Betting Big on Small Industrials

by: Alan Brochstein, CFA

At the beginning of the year, I shared the entire list of holdings in my Top 20 Model Portfolio. The model has performed very well this year, up 29% compared to a 7% return for the S&P 500. The portfolio today looks much different than it did at the beginning of the year.

As I described then, we were set up to be value-oriented and with a pretty small market cap (median of $850mm). That's still the case, but the players are so different. At the beginning of the year, we had no Energy (one name now) or Technology (16% now) and were most overweight Consumer Discretionary (just 7% now) and Industrial. So far in 2010, we have sold out of 13 of the 20 names, including Aceto (NASDAQ:ACET), C.R. Bard (NYSE:BCR), Cardiac Science (CSCX), Dorman Products (NASDAQ:DORM), Family Dollar (NYSE:FDO), Foot Locker (NYSE:FL), Hormel Foods (NYSE:HRL), Martek Biosciences (MATK), National Presto (NYSE:NPK), Somanetics (SMTS), Timberland (NYSE:TBL), Titan International (NYSE:TWI) and Volcano (NASDAQ:VOLC). SMTS was acquired at a pretty big premium, one of our two acquisitions so far this year. Quite frankly, I think that the initial portfolio I shared is up slightly more than the actual return we have experienced, which is a bit disappointing to me. It sure would have been easier to let well enough alone!

I intend to share the Top 20 holdings in full again at year-end, but I wanted to highlight what is clearly the model's biggest bet: Small-Cap Industrials. We currently hold 38% of the portfolio in the Industrial sector, which includes 8 names. The S&P 500 weight for the sector is just 11%. From the beginning of the year, we have held Allegiant Travel (NASDAQ:ALGT), which, to me, is actually a Consumer Discretionary company, Ceradyne (CRDN), and Met-Pro (NYSE:MPR). We have added:

  • Arkansas Best (ABFS)
  • Apogee Enterprises (NASDAQ:APOG)
  • Copart (NASDAQ:CPRT)
  • Orion Marine (NYSE:ORN)
  • Tecumseh Products (TECUA)

I have written about Orion and Tecumseh somewhat recently. Orion provides marine construction services and is a great play on the widening of the Panama Canal. Tecumseh makes compressors for refrigeration and HVAC and is a major beneficiary of growth in Brazil. ABFS is a less-than-truckload carrier with high costs due to its unionized labor force but could restructure those and some other costs and is poised to benefit from the potential demise of YRC Woldwide (NASDAQ:YRCW). ALGT helps small-town residents travel non-stop to resort destinations for low cost. APOG makes high-end glass windows and is a play on energy efficiency. CRDN is a busted defense company story (though one that could resurrect) that is now a big play on alternative energy (solar) as well as general industrial (through its ESK subsidiary). CPRT is an internet-based auctioneer of used cars (wrecked cars mainly). MPR makes pollution control and energy recovery products as well as water filtration consumables and products.

The 8 names range in market capitalization from $161mm for MPR to $2.9 billion for CPRT ($750mm average). There is a nice balance between secular growth (ALGT, CPRT, ORN and, primarily, CRDN) and cyclicality (ABFS, APOG, MPR, TECUA, and to a limited degree, CRDN). One of the key attributes is the very low net debt to capital - none of these companies has net debt. Another interesting aspect is the typical price-to-tangible-book-value ratio is below 2X (ALGT, CPRT and MPR are higher). My assessment of the management teams is strong to very strong at most of these companies and certainly improving at TECUA. So, the basic story is a call option on good teams getting back in the groove.

When investors are looking at Industrials today, they are looking for international exposure and margin expansion potential. I have to admit that some of these companies are encumbered on the international front. Some have absolutely no exposure: ABFS, ALGT, and ORN. TECUA is massive, while CRDN is high. APOG, CPRT and MPR are average at best. I do believe that the investor response to the weakening dollar has resulted in too much of a price reaction based upon this factor alone. I would also point out that even though a trucker like ABFS is domestic, the improvement in international trade will ultimately help them as well.

A final characteristic is that some of the names may be "late cycle" to some degree. The best example is Apogee, which caters to the commercial construction market (particularly office buildings). Investors are not so interested today in waiting for signs of recovery there, but it seems like the low valuation affords patient investors a low-risk ability to wait for that inevitable improvement.

I think a very good question might be: Alan, why are you messing around with all of these Industrial names that we have never heard of when there seems to be such opportunity across the sector? My main answer would be M&A potential - let me come back to that in a moment. First, I want to point out that S&P 500 Industrials are leading the way in 2010: 14.66%, a full 7% ahead of second-place Consumer Staples. The S&P 600 Small-Cap Industrials are up a nice 10.7%, but this is actually middle-of-the-pack and even behind the return of the overall index (12.4% price return). The dynamic is similar for Mid-Caps. So, part of my interest is that the macro guys have placed their bets on the big boys, and I expect that if they are right (and I think that they are), we will see it trickle down.

OK, back to the main reason, though: M&A potential. Not all 8 of our holdings are what I would consider highly likely, but I would throw APOG, CRDN, MPR, ORN and TECUA into that camp and wouldn't rule out ABFS. On Friday, one of the companies we own in the Conservative Growth/Balanced Model Portfolio, Carlisle Companies (NYSE:CSL), bought a company that had put itself up for sale in the summer, paying 100% premium to where it had been at the start of the process. As an aside, I like the deal. CSL is the company to which I had alluded in an article I contributed about the dollar weakening presenting an opportunity for left-behind domestically focused companies. The company shared on the call that "public company costs" for Hawk (HWK) were "$6-7mm per year" - yikes. HWK has a market cap at the acquisition price of about $400mm, so that puts it as larger than APOG, MPR, ORN and TECUA (the ones I mention as "highly likely" to be potentially acquired). On an after-tax basis, these public company costs (not to mention all of the other potential synergies of folding in a small company into a larger one), amounted to about .50 per share for HWK (more than 20% of its EPS for the current year). The impact is greater for smaller companies. So, M&A potential seems great these days, and with the stocks of the larger companies already doing so well, it seems more and more likely.

Over the years, I have learned that one doesn't beat the market by merely mimicking it. I have a strong view regarding smaller Industrials, and I have structured my model portfolio accordingly.

Disclosure: Long ABFS, ALGT, APOG, CPRT, CRDN, CSL, MPR, ORN, and TECUA in model portfolios at