Small Caps' Big Gains

John Richardson of the Munder Small-Cap Value Fund finds bargains that produce a healthy return for the portfolio

Small-cap stocks still sell at discounts to larger names -- and the sector contains a number of good values. So says John Richardson, manager of the Munder Small-Cap Value Fund, who seeks out companies with good cash flow. Adds Richardson: "We love companies that are very profitable that you don't have to pay too much for."

The fund he manages (MCVYX ) is highly diversified, with more than 100 stocks. And it's up 44% since the beginning of the year -- and consistently outperforms the Russell 200 Value Index, Richardson reports.

Among the better performers in the portfolio, he says, are American Axle (AXL ), homebuilder Ryland Group (RYL ), Merit Medical Systems (MMSI ), and New Century Financial (NCEN ). Richardson notes that he likes homebuilders because, among other things, they don't compete with China or sell to companies such as Wal-Mart (WMT ) or General Motors (GM ) that could squeeze them.

These were a few of the points Richardson made in an investing chat presented Nov. 13 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: John, the market is up significantly, albeit with a few pauses, such as today's. What's your mood about the future for stocks overall?

A:

I guess that any time the market moves as sharply as it has, especially in small caps, it takes a little time to get used to these new valuation levels. It's our feeling that earnings will probably continue to be robust going forward, but if there's any increase in economic weakness, stocks may be vulnerable to a pullback.

Q: How has your fund done so far this year and longer-term also?

A:

We've had an excellent year. We were up about 44% through yesterday. Longer-term, I've been managing the fund since March of 2000. Every year, we've outperformed the Russell 2000 Value index by a healthy margin.

Q: Aren't small caps overvalued at this time?

A:

Small caps are certainly less attractive than they were, but they still sell at discounts to larger caps. In history, there were quite a few times where small caps sold at premiums to larger caps.

Q: How do you find undervalued small caps in this market?

A:

A number of ways. One is that we have screens that focus on companies with high returns on invested capital -- that generates ideas. We meet frequently with managements, we talk to sell-side analysts, and we have been in the investment business for a number of years and have a wide familiarity with a number of names.

Q: How about a sampling of your best performers here?

A:

Among our favorite names have been a couple of auto suppliers -- American Axle (AXL ) is one. We like some homebuilders -- Ryland Group (RYL ) comes to mind. Within the financials, New Century (NCEN ) has been an excellent performer. Merit Medical Systems (MMSI ) has been great in health care. We like Headwaters (HDWR ), which has been a controversial stock but has done well. Those are some of our better stocks. Oshkosh Truck (OSK ) is also one of our favorite core holdings.

Q: How diversified is your fund as to investment sectors?

A:

Well, we have representation in all the broad investment sectors, and we currently own between 100 and 110 individual names. Generally, the largest weighting we would allow in the fund is a 2.5% weighting.

Q: Can you tell us why you like some homebuilders? Mortgage rates have been creeping up.

A:

There are a number of reasons. One is that, despite having performed exceptionally well, they still sell at low valuations. They are very profitable, as measured by return on capital and return on equity. They don't have to worry about the Chinese, they don't sell to Wal-Mart or GM, where they can get squeezed.

They benefit from economies of scale, they're gaining market share in what has been a very fractured industry, and they produced fantastic earnings growth over the last four or five years. Pertinent to your question would be that homebuilding would only be hurt if we had a sharp rise in interest rates. A gradual rise, because of strength in the economy, would not necessarily be bad for the homebuilders.

Q: You say you don't like to hold too many tech stocks. Are there any in the fund now, and if so what are they?

A:

Well, the answer is yes. We own CACI International (CAC ), Digi International (DGII ), Itron (ITRI ), Manufacturers' Services (MSV ).

Our favorite name in technology, which reported fabulous earnings today, is a Canadian company, Pason Systems (PSI.T ). Sigmatel (SGTL ) is another we like, Websense (WBSN ) we like also. And webMethods (WEBM ) and White Electronic Designs (WEDC ) are also doing well right now.

Q: Since small cap is often considered a growth area, how do you make your distinction between growth and value?

A:

First of all, we must feel that it's a value stock, but we look for the highest growth in terms of value by sector. The best way of looking at our portfolio is that we have companies that are significantly more profitable, as measured by return on capital, yet sell at a discount based on enterprise value by sector. We're not looking for deep value, we just want good companies that are reasonably priced.

Q: What is the market cap you use for small cap?

A:

For a brand-new purchase, $1.5 billion is the largest. We'll add to names that are somewhat higher but won't initiate.

Q: What about health care? Which segments or stocks do you like?

A:

In small-cap health care, it's not so much a sector but individual names. We like the sector, although it has done extremely well and has some high valuations. Our favorite names there there would be Merit Medical (much more of a growth stock) and Respironics (RESP ), a beneficiary of sleep-apnea research. We also like OrthoFix (OFIX ).

Q: Can you give any example of something you sold and why?

A:

Our sell discipline would be, first of all, if we lost confidence in the management and its plan. Second is if the stock performs beyond our expectations.... Thirdly is if we have better alternatives. Right now, mostly we've been buying since we've had such cash flow, but in the technology area, names like REMEC (REMC ), which has doubled in price, we sold on valuation.

We recently sold one we like quite a bit, Monaco Coach (MNC ), in the RV industry. It went up quite a bit this year, ahead of its earnings, and we think there are better alternatives.

Q: You also mentioned you like auto suppliers. What's your thesis there?

A:

Primarily, the thesis is that they're very profitable companies that sell at low valuations, and a number of them have executed extremely well. We love companies that are very profitable that you don't have to pay too much for. That's the best way of cataloging our investment philosophy. We like companies with cash flow.

Q: Has Munder or your fund been affected at all by the mutual-fund trading scandal?

A:

Fortunately not. If anything, we've maybe seen some additional inflows.

Q: What do you think of Matrix Services (MTRX )?

A:

I don't know the name, sorry, but at a glance it looks good. Maybe I should know this one. It looks good enough that I'm going to take a look at it -- how about that?

Q: What proportion of a portfolio would you suggest for small caps?

A:

Well, I always take exception with a lot of advice that I hear from financial planners, etc., especially going back a few years ago, when small caps were ridiculously undervalued. I personally have between 80% and 100% of my personal holdings in small caps, so I eat my own cooking. I wouldn't recommend that to everybody, but I don't think you necessarily need to differentiate between small, medium, and large. You just need good stocks and some diversification between names.

Q: Do you prefer small caps that pay a dividend? Is this a place to look for income?

A:

I think that a dividend provides downside support, and they're a good barometer for cash flow, but it's only one criterion -- we own a lot of stocks that don't pay them. We own a few companies (mostly in the REIT area) where the only real attractive quality is a high dividend, though.

Q: Someone asked earlier about REITs -- which ones do you have and like?

A:

We own a fair number of REITs, both equity and specialty REITs. Among the equity REITs we like would be Correctional Properties Trust (CPV ). We also like Corporate Office Properties (OFC ), although that has done extremely well in terms of valuation. Among specialty REITs that we like quite a bit would be Friedman Billings Ramsey (FBR ). We like Newcastle (NCT ) and American Financial Realty (AFR ). Those would be among our favorites.

Q: Have you bought anything new for the fund that you're excited about?

A:

Well, everything has gone up a lot in price. Among the new additions that we like would be Old Dominion Freight (ODFL ). Actually, other than them, we haven't really added anything new to the fund. Most of our good performers we've had for six months or longer.... DGII is our newest purchase, actually. They're doing very well.

Edited by Jack Dierdorff

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