When "Small Cap" Matches "Deep Value"

That's the formula Aegis Value Fund Manager Scott Barbee strives to achieve -- very successfully, too, even in these uncertain days

By Robert Barker

So far, this new millennium seems to be all about reminding investors how to spell that four-letter word: R-I-S-K. Or make that plural, as some of the most horrible risks become apparent.

One fund that has been staying afloat both before and since the recent turmoil is Aegis Value Fund (AVALX ), which turned three in May. (On its anniversary, it won five stars from Morningstar.) The young fund is being run with an old-fashioned appreciation for risk, and the managers clearly have an eye for very cheap stocks. Up nearly 32% on the year before the terrorist attacks, its gain remained at almost 29% after trading resumed this week.

To find out how the fund has been succeeding despite the new risks, I reached one of its managers, Scott Barbee, by phone the other day at his office in Arlington, Va. Edited excerpts from our discussion follow.

Q: Why is your fund holding up with the market selling off so badly?


Our smallest stocks have seemed to hold up fairly well, with many of our holdings having no major buyers or sellers. Fortunately, because of significant recent [cash] inflows, we were 40% in cash on Sept. 11.

Q: Tell me, who are you guys?


My two partners came from Kahn Brothers. They were initially the Washington, D.C., office of Kahn Brothers.

Q: Kahn Brothers -- the value-investing firm in New York?


You got it. With Irving Kahn having been one of the patriarchs of value investing, [having worked] for Ben Graham.

Q: When did your partners strike out on their own?


1994. And I became very interested in value investing when I was at Wharton...and got in touch with the folks here and joined the firm upon graduation.

Q: What year was that?


'97. Our goal was to create a firm with a real focus on the deep-value niche. We started the fund in May of '98.

Q: How much money do you guys run?


The firm now has around $60 million in assets. The fund is $24 million, and $36 million is in [separately] managed accounts.

Q: You hardly started at a propitious moment.


It was a horrible time for deep-value investing, as everybody was selling the crown jewels to go speculate.

Q: So, tell me this: After people give you money, where do you look for stocks to buy?


We're focused on the segment of the market that is really a niche -- small cap, deep value.

Q: And how do you define small cap?


Less than $1 billion in market cap, but we have a lot of holdings that are less than $100 million.

Q: There are a gazillion small-cap stocks, yet your portfolio has only about 40 names. How do you pick them?


First of all, we screen for [stocks of] less than $1 billion in market cap. And then we screen for either cash-flow plays or asset-value plays, with our goal [being] to find companies that have both cash-flow and asset-value protection. We're looking for things that trade at maybe seven times earnings or less, or companies that are trading at less than the tangible book value.

Q: Do you go in and try to revalue the balance sheet, or do you just take the numbers that are posted on company balance sheets and use them?


We do go in and see if we need to adjust them because all these balance sheets are not perfect at tracking exactly what the value is. We're not a "quant" [quantitative] firm. This is just the first pass at these companies. Then we'll start to do our fundamental analysis on the names that come out of that group, looking for companies where management is allocating capital properly.

Q: Meaning?


What I'm saying is we look for [stock] repurchases, which are done at bargain pricing levels. We look for managements that are properly incented, and so insider buying is an important aspect of what we look at. And then we also are on the lookout for nichey type of valuation disparities that might be coloring a company. You might have a company that has a money-losing division that, if you closed it down, you could see the underlying intrinsic strength in the rest of the business.

Q: Examples?


One of the companies I guess that we're looking at is a company called Ecometry (ECOM ). It trades around $1.50 [a share]. It's a debt-free company with a market cap of maybe $20 million. So it's a fairly tiny company, but it has $3 of cash per share. They're active in [selling] computer software [to the] mail-order industry. They had $45 million in sales maybe a year-and-a-half ago.

Q: What's wrong now?


The business has fallen off and they're having trouble maintaining profitability, but, on the other hand, they're making the hard decisions to right-size their business in order to keep their cash intact.

Q: What's your biggest holding?


A company called Andersons (ANDE ), and it trades between $9 and $9.50 a share. Earnings are about $1 a share. They're active in grain storage and transportation, as well as fertilizer manufacturing and distribution businesses.

Q: Those don't sound like businesses run by a bunch of young guys in black suits and parallelogram eyeglasses.


No. It's kind of like an Archer Daniels Midland (ADM ) or Cargill. Once there's a grain elevator in a particular region of the country, there's no incentive [for rivals to enter the market]. These guys have an installed base of grain elevators within Ohio, Illinois, and the central Midwest. These elevators are [undervalued] on the books.... Our sense is that the tangible book value in the company is something like $14 a share.

Q: What about the fertilizer part?


It's losing money in a very significant fashion. We believe that something will happen with that business. It will not be allowed to continue bleeding forever. If they would make a move to cut that business off, either selling it to consolidate the industry or perhaps even just shutting it down, you can pretty much see a possibility for a pro forma earnings increase from maybe $1 to $1.50 [a share].

Q: When you buy into a such a situation, how long are you willing to wait?


We always have to keep an eye on the end potential that we're striving for, and [ask if] the pot of gold at the end of this difficult rainbow is really worth the cost. And as long as in our best estimation we believe that that's the case, we would continue to hold on. The valuation of the business is so cheap that it's already discounting a continuation of these cash burn rates.

Q: Do you pay any attention to overall market trends or economic trends, or are you pretty much doing it simply stock by stock?


We certainly are interested in events that may impact the business fundamentals of the companies that we're in. If we're in high-priced California real estate, we would be real nervous about the explosion in the dot-coms and how that might impact companies that own large portfolios of high-net-worth home loans, for example.

Q: Do you have a ceiling on the amount of money you will run in the fund?


Not yet. We're still at a point where we're quite far from the average amount of assets that are managed in small-cap funds. My sense is that we can manage something near the market cap of our average holding, which is maybe $120 million to $150 million. When you start to stretch beyond that you are not paying quite as much attention as you probably should.

Q: What kind of investor do you hope to attract?


We were hoping to find investors who are long-term oriented, who realize that the cost of long-term outperformance...[is] to underperform sometimes for longer periods of time. The late '90s was a tremendous example of that. You have to be willing to go your own separate way.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online

Edited by Patricia O'Connell