Value Investing: Two Sectors You Must Know
And where those two sectors intersect are the best values of all.
Brian Frank: Absolutely. I think the fact that we have been so far from investors' thoughts—the savvy investors—usually means we are at the bottom of the value cycle. It is a fantastic time to start looking at fundamentals.
Most of the value gurus I follow are trailing the market this year, including ourselves, and a lot of growth and momentum stocks are clearly in favor. Just by focusing on the numbers and running a strategy based on valuation, we are finding a lot of compelling ideas, a lot of things that haven’t moved in the bull market, and a lot of smaller stocks especially, that have gotten left behind.
The fundamentals look great, the business line and the stock prices look great, and I think a lot of these small stocks are ripe for buyouts too.
Gregg Early: You’re fairly secular in what you’re looking for. I mean you don’t care whether it’s large-cap value or small-cap value or mid cap for that matter. Is that correct?
Brian Frank: Correct. We run an all-cap strategy just for the simple idea of if you’re running your own money, why would you limit yourself into one space?
If all large-cap stocks are expensive and you’re a large-cap manager, you have to buy those stocks. That just never even made sense to me because we started with family money, even before we had the fund, and the idea was "make money in the stock market." It wasn’t built to fit a style box.
So by having an all-cap fund, our universe is about 3,500 stocks, which is larger than the universe of almost every major fund company out there. We are looking for the best 25 to 40 stocks that are extremely low in valuation, but have extremely high returns on capital.
Of course, we do a bunch of qualitative metrics that we check on from there as well. We are trying to build a concentrative portfolio that can outperform the S&P (INDEXSP:.INX), because I think in order to beat an index, you can’t look like one and own hundreds of stocks like many other funds do.
Gregg Early: You said you’re finding more value in small-caps at this point?
Brian Frank: Correct. The fund started in 2004, and for the first six years or so we were about 60% to 70% small- and mid cap stocks, which was a nice balance for us. Then, after the recovery from the financial crisis in 2009, small stocks really led the way and kind of took off in valuation.
We never want to overpay for anything, so we started going up the cap curve toward large- and mega caps. Large and mega really got ignored in 2010, and in 2011 the fund outperformed the S&P by about 600 basis points. I think the reason is we were very large. We had Pfizer (NYSE:PFE), Berkshire Hathaway (NYSE:BRK.A) and a lot of the giants in the fund, which wasn’t the norm for us. We were about 60% to 70% large cap at that point, and it ended up doing very well for us.
Now in 2012, a lot of these big-cap companies are getting bought up. A lot of people are chasing the dividends on them and the P/Es are going up, so we are moving away again. We’re finding where the P/Es are low and there are definitely some Russell 2000—some small-cap stocks that have really come down this year. The valuation looks better in small right now.
Gregg Early: Are there any examples in particular, or are there any sectors specifically that seem to be a well of value?
Brian Frank: Absolutely. I would say all IT companies, most technology companies, are cheap right now, and in the small-cap technology space we have a position in Quality Systems (NASDAQ:QSII). This is a smallish company that does electronic health records for hospitals and physicians.
It is a growth company, but in about the second quarter they disappointed the growth investors by not growing as fast as everyone thought they were. There was indiscriminate selling in this stock.
Then, over the summer, one of its directors who held all of his shares in a margin account—this is not something you should ever think of doing, because if the stock declines you have margin calls—the stock just went off a cliff in July.
After exhaustive research on this company, we found out that it is actually very well positioned. The cash flows are very consistent, which is one of the most important things that we look at. Not only do we want to buy cheap, but we want to make sure those metrics are going to continue in the future.
When you install a software system, you have to pay maintenance fees on it, so it is very hard to switch once you have a large electronic health-records system in your hospital. The maintenance fees go on, almost forever. That is the great consistent cash flow from this company. And like I said, the valuation makes a lot of sense at this price.
Gregg Early: Right, so they have the recurring revenue and they sign the contracts. They just had a C-level cowboy up there running the stock for a little while.
Brian Frank: Yes, definitely, there was some turmoil in the management. They have had proxy fights with this guy a few times, and there has been a little bit of turnover in the sales force. Like I said, it didn’t grow as fast as everyone thought it should.
There is going to be a little bit of a delay between what is called phase 1 and phase 2 of the implementation of the electronic health records. It is actually from the stimulus bill, not from the health-care bill. People don’ t know exactly when it is going to occur, and one of the things that Wall Street hates the most is uncertainty.
However, it is just the uncertainty of the timing. If you are a long-term investor, like we are, you can hang on to this and wait out whatever it is going to be, the 12 or 18 months, before phase 2 kicks in and the growth comes back.
Gregg Early: Are you seeing any transitions now that look more deeply at the slight economic recovery? Are you seeing any transports or any logistics companies that seem to be gaining a foothold here?
Brian Frank: I have looked into them, I have an eye on FedEx (NYSE:FDX), especially after it disappointed in earnings, but the stock price didn’t reflect that disappointment at all. They are still quite expensive here.
They are, of course, very solid companies, and although the US looks like it is picking up, the global economy looks like it is under a lot of pressure right now.
I actually want to remain what I call counter-cyclical, or acyclical. A lot of the other ideas we have, QSI in particular, is related more to health-care spending or IT spending. We own Humana (NYSE:HUM) and we are looking at some other health-care stocks.
We just bought a position in AmerisourceBergen (NYSE:ABC), which is drug delivery, so that is purely based on the amount of pharmaceuticals that the United States needs, which isn’t exactly correlated to the global economy. The transports are still a little bit too cyclical for me and too expensive.
Gregg Early: Right, plus they have more global exposure than the more focused US market, which seems to be healthier than the rest of the world at this point.
Brian Frank: Absolutely. You need to follow the pockets of growth. Within the US there are some great sectors right now. IT in particular. Health care is always pretty darn consistent, but it looks very underpriced here, so it is a great area to be in.
Even though we focus only on US-listed stocks, we are able to get some of that emerging-market exposure. What we insist on is that you file with the SEC and you have an American auditor. My background is actually partially accounting, so I understand the games a lot of these companies can play, but I also understand that places like Malaysia and Indonesia are growing very rapidly.
We get exposure through there through American companies that have the majority of their sales overseas, and one of those is called NuSkin (NYSE:NUS). That is a global consumer company. They sell a weight loss pill, and they sell skin creams, and all of the growth is coming out of China, Malaysia, Singapore, Indonesia, Vietnam. So it is these pockets of growth that we are going after.
Editor's Note: This article was written by Gregg Early of MoneyShow.
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