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Big Gains from Small-Caps

During the recession many investors steered clear of small-cap names, blinded by the illusion that smaller firms lacked the resources to weather the downturn. Investors who saw beyond this misconception and put their money into this fund reaped the benefits.

Eric Cinnamond has managed Intrepid Small Cap (MUTF:ICMAX) since the fund’s inception in October 2005. Cinnamond is a highly experienced manager who takes a bottom-up approach to investing, emphasizing fundamental analysis and valuation work. Instead of worrying about benchmarks and sector weights, he focuses on absolute returns, allowing his team to search solely for the most valuable names.

The fund focuses on established firms that generate a lot of cash and have a history of performing in all economic environments. The names in the portfolio have strong balance sheets and tend to involve less risk than companies with substantial leverage. This emphasis on quality paid off during the Great Recession.

In 2009, the Russell 3000, a popular index of small-cap stocks, sank to a low of 350 from a peak of 850. Many small-cap stocks traded at extremely cheap prices, and Cinnamond had a field day.

The fund increased its stake in Tidewater (NYSE: TDW), an energy company that owns and operates one of the world’s largest fleets. Tidewater has little debt, but the firm’s business is rather volatile and streams of cash flow are harder to predict. But margins are high and have increased steadily over the past 10 years. The trend is expected to continue, as revenue keeps growing.

Last year Constellation Brands (NYSE: STZ), a company at the forefront of the wine industry, was added to the portfolio. US wine consumption is growing at 2 to 3 percent per year, which bodes well for the company’s revenues.

Like many others, Intrepid Small Cap stayed away from banks but identified Washington Federal (NasdaqGS: WFSL) as a name with little subprime exposure and an attractive valuation. The firm had a high number of nonperforming loans but has reduced the count drastically. And with a healthy cushion of capital, the bank is in good shape.

The fund’s cyclical holdings rallied off the March lows but were sold toward the end of 2009 as they reached Cinnamond’s valuation targets. Many of these cyclical names were in the energy space--for example, Patterson-UTI Energy (NasdaqGS: PTEN), St. Mary Land & Exploration (NYSE: SM), Unit Corp (NYSE: UNT) and Cabot Oil & Gas Corp (NYSE: COG).

Early in 2009, energy stocks accounted for 23 percent of net assets; now that allocation is closer to 6 or 7 percent. Given stock valuations in the energy patch, the fund’s exposure to this group will likely remain on the low side. That being said, Cinnamond still finds value in energy names Bill Barrett Corp (NYSE: BBG) and Contango Oil and Gas (NYSE: MCF).

History demonstrates that small-cap stocks recover faster from economic downturns than large-cap stocks. After stocking up on undervalued names last year and maintaining its traditional emphasis on companies with strong balance sheets and ample cash flow, the fund is well positioned to ride the recovery.

The fund is unlikely to replicate last year’s returns, but management’s strategy of investing in companies with solid fundamentals and valuations should pay off over the long haul.

Why to Buy

Intrepid Small Cap (ICMAX)

• Expert management team

• Focus on quality names that perform in good and bad times

• Upside for small caps as the economy recovers

Hannah Hsu is Research Editor of Louis Rukeyser's Wall Street



Disclosure: no positions