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4 Hot Picks from a Small-Cap Manager

|Includes: AAPL, BA, DDD, F, ORLY, Pool Corporation (POOL)

Villere Balanced Fund (VILLX) has amassed an outstanding track record of returns within the Morningstar Moderate Allocation category for mutual funds. Its co-manager, George Young, shares some investment ideas with, and describes why these stocks caught his eye.

Kate Stalter: I am speaking today with George Young. He is the co-manager of the Villere Balanced Fund, which has a five-star rating from Morningstar.

George, let’s start off with a description of your fund’s objective and your investing philosophy.

George Young: Our fund is Villere Balanced Fund. The name implies that we have to have between 20% and 40% in bonds. We have to have between 60% and 70% in equities.

As for our objectives, we pride ourselves on having more small-cap orientation, and the reason we do that is we think there is more value in small cap over the long term. We don’t have big turnover—maybe 25% turnover in the course of the year—so we like to buy what we know and hold on to those things.

Kate Stalter: You just mentioned that the bulk of the portfolio does happen to be in equities. Talk about your view of domestic versus overseas equities, and versus fixed income.

George Young: Sure. We don’t necessarily have anything against international investments. The problem we find, though, is that if you stay domestic, you can rely on GAAP accounting, and you can rely on a set of legal rules that you are familiar with. You can rely on management that has the same culture, if you will.

So I don’t have a problem investing overseas, but that just doesn’t fit for us. So we prefer to stick to what we know. We have ventured abroad from time to time.

Don’t forget that our holdings, like a lot of other holdings, have some exposure overseas, meaning we get revenues in euros. A lot of our companies we get revenues in other foreign currencies.

But today we can rely on GAAP. We can rely on rules that we are familiar with, and rules that make sense to us, so we stick to what we know.

Kate Stalter: And how about being overweighted in equities vs. fixed income at this time? Say a little about that.

George Young: Sure, glad to. Fixed income we think of as a necessary evil.

The reason I say that: Everybody is aware that bonds are at a historically low yield, and we are very nervous that at some point you are going to have inflation come back roaring into this economy.

I said earlier that we don’t have much turnover in our stocks, and we certainly don’t have much turnover in our bonds. By order of the prospectus, we have to have a certain amount in bonds, but we think of that as a necessary evil, so we are trying to stay at the shorter term, which would be the less volatile side of the bond holdings. We are buying what we have to buy.

We are able to buy 10% of our bond holdings in junk, and that is where we are right now. When I say junk, you can call them less-than-investment grade, but that is where we find that we have got a little bit of an edge on our research.

Kate Stalter: A lot of our listeners today are retail investors, and I am sure that they are going to be very interested in some of the individual holdings and how you select these.

You are known as bottom-up stock pickers and you have a number of small caps that maybe don’t show up in every portfolio. Talk to me about some of the major holdings, George, and how you selected them.

George Young: Sure. I think one thing is important to keep in mind: If you buy smaller-cap stocks, you have got a possibility that those things can grow and those things can grow into household names, and also ultimately, you have somebody that buys those out.

If you buy the larger-cap stocks of the world, you are not able to realize the investment growth that you can in the smaller-cap stocks.

So a couple of them that I thought might be interesting to talk about…One is Pool Corp. (POOL). You might say this is a boring business, because what they do is distribute swimming pool supplies around the world, principally in the United States.

But if you think about it, you can’t fill in a pool. People usually don’t choose to do that. So, if you don’t keep a swimming pool current, it will turn black, it will turn green, it will turn all these horrible colors you don’t want.

The interesting thing about Pool Corp is that they have got the dominant franchise in the country. They have got maybe a 40% or 50% market share in distributing pool supplies to contractors—anybody doing pool repair. So if you need a pump for a 1988 swimming pool, they are the ones you can get it from.

And don’t forget that in this weak economy, what has happened is that a lot of the smaller mom-and-pop distributors have gone out of business. So the contractors are doing work and they know they can get the pump, they can get the materials they need from Pool Corp. So that is one that I think is interesting.

It is not an expensive stock, meaning it is trading at about 15 times next year’s earnings. We think that it can grow more like 18% per year. It has got relatively manageable debt, and it has got about a 2% yield. So that is one stock that makes sense.

The other one is maybe a little bit more sexy, a little bit more interesting. It is more of a technology company, and that is something called 3D Systems (DDD). They can make models from a computer-generated diagram. So if you can conceive of it, you can build this model.

So, think about a car designer. Ford (F), for next year, is trying to come out with a newly-oriented design. They need to make sure that it can be sent to the engineers and then replicated. 3-D is able to do that in an hour’s time…make a model of that car so that it can be sent to the factory for production.

They can also make limbs, prosthetics. They can do Invisalign Braces. They have relationships withBoeing (BA). Anybody who manufactures anything, they can do it. It is a rapid prototyping, is what it is called.

Kate Stalter: Now I noticed too, that your portfolio really is multi-cap. Anything in the mid-cap or larger-cap arena that you might want to mention?

George Young: Sure. Having said that we are more small-cap oriented, we did buy Apple (AAPL) recently.

We wrestled that one for a while because that is a huge-cap company, so yes, you might say that is the departure from what we would normally want to buy. But in this case, it offers good value, it has a product that everybody in the world seems to love, and that is always a good sign.

It is not an expensive stock, meaning they have got something like $60 per share in cash, and they are trying to figure out what to do with that. They may well dividend that out, because Steve Jobs was not a fan of dividending, but I think Tim Cook may well be.

Nonetheless, you still have that safety net of having a sixth of the share price you pay in cash available. They have no debt. They are worldwide producers of fantastic products. They have had very few failures, and they have got a worldwide acceptance of their products. So that is a departure, but it is one that I think makes sense.

Kate Stalter: Any position you have entered or exited in response to some of the volatility, market swings, or even company-specific developments in the past few months?

George Young: No I wouldn’t say that we are really prone to reacting to what the market has been doing. Certainly there has been more volatility in the market in the last six months than we have had before, and although we don’t like it, we accept that. That is part of the risk that you take by being in the equity market. You have to just accept that going in.

What we have been able to do is to trim back a couple of holdings that we thought were slightly overvalued. An example of that is O’Reilly (ORLY) in car parts. We decided to trim that back…and it has done very well.

The reason it has done well is because a lot of people that can’t afford new cars, yet have to get to work, and have to make sure that their car is maintained. So they have to go to an O’Reilly to make sure that they have the parts, so their car is maintainable and drivable, and ready to service them.

Kate Stalter: A lot of our listeners, as I mentioned, are retail investors, just kind of wondering how to handle these particular market swings. Just want to wrap up today, George: Would you have any advice for them?

George Young: Sure. The most important thing is to figure out what are your objectives.

I hear of a lot of people who are 35 years old and they have an IRA. They are thinking, “Oh, I need to make a couple of moves to accomplish some short-term goals. That 35-year-old should say, “In my IRA, I am planning not to take it out for 35 more years, until the government makes me take it out.”

If that is your stance, then you need to have a preponderance of equity in your portfolio, regardless of what you think is going to happen in Italy, Greece, or your own back yard. So you need to, first of all, focus on your objectives.