These three small caps are undervalued due to various factors, argues fund manager Mark Travis, who also discusses the factors and metrics he uses to identify investment picks.
Kate Stalter: I'm on the phone today with Mark Travis of Intrepid Capital.
Mark Travis: Well Kate, first and foremost we ideally have a good business at a good price. We tend to focus on the parts of the capital markets that we feel are less efficient, which is generally the smaller to mid-cap equity, and also the shorter duration high-yield debt.
We use very, as some people call "penal discount rates" that really I think give us an assurance that we're buying a security at what we think is a discount in the private market value. We typically are only interested in buying $1 for 80 cents or less, using a discounted cash flow calculation. Our discount rate indicators are higher than many, in that we use what we would like to earn as an equity holder.
For a more conservatively run, stable business, we might use a 12% discount rate. For a more volatile, say, telecom business, we might use a 15% discount rate.
Keep in mind that we're a firm that I call absolutist, and many of our industry are relativist. So many of our competitors are based off a benchmark and how they do relative to that benchmark, and their compensation is based on that, and the assignments they get from a consultant for big assignments are based on their relative performance.
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Our charge since inception has been to deliver absolute positive returns, and so our default, if we can't find security that meets our criterion, is cash. Many of our peers might have been excited after 2008 that the relative benchmark was down 40% and they only lost 37% of their capital. That's not something that we would be excited about at Intrepid.
We really focus on kind of defensive characteristics, businesses that are overlooked, things that people need and use, or occasions where the human emotions of fear have taken over and there's a disconnect between price and value.
We find ourselves, as prices rise in equity markets, having higher cash balances, because it gets more difficult to find that disconnect between price and value, and we won't buy security if it's not at a discount. Again, many of our relativist peers would buy something based on its weighting in the index and try to stay fully invested for the simple reason that their only concern is how they look, relative to the benchmark.
We want to, in a perfect world, wake up every day with more money. It doesn't always work that way, but we're careful as much as anything not to lose money. It's a little bit different process than many use in the industry. It's not for everybody, but it's a very defensive portfolio management technique.
Kate Stalter: One of the things that you and I have talked about before, Mark, is looking at analyst coverage on some of the small stocks that maybe don't get a lot of attention. Can you say a little bit about that?
Mark Travis: Sure, Kate, the soliloquy that I typically go through is: If you need the financing either to issue equity or debt, you're going to go to Wall Street and they're going to figure out what you need and how to sell that into a road show.
Typically a company that's not a real high generator of cash and free cash flow is going to need financing. Once they go to one of the big Wall Street firms and also get analyst coverage, they're going to put together a road show and really pump up demand for the stock or bond that they're going to sell to provide this financing.
Well, many of the smaller companies, in particular, that are very good generators of cash have no need for financing, and because they don't need financing they get no analyst coverage. They tend to languish, and many of them really don't talk to the Street.
I contend that a lot of them are really run like a private company, and that they're very conservative with their balance sheet. They have very few debt obligations, if any. Many times they have net liquidity on their balance sheet.
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Often it's a second- or third-generation family member running the business, so it's really the family heirloom, and I think they're usually very careful protecting growing, versus a bigger cap company where they've parachuted in a mercenary management team that has some options a little bit out of money they're trying to pop. This is a different mindset.
I feel like that type of management will typically treat our shareholders better through that commonality. Again, many of the firms that we compete with are much larger and they can't really buy the securities that we buy, because they've got too much under management.
I tend to think assets under management at a certain point becomes detrimental to good performance. I know there have been some limited exceptions, but from my perspective it's hard once you reach about a $3 billion to $5 billion in assets under management to take advantage of all the opportunities the capital markets might present as a PM.
Kate Stalter: It makes a lot of sense. Well, on that note, can you say a little bit about some of the companies that you are holding right now?
Mark Travis: Yeah, we've got a few that don't fall into every one of those requirements as far as prerequisites we like. Several of them have changes occurring that we think will help bridge the discount between price and value.
The first one is Regis (RGS). It's a brand and a name that many people may not recognize. It's really 16,000 hair salons. One of the brands they own is the one I take advantage of because I get a very simple haircut as my hairline recedes, called Supercuts.
You've got a business that has about a $900 million market cap. The shares are at $15.80 today. We think those shares are worth in the high teens.
Management has probably not done as great a job as we'd like at allocating capital. They've bought back shares in the low $30s and issued some in the teens, which is kind of the opposite of the way you'd want them to do it.
They've also got an activist firm called Starboard Value that's wants some seats on their board and owns a fair amount of the shares. We actually were there before Starboard. Starboard is about a 5% holder, we are a 3.35% holder of the equity.
The interesting part about haircuts is people keep getting them even in a recession. That's another thing that we like, is a business that has kind of a nondiscretionary component to it. In a recession, the typical man gets ten haircuts a year. He may spread that out a little bit…but that incremental $15 is not going to really change his habits. I think the average woman gets eight hairdos a year, and again they may spread that out a little bit, but not indefinitely.
We think there is potential there…but again you've got a $900 million market cap that generates about $100 million in free cash flow. Just to give you that calculation from my perspective, that's a low double-digit, as we would call it, free cash flow yield.
We're really categorizing free cash flow as is the money left over after an allowance from capital expenditures and growth that the management has discretion either to add to their balance sheet, reduce debt, buy back shares, or expand their business. In that case we've got an 11.1% free cash flow yield.
The next company is probably even less known, it's called CoreLogic (CLGX). This company was a spinoff from First American Trust Company, and where you may see it occasionally, Kate, is whenever there is an article about real estate, sometimes they'll reference Core Logic. What they have is really an outstanding database of tax records and property ownership and changes in value-just a menagerie of things related to real estate.
They've also got some exposure to the mortgage business. All the new laws with Dodd-Frank are changing the mortgage business.
But what's interesting here is the change: they hired Greenhill & Company in late August. The shares were a couple of dollars lower, and they've indicated they're seeking strategic alternatives. Well that's code for, "We're considering selling the business." The shares have come up from the $11 range into the mid-$13s today.
Again, I think these shares are worth again in the high teens. Maybe in the low $20s. So we're happy to hang on, and when we get that valuation we'll be curious to see if they end up selling it. The business, I think, has long-term merit. So it's a proprietary database and that's what we like about it.
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The last one is somewhat related, it's really a company I've known about for a long time, Computer Sciences (CSC). Their problem is-and I kind of chuckle when I say this-they tried to establish a national health database in Great Britain. Keep in mind that that's the health that Obamacare is now going to offer us.
One of the things that they tried to do in this national health database…basically they're going to have to write down a big contract, and so it's really hurt the share price. They've come back a fair amount. We think longer term-the shares today are in the mid $20s, but we think they're worth close to $40 a share.
Like a lot of businesses in the information technology consulting area, they do a lot of work with the government.
One of the other issues is a lot of the governmental work they do is for the Department of Defense. With the new austerity measures-I guess that's what they call them-you know, the debate they had in Congress right before Thanksgiving as far as trying to come to some kind of agreement on both sides of the aisle. One of the areas they agreed to cut back on was defense.You got those two things overhanging the shares, but we think they create an opportunity for somebody with a several-year point of view, which we do. You can buy that business at eight times operating income, and so we think that is an attractive entry point for these shares.