEPH manufactures biopharmaceutical drugs for the treatment of neurological disorders and cancer. Its two main drugs, Treanda for oncology and Amrix, a muscle relaxant, continue to gain market share and outpace street expectations. Its stock price has also held up well this year. Earnings are growing 20% and the stock should trade for at least 16-17 times those earnings, driving our $90 to $100 target price. I won't go into detail on ICON or the other healthcare names we own at this time, but ICON's business is healthy, it's a market leader in the Clinical Research Outsourcing space and its stock offers significant appreciation potential as investors realize that pharma and biotech companies will need to continue outsourcing their drug trial management.