True Value: How the Aegis Fund Turned Up the Heat in 2001

By Richard Hefter

When you're up 30-plus percent in a year like this, you're probably very good and a little bit lucky. Scott Barbee, manager of the red-hot $27 million Aegis Value Fund in Arlington, Va., wouldn't mind admitting he's been long overdue for a little luck, what with managing a fund that began in 1994 just when small value was going out of vogue. As momentum stocks that rarely saw an operating loss they didn't like soared with the Internet craze, Barbee could only watch and wait for low P/Es to once again prevail. Prevail they have, and along with sector outperformance has come some quite good - and quite, well, timely - picks this year that Barbee shares.

RH: Would you have ever expected 30-plus percent returns in a year buying value stocks?

SB: It's an interesting thing because when you buy these stocks, you never have control over when a sector shift is going to happen. So when it does, you're never as smart as the market sometimes make you feel, or as dumb as it sometimes make you feel.

You have to be feeling pretty smart at the moment.

Well, we certainly believed in March of 2000 that these darn stocks were massively undervalued vis-à-vis the rest of the market, so it did not surprise us at all that we had tremendous relative outperformance going forward from that point.

On top of that, you've made some calls that included buying defense-related Allied Research (ALR) over the summer.

We look for companies with less than a billion dollars in market cap that trade in the lowest decile of price-to-book or price-to-earnings. That comes to less than 1x tangible book value or less than about 7x earnings. It's "either or". We'll do either asset value plays or cash flow, earnings-type plays.

Here was a $40 million market-cap company that had $20 million in cash on the books and no debt and it was trading at 4x earnings at the time. So it met our criteria.

It's in the munitions manufacturing business and also owns a business in Europe that does building security and intrusion detection. We had only two positions going into September 11 that were 5% holdings, and Allied Research was one of them. So our timing was good. We bought it in July and August at an average price of about $8.50 a share, and now it's at $18. But it's still only at 8-1/2 - 9 times earnings right now.

What's your most undervalued holding?

That might be our other 5% holding, which is currently right at where we purchased it, at about $9 a share, expected to earn $1 this year. It's a company called The Andersons Inc. (ANDE), out of Maumee, Ohio, which is active in grain handling and storage, and also fertilizer distribution. The company is run by a terrific management team that is very ethical, which is important in our business. When you screen for low price-to-book, low price-to-earnings stocks, a lot of times you get a lot of bathwater and not a lot of babies.

What else do you like about the company?

Its book value is around $14 a share, so at $9 it's trading at a fairly significant discount to tangible book value. Further, the company has a business that's losing quite a bit of money currently in this fertilizer distribution arena. They expanded a few years ago right into the jaws of a retrenchment in the industry and ended up with way too much capacity.

My sense is there's a fairly high chance over the next year or two, that business will be rationalized somehow. And if that happens and they can eliminate the losses in this one division, the other divisions will push their earnings to $1.50-plus a year, more than 50% higher than currently.

So you're looking in general for a catalyst to make stock price better reflect true value?

Yes. Obviously, a value stock that remains a value stock is not a value stock. You've got to find something that will grow the stock.

Such as?

We like to see things like share repurchases. We like management that will buy their own shares and put a significant portion of their capital in their own shares because managements know a lot more about their own companies than we do. So when you see that kind of activity going on in a meaningful way, you have to be excited about it.

Some managements manipulate that. The one that comes to mind is Conseco. When Conseco made tremendous business loans to their top executives to buy in the stock, we found that fairly distasteful. Because if the stock price plunges a lot of times those loans are forgiven, so it's a kind of "heads I win, tails you lose" situation.

Do you do your own research?

Yes, we're probably 99% internal. There are very few analysts that actually cover small-cap situations. There's no money in it on the sell side, and on the buy side a lot of guys are managing way too much money to make an impact.

But with good fundamental research, we believe that you can get an extra kick with small-cap stocks, which academic studies show already tend to outperform the rest of the market in the long-term. We believe there are bargains that come available because these markets trade very inefficiently, and you can deliver a return that's above the already very strong long-term passive returns by doing good fundamental research on this undercovered market segment.

You mentioned before you screen for either very low price-to-book or very low price-to-earnings. Can you explain that further?

We'll accept companies that are losing money if they have a lot of asset value protection. On the flipside, we'll own companies that are like money management firms, for example, that don't have a lot of assets, but might have a lot of intrinsic value just from the cash they're able to generate. We're either trying to buy assets that are marketable but might not be earning a lot of cash currently at a discount, or buying discounted cash flows at a discount.

What other stocks do you like?

We've been actively purchasing Prime Hospitality (PDQ), which owns the AmeriSuites hotel chain. We believe their net asset value, before September, was about $17 a share. That's what you'd have if you sold off all the hotels and sold off the brand and paid off all your debt. The stock's been trading at $9-10 a share.

A lot of hotels are very levered, so you wonder if it's a tenable situation if the market stays as bad as it is currently. In Prime Hospitality's case, their debt levels are very low, so they have a lot of staying power. Management has been very active in selling off the hotels and using the capital to pay down debt, which has made them more solid in this downturn. And a lot of their hotels, too, are in drive-to locations, so we don't believe it's quite going to get that some of these destination resort type hotels might have problems.

Do you see small-cap value stocks continuing to outperform even with this run-up?

I still don't believe the public, in general, really understands the extent to which all the water in the bathtub was pushed over to one side and how much even with the run-up in the value-type names, there's been such a bear market in these stocks vis-avis the large cap growthy names that we are still at a fairly significant historical discount versus those other large caps.

Compare the S&P 500 at 5x book value and something like 2x revenues to our fund, which is at 0.6x revenues and 0.8x book value. We're between one quarter and one third the valuation of the overall market. Though our fund is a little bit on the extreme, there's still a disparity for the overall small value market.

What that says is the risk/reward ratio of holding these small-value type stocks is a lot better than the risk/reward ratio of holding the S&P 500 stocks at 27x earnings. I don't know if the result is we do better in an economic recovery or we don't do as badly in a decline, but I can tell you for darn sure that if you want to be buying equities this is the market segment you want to be looking at most intensely.