Betting on small businesses has yielded big returns

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Small-cap value stocks rank among the riskiest stocks on the market.

But higher risk can bring greater rewards, and in the first quarter that was the case for three of the top performing mutual funds. Each has made more than 20 percent when betting on the value of small caps.

Value investors bet on stocks that they believe are trading below their fundamental value. Often, companies end up being classified this way because they operate in disadvantaged sectors or have experienced setbacks.

Here are some of the choices that have made three funds successful.

The Kinetics Small-Cap Opportunities Fund posted a first quarter return that would have been huge for an entire year – 60.5%. In contrast, the S&P 500 Index gave a total return of 6.2% for the quarter.

Peter Doyle, one of the fund’s co-managers, said his fund achieved its bottom line thanks to an unusual holding company: the Texas Pacific Land Corporation.

Texas Pacific was born out of the bankruptcy of the Texas Pacific Railroad in the 1800s. It holds rights to land and water in the Permian Basin of Texas, one of the major oil and gas producing sites in the United States. . The company collects royalties from other people’s drilling on its land, and its shares have soared in the first quarter, returning nearly 120 percent.

Until this year, some mutual funds did not own Texas Pacific because it was a publicly traded trust, not a corporation. It converted its legal structure in January, although Kinetics has owned it since 2002.

Texas Pacific recently accounted for 43.9% of the fund’s assets. It was one of 36 farms.

Kinetics’ huge gamble is “an outgrowth of our long-term horizon and low turnover strategy,” said Mr. Doyle. “Maybe five of our names will be great investments. If you don’t turn around frequently, those five will become a growing percentage of the portfolio.

Mr. Doyle said patience is essential to the way he and his co-managers manage their funds. He said they saw it as an advantage in a company characterized by short-term thinking.

Fund managers’ bonuses are often based on annual returns, so they focus on those, he said. “If you can get by, you can buy big companies for less. “

But a focused approach, like that of Kinetics, can increase risk because it reduces diversification.

By at least one measure, the fund is riskier than its peers: Morningstar says the standard deviation of its returns – a measure of their highs and lows – is 35.7%, compared to 25.5%. his average peer. A higher number indicates more risk.

The fund’s no-load stocks have a net expense ratio of 1.65% and generated an average annual return of 26.4% for the five years ended March 31, compared to 16.3% per year for the S&P 500.

Sean M. Kammann, manager of the Hartford Small Cap Value Fund, is also looking for stocks. But unlike Mr. Doyle, he avoids the energy sector.

He said it was an outgrowth of his approach, which focuses on the ability of businesses to generate free cash flow – that is, the remaining cash after a business has financed its operations and maintained its assets. (Small-cap energy companies can be speculative and require substantial investment before they produce free cash.)

To spot liquidity taps, Kammann ranks the 900 stocks in his investment universe and delves into the best ones to understand why they’re cheap.

“One of the risks that I take, quite intentionally, is that I select stocks that the market is fearful of,” he said. Otherwise, stocks would not be a good deal.

Value hunters bet the market is wrong and their stocks are strong enough to outperform lagging industries or bounce back from struggles.

“The key is that investors tend to overextrapolate the good news and bad news, ”Kammann said. “That’s why value investing works. “

Lately, his stock picking has led him to a company aided by the pandemic: Poly, formerly known as Plantronics, a maker of headsets and other communications equipment.

The company had seen a planned merger collapse and a competitor, Jabro, swept away market share. The stock sank at the start of the pandemic.

Mr. Kammann sensed a buying opportunity. “We believed that the stay-at-home environment would be positive for helmets and that after Covid there would continue to be some form of hybrid work. We have therefore redoubled our position.

The Hartford fund, whose A shares have a 1.3% net expense ratio, returned 23.8% in the first quarter.

Free cash flow is also a common thread for Jeff John, lead portfolio manager of the American Century Small-Cap Value Fund.

This is one of the many metrics he considers when selecting companies. Others include the strength of the balance sheet and the quality of management.

“We generate a score for each company, which allows us to compare it to other companies in its industry and across the portfolio,” he said. “We want to use the data to remove some of the inherent biases that we all have. “

Like Mr. Kammann’s approach, Mr. John’s has moved him away from traditional value-driven industries like energy and utilities.

Instead, he recently found a promise in Compass Diversified, which he calls a mini-conglomerate.

Compass, a publicly-traded partnership, owns companies as diverse as the Sterno Group, a producer of canned fuel, and 5.11, a manufacturer of law enforcement and outdoor clothing and equipment.

Compass managers are “incredible distributors of capital,” said John. “They invest in these businesses and help them grow, and if there is an opportunity to sell them, they will.”

In 2019, for example, Compass sold Clean Earth, an environmental remediation company, and Manitoba Harvest, a hemp-based food producer.

Mr. John also likes Penske Automotive, calling it “one of our major holdings for quite some time.”

Penske is known for its network of car dealerships, but its business is more robust than that, he said. Commercial trucks, through sale and rental, have recently fueled the growth of the company.

“Within the commercial truck space, 70 percent of gross profit comes from maintenance,” he said. “A sale is really just an entry to providing a service over time.”

Company president Roger S. Penske makes shareholder interests a priority because he himself is important, John said. “Penske owns over 40% of the company. “

The American Century Fund, whose investor stocks have an expense ratio of 1.25%, returned 24.7% in the first quarter.



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