Small Caps: More than Meets the Eye

by: Benjamin Shepherd

Many investors regard small-cap stocks as highly volatile growth plays, but this broad category is far more variegated than this stereotype would suggest. We recently spoke with Eric Cinnamond, manager of Intrepid Small Cap (ICMAX), whose stock-picking acumen propelled the fund to the top of Morningstar’s Small Value category in 2007 and 2008. Here Eric discusses his investment strategy and the dangers of judging a small-cap stock by its classification.

What’s your strategy when it comes to equities selection?

We take a bottom-up approach to investing that emphasizes fundamental analysis and valuation work, but we don’t use sell-side research. We focus on absolute returns and don’t worry about benchmarks and sector weights, which makes us a bit more flexible than the typical fund and allows us to gravitate to whatever names offer value.

We evaluate stocks by discounting free cash flow, though we value the assets of energy firms, financial companies and other asset-heavy businesses. We tend to focus on established companies that generate a lot of cash and have weathered a lot of economic cycles, qualities that enable us to have a high degree of confidence in our valuations. We find that if you keep the ball on the fairway you tend to do much better than swinging for the fences; we don’t hit a lot of homeruns, but we also don’t strike out a lot.

We generate our returns through a thoughtful, slow-and-steady type of investment strategy that isn’t overly complicated--though it can be hard to stick to, especially during speculative periods. Back in 2007 leveraged-buyout firms were paying outrageous prices for mundane businesses, extrapolating crazy earnings growth or extremely low financial costs over a long period. Of course, that approach backfired in late 2008.

Speaking of hysteria, there was a huge run in small-cap stocks through much of 2009. What drove that?

Small-cap stocks traded at incredibly low values in March 2009, when the Russell 3000 sank to roughly 350 from a peak of 850. At that time, we found a boatload of good values because many investors acted as though the economy were dead and would never to operate again. Given the degree of overreaction on the downside, a lot of the rebound struck us as quite rational--a return to fair value. Today small-cap stocks trade at fair value, though some segments may be slightly overvalued. We’re still finding opportunities, but it’s definitely not as easy as it was.

I think speculation is definitely the culprit if stock prices head 20 to 30 percent higher from current levels. Market cycles are so compressed, and memories are getting shorter and shorter--you had the tech bubble, the housing bubble and oil at USD140--so I wouldn’t rule out another speculative period. And I think investors are almost conditioned to expect another bubble; given the prevalence of the word these days, it’s seemingly a permanent feature of the new landscape.

Although the stocks that we choose to include in our portfolio are a big part of the fund’s success, it’s important to remember that selectivity also implies avoiding certain stocks or industries.

We steered clear of banks and didn’t have any energy or cyclical companies in mid-2008, when that group was in vogue. Then energy names made up almost 23 percent of the portfolio at one point in late 2008; we had moved into cyclical names because those were getting hit the hardest and that’s where we were finding value. Uncharacteristically, we also found value in companies with debt--a quality we typically avoid. These were ideas we usually wouldn’t pursue, but the discounts were so large we thought the potential upside was worthwhile.

That being said, when we buy energy companies or stocks issued by companies with debt, we never take on operating and financial risk at the same time.

We built a stake in an energy company called Tidewater (NYSE: TDW), which has no debt net of cash. This limited financial risk was offset by operating risk; Tidewater’s business is relatively volatile, and its stream of cash flow can range between USD2 and USD8.

On the other side, we bought Constellation Brands (NYSE: STZ), the market leader in wine. Constellation has some debt exposure, but US wine consumption is growing 2 to 3 percent per year. In this instance, the financial risk is offset by the steady nature of the company’s business.

Higher-risk cyclical names have rallied the most this year, and we’ve recently sold those that hit our valuation targets. Our most recent ideas have been in line with our long-term strategy of investing in companies that boast a strong balance sheet, generate ample free cash flow and operate in relatively stable end markets--boring stuff, but it works.

Your portfolio features a lot stocks that are typically classified as early-cycle investments. What’s your take on the recovery and its sustainability?

A lot of small caps are in unique industries and don’t really fit neatly into a classification scheme. One of the stocks we own is Oil-Dri Corp of America (NYSE: ODC), which falls into the consumer discretionary or industrial category. One could also argue that it’s a mining company. The firm mines clay, dries it, and then processes it into cat litter. To me, that’s a consumer staple. I have a cat and, believe me, you have to buy cat litter; you will not like the results if you replace it with paper litter.

PetSmart (NSDQ: PETM) is one discretionary name that continues to generate quite a bit of cash. It’s slowed its growth from 100 stores a year to 40 stores, transforming itself into a cash cow rather than a growth company. But the specialty retailer’s comparable sales have remained positive--hardly what one would expect from a consumer-discretionary name.

Another example is Core-Mark Holding Company (NSDQ: CORE), the second-largest distributor to convenience stores. Over the past 10 years it has grown sales to convenience stores over 7 percent annually. Nevertheless, it’s often categorized as a transportation company--even though it lacks the high capital expenditures and volatile day rates and utilization that are part and parcel to that business segment. It’s not as risky as the transportation label would suggest.

Our investments in the energy patch are another case where there’s more than meets the eye. Because we focus on companies with the strongest balance sheets, our holdings are less volatile than other names with levered balance sheets. Regardless of where we are in the economic cycle, Tidewater will continue its steady performance and its long-lived assets will only increase in value. We always lean toward lower-risk plays, but sometimes an industry pie chart doesn’t capture that lower risk portfolio.

Because of our efforts to limit risk while generating total returns, the fund has posted a negative annual return on only one occasion: The market turmoil of 2008 resulted in a 7 percent loss. Of course, this approach also limits our upside. If the markets were to go up 20 to 30 percent, I would expect our fund to lag. However, thus far in 2009 we’ve outperformed, which is unusual for us; because so many high-quality names traded at a discount, we were more aggressive than usual in our investments.

The fund is still extremely light on banks. Is there just not any value there?

I recently bought my first bank stock in about five years when I added Washington Federal (NSDQ: WSFL). It’s got no subprime exposure and had equity to assets of around 15 percent

Despite having loads of capital, they participated in the Treasury Dept’s Troubled Asset Relief Program to establish their strength; once management realized that participation in the bailout wasn’t necessarily a sign of health, the bank quickly repaid the government. Washington Federal was one of the first banks to tell the truth about its book of business, quickly classifying loans as nonperforming. This high number of nonperforming loans has declined fairly quickly.

The banks I’m skeptical of are the ones with low loan losses and low loan-loss provisions; I just don’t believe them. The banks are so hard to value because they lump so many assets under one category that it’s really hard to decipher the quality of their books.

What’s your best advice for investors over the next year?

Be careful, the time to take risk was 6 to twelve months ago. Patience is the most important virtue for successful investors.

Disclosure: "No Positions"