Sniffing Out the Best Small Caps

Excelsior Small Cap Fund's Doug Pyle has scored with a concentrated portfolio of names with solid fundamentals. Among his picks: GFI Group and Nautilus

The early June market rout doesn't bother Doug Pyle, manager of the Excelsior Small Cap fund (UMLCX). "It's been 10 months straight up, so there's a banana peel out there someplace," he figures. "It's going to correct—it always does."

Pyle thinks stock prices will be driven higher as more people shift money back into equities from souring real estate, while hedge funds and private equity investors keep doing M&A deals. Although small caps have been outperforming large companies for many years, he thinks stocks of all sizes will benefit.

In the meantime, the 56-year-old manager keeps his eyes on the prize down the road. "In this market, if you've got your fundamentals right on a stock and earnings direction correct, the best policy is to hang on to your names," he says.

Ahead of the Pack

That means you really need to know what you're buying. Pyle travels from his perch in Wayne, Pa., to meet company executives to understand how their business works and then assesses their "normalized earnings" power and risk (see, 8/9/06, "Bottom-Fishing for Small-Caps"). The Excelsior Small Cap fund owns just 40 small companies, and typically holds them for about three years.

Pyle's concentrated $726 million portfolio has pushed ahead of the pack. Excelsior Small Cap is up 11% so far this year through June 7, putting it in the top 13% of small-cap funds—and 5 percentage points above the large-cap Standard & Poor's 500-stock index, according to Morningstar (MORN). The fund's three- and five-year annualized returns stand at roughly 14%, placing it in the top 16%-18% of its peers and 3-4 points above the S&P 500.

BusinessWeek's Karyn McCormack had lunch with Pyle on June 6 while the market was suffering some summertime blues. Edited excerpts from their conversation follow.

What are some of your top holdings?We still own Philadelphia Consolidated (PHLY), Quanta Services (PWR), FTI Consulting (FCN), Sotheby's (BID), Manhattan Associates (MANH), and CommScope (CTV)—I'd say many of our top 25 holdings are ones that we've held for a considerable time.

In this market, if you've got your fundamentals right on a stock and earnings direction correct, the best policy is to hang on to your names. Somehow it seems like it's gone from a fundamentally driven market to one that's driven by price momentum. We still like all these stocks fundamentally, but it's really been the best strategy to stick with what you have.

Do you have any new positions?Our No. 2 holding is new. GFI Group (GFIG) is a broker of interest-rate derivatives, primarily credit default swaps, which is an instrument used to hedge against potential default of your fixed-income position. Only about 1% of fixed-income positions are now hedged, and we believe that the explosion in private capital is coincidental with an explosion in corporate debt financing. Some of it is low quality but some is high quality. There's been a discussion of covenant light, where the restrictions on lending are still loose. So we feel that most of the holders of these positions are going to want to have some form of hedge against a default, so credit default swaps are the best way to do that.

There are only two significant factors in this industry—one is called ICAP, which is a London-based derivatives broker, and GFI Group. One of the other things that benefits GFI is volatility. As volatility increases, more people will want to hedge their positions. I'll venture to say that the very long period of low volatility has ended. So we think there's a rise in volatility, and we see an explosion in debt financing, so GFI is a great way to play both of those things.

The major risk for GFI is competition. Lehman Brothers (LEH) is said to be interested in getting into this market. This also makes GFI interesting as a potential takeover. The expansion plan for the New York Stock Exchange is to have more electronic trading and more exposure to derivatives.

We use a process to calculate earnings called normalized earnings—it takes what we believe is a sustainable return-on-equity and applies it to book value. You can also do it on the basis of return-on-assets and return-on-sales—and actually we look at all three to determine normal earnings power. For GFI, I have a $4 earnings estimate, and I think the stock earning at 25% should get a p-e that reflects that. So I think the stock should be worth about $100. The stock has done well, but it's still around $70. We bought it in the high 40s last autumn.

What are some of your recent winners?One stock that's been very successful for us and is still very interesting is Innovative Solutions and Support (ISSC). The stock is around $26-$27. We bought it around $14 last September.

It has developed a flat-panel display of avionics for commercial aircraft cockpits. I met with the management and chairman. He was fascinating. He was trying to come up with a flat-panel display for avionics, and looked at his wife's Apple (AAPL) iBook and thought that's the perfect-size screen for what he wanted to accomplish. So he contacted the company that manufactures the screen. He also liked the colorful screens to monitor the various engine components, so he went to NVIDIA (NVDA)—the maker of graphic chips for games—to supply the chips for his displays.

Their typical installation costs $250,000. Their competitors are Rockwell Collins (COL) and Honeywell (HON), and their competing products cost $1.2 million. Innovative's installation is also very efficient: It's plug-and-play. An aircraft will go into their facility in Dayton, Ohio. They fly in on a Friday afternoon, pilots spend the weekend being trained, the units are installed, and the plane takes off Monday morning. Every commercial plane that's out of service costs an airline about $70,000 a day, so a faster turnaround time is obviously beneficial for the airlines. Their main two competitors take up to three weeks to install their display system.

The final benefit is Innovative's installation weighs about 200 pounds less than their competitors'. So it has all the benefits of installation, price, and lower weight. It won a contract with Eclipse to build about 2,500 cockpit displays in lightweight jets over the next three years.

If you look at the chart, the stock is up 61% this year and you might say: I missed it. An interesting follow-on to their success is that their display is now being evaluated by the FAA [Federal Aviation Administration] for certification for the Boeing (BA) 727-737, which is the workhorse of commercial fleets. So when and if they get the certification, the broadest opportunities are still in front of them.

What hasn't worked out so well for you?Another position that's fairly new that has not been successful, but we think holds a lot of opportunity, is Nautilus (NLS), the maker of weight-training equipment. Nautilus' primary product has been Bowflex for strength training and resistance training. That was sold primarily through the direct retail route (infomercials). The direct route has good margins, but they wanted to increase the penetration of their products, so they moved to more traditional retail outlets like Sears (SHLD), Sports Authority, and direct sales to sports clubs. It's also increased its product line—they've added StairMaster for aerobic exercise and bought Schwinn for bike and cardiac training.

One problem is they shifted from a more profitable distribution to one that's less profitable, so it's gone through some margin adjustments. But we think, as evidenced in its last quarter, margins are starting to expand. If they can get the same industry margins as competitors like Cybex (CYBI), which would be low-to-mid teens, we think they've got $1.20 earnings power.

The stock is at $12—trading at a five-year low in price, which we think is appealing in an elevated market. It has a very clean balance sheet and has a share repurchase. When it completes its share repurchase, it will add another dime to earnings.

And earlier this year, a private equity firm, Sun Capital Partners, which owns Levi's/Dockers and a nice portfolio of brands, filed that it owns a 5% position. The company reported a disappointing first calendar quarter, the stock drifted back down again, and Sun Capital has taken its position even higher. So it has that potential, with a very clean balance sheet, well-recognized product, and good management in place. It could work out fundamentally, and if it beats our earnings target we think the stock should trade in the mid-to-low 20s, so that's a double from here. And it has the kicker of possibly being taken private. In the meantime, it's got a nice dividend yield of about 4%.

It has the classic profile of what we like: low risk, high potential, changes taking place within the company that are positive, and we're starting to see it in terms of margin improvement. We think in a high market like we're in, even if there's a correction at some point, this kind of stock really stands up in a down market.

Are you worried that the bull run in small caps could stumble?People have been calling for the small-cap cycle to end since 2004. We found very little valuation discrepancies between large and small stocks. I think what you need to have it end would be to have a big valuation disparity between large and small.

I think investors want to make it neat and simple. Like a trapeze artist, we're going from the small-cap perch to the large-cap perch. They're all doing well. It doesn't have to be at the expense of one for the other to do better.

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