A Buoyant Performer

Kinetics Small Cap Opportunity has scored with savvy bets on industrial stocks. Its latest focus: water purification firms

Launched in March 2000, at the cusp of the Nasdaq nose-dive, the Kinetics Small Cap Opportunity Fund (KSCOX ) seeks out value stocks, generally confined to the small and micro-cap sectors. Lead portfolio manager Fred Froewiss also plays on attractive industrial themes -- for example, he recently purchased some stocks in the water filtration/purification industry, where the supply and demand fundamentals are thought to be extremely positive. Among the fund's favorite water stocks is Vermont Pure Holdings (VPS ).

Some other current bets: Woodward Governor (WGOV ) and Oshkosh Truck (OTRKB ), which Froewiss calls "infrastructure plays." He believes Pathmark Stores (PTMK ) can withstand competitive pressures from Wal-Mart Stores (WMT ).

The fund is up 21.9% year-to-date through June 20, while its nearest benchmark, the Russell 2000 Index, was up only 3.2% From inception through the end of calendar 2000, the fund gained 11.0%. Froewiss has co-managed this fund with Murray Stahl since its inception.

Palash Ghosh of Standard & Poor's FundAdvisor recently spoke with Froewiss about the fund's investing strategy, its top holdings and recent portfolio moves. Edited excerpts from their conversation follow:

Q: How large is the fund currently?


We have about $4-million in net assets comprising 35 stocks.

Q: What kind of stocks do you look for?


We try to find companies that are undervalued for a variety of reasons -- perhaps they've reported sub-par performance for the past quarter or two; maybe they're in an industry that's temporarily out-of-favor. Then we try to identify a catalyst that will change the perception of the company and improve its valuation. Such a catalyst could be a restructuring or a new product, etc.

Ideally, we target stocks with market caps under $1-billion, so we have a small-cap bias. The portfolio's average market cap is about $500- or $600-million, although we have stocks in the fund with caps as low as $30-million. We find that small and micro-cap companies are practically ignored by Wall Street and where one can find great values.

Q: What are your largest holdings?


As of May 31, 2001: Woodward Governor, 3.2%; Pathmark Stores, 3.0%; Oshkosh Truck, 2.9%; Excel Legacy (XLG), 2.7%; Ionics Inc. (ION ), 2.6%; ADVO Inc. (AD ), 2.5%; Flowers Foods (FLO ), 2.4%; Vermont Pure, 2.3%; Alexander & Baldwin (ALEX ), 2.2%%, and Osmonics, Inc. (OSM ), 2.2%.

Q: Tell me about Woodward Governor -- that stock has been on an incredible run, with its share price having doubled since the start of the year.


Woodward Governor manufactures fuel injection systems for jet aircraft engines. Some might look at this as an `aircraft play,' but their injection systems are also used in gas turbines -- their major customer is General Electric, both for their power systems and their aviation segment. Woodward is more of a play on the backlog for gas turbines for electricity generation. The main catalyst here was the fact that GE has a firm backlog until at least 2005 -- plus, the Department of Energy estimates that we have to build about 20 new power plants annually for the next 10 years. So, Woodward is certain to see tremendous growth -- at least 20% annually. When we first bought Woodward at $50 per share earlier this year, it had a p-e of about 14 (or about half of the average market multiple). Now it's trading at $80 and it remains very undervalued, and its earnings visibility is extremely good. We feel it can get as high as $125 or $150 per share.

Q: Is there any top-down approach to your investment process?


Yes, we look at attractive trends that are happening in certain specific industries. For example, we've recently made some purchases in the water industry, which should see strong revenue growth due to heavy demand and short supply. In this area, we've recently purchased Ionics Inc., Calgon Carbon (CCC ) and Osmonics Inc., each of which is involved in water filtration and purification.

In the water consumer area, we've bought Philadelphia Suburban (PSC ), a very attractive water utility which is 11%-owned by the French company, Vivendi (V ). Incidentally, Vivendi recently announced it will list its shares on the New York Stock Exchange. Vivendi has been making a lot of transactions in the water industry, and they might be looking to make some acquisitions here, perhaps including Philadelphia Suburban.

One of our favorite water-related holdings is Vermont Pure Holdings, which is one of the few remaining independent bottled-water firms in the U.S., most of the others have been taken over. Unit growth in bottled water is about 7% this year (by comparison, unit growth for carbonated beverages is less than 3%) -- thus, bottled water is an attractive growth area with few independent players. We think Vermont Pure can grow 15% per year for the next three to five years -- and no one on Wall Street follows this company. But we feel that Vermont Pure could receive a takeover offer from one of the major beverage companies. It's currently trading at $3 per share -- any takeover offer would probably value the stock as high as $8 to $12 per share. The company will earn about $0.12-$0.13 for this fiscal year ending October -- but it will probably generate earnings of $0.25 in its next fiscal year, due to certain internal synergies.

Q: One of your main holdings, Oshkosh Truck, has been very volatile this year.


Oshkosh operates in three segments: they make fire trucks and transport trucks for airports; they make military vehicles under contract with the Defense Department; and they also manufacture ultra-heavy-duty trucks for construction, like cement-mixers. The first two segments have been doing very well, but their construction business has been under-performing. But we think that as more infrastructure projects get off the ground -- that is, things like the construction of oil refineries, generating plants, and transmission facilities -- there will be great demand for the kinds of trucks Oshkosh produces; thus we feel it has great earnings growth power. Thus, Oshkosh is a cyclical play, but I think it will receive more attention from Wall Street. In the last few weeks, the price has actually risen from $37 to $43. Our price target on the company is about $50 -- at that level, we'll revisit it.

Q: Tell me about Pathmark, they've performed well this year -- having jumped from about $15 at the beginning of the year to $23 currently.


The big fear in the supermarket industry is Wal-Mart Stores (WMT ) -- will Wal-Mart come into our region and take market share away? After Pathmark came out of bankruptcy, they had a clean slate and a good management team. Because of the areas that Pathmark operates in -- urban and semi-urban -- Wal-Mart has difficulty moving in there. So we think Pathmark may be relatively immune from competition from Wal-Mart. Pathmark has good earnings strength, and it is an attractive franchise that could generate takeover interest -- as the supermarket industry is indeed consolidating.

Q: Are there other attractive sector trends you're currently focused on?


At the moment, no, but in the near future we might want to look at some of the beaten-down telecom stocks. Obviously, that sector will see a renewal of growth -- long-term demand for bandwidth will be there, although we have a temporary over-capacity.

Q: Your fund gained 11.0% last year. What do you attribute that good performance to?


We got in early in some natural gas stocks like Forest Oil (FST ), Chesapeake Energy (CHK ) and Western Gas Resources (WGR ). We observed that there was a shortage of natural gas, and, of course, we couldn't realize that the price of gas would reach as high as $9/MCF. Thus, playing the gas theme pushed our performance.

Q: Do you still have any of those natural gas holdings?


We retained Chesapeake, which is still very cheaply priced at about $7.50/share, or about 5-times forward earnings. At the moment, natural gas prices are down, as we are not in the winter heating season; so we may actually raise our exposure to the natural gas sector going into the autumn. We also own Grey Wolf (GW ), an oil service company that provides natural gas drilling services.

Q: What are your sell criteria?


We'll sell when a stock's valuation becomes too rich relative to its expected growth rate. We'll also trim back a holding if it starts to occupy too large a position in the fund -- we'll rarely have a stock represent more than 7% or 8% of the portfolio's assets. We'll also sell when fundamentals deteriorate and when we realize that our original investment premise was wrong.

Q: Can you cite a stock you recently sold off and why?


We originally bought Capstone Turbine (CPST ), a microturbine manufacturer, based on our belief that they would benefit from the growth of the electricity generation market. We initially bought it at $25. It ran up to $37-$38, then it backed off to about $29 about a month and a half ago. At this time, we felt the valuation was out of line, given industry fundamentals for the next three to six months.

Q: What is your portfolio turnover rate?


Between 80% and 100% annually.

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