Playing Themes with Low P/Es: First Wilshire's Scott Hood

By Richard Hefter, Editor, Small Cap Manager

The name First Wilshire Securities Management may not be on the tip of every small-cap investorís tongue, but the Pasadena, Calif.-based money management firm, with $55 million under management, has had the 2nd-best returns among U.S. small-cap blend managers over the last 7 and 10 years, according to Money Manager Review. It was also 4th for the last 3 years through September 30, 2002, according to Money Managerís ranking of leading private managers. First Wilshire has produced 3-year annual returns of 13.24% versus -4.08% for the Russell 2000 and -12.89% for the S&P 500. This year the firmís strategy, managed by Scott Hood and Fred Astman, is up just a few percentage points, but thatís a far cry from the double-digit negative returns many investors have been dealt. Hood, with 10 years of experience in small-cap research and portfolio management, explains how the strategy has survived the bear market.

What have you done to stave off negative returns this year?

We've become more diversified, especially in this environment where any single company could have an accounting or other problem. We've also built up a little more cash heading into the summer, which was a good time to have cash and allowed us to pick up things that were getting slammed around. In addition, we've been in industries that are a little bit more defensive and counter-cyclical.

What industries are those?

We have positions in, for example, companies that offer pawnshops and payday advance loans. It's their kind of market, along with companies in credit collection and subrogation recovery. These are businesses that aren't going to be negatively affected by a downturn in the economy. We generally don't time things, and we're always in low p/e value-type companies, but we've had a little preference this year for counter-cyclical companies, avoiding a high concentration of companies that rely on the prosperity of the economy to grow their business.

How many companies are in your portfolio?

We're up to about 50, but the top 20 are about 80% of the portfolio and the top 10 are probably 60% of the portfolio. Initially, we'll take a 2-5% position and we'll add to it as the company comes through with their objectives. Lately we have added more companies as valuations have become more compelling. For a value investor, the gloomiest market is the best time to buy.

What do you look for in an investment?

We like companies that have a substantial operating history and a proven track record, as well as companies that have little to no analyst coverage or institutional ownership. We love to be the first one to visit.

On the fundamental side we like a strong balance sheet, particularly in today's environment. We don't want companies with a leveraged balance sheet. We like 20% or getter growth, companies in favorable industries with high barriers to entry and companies whom exhibit a sustainable competitive advantage.

What would you say gives you your competitive edge?

I think it's been a commitment to intense and thorough research and simply from working hard and loving what we do. I don't believe other investment firms do as comprehensive research as First Wilshire in the small- and micro-cap area. We have also stuck to our investment style emphasizing low p/e, undiscovered companies. Specific to this year, we have reacted to the environment and that's benefited us quite a bit.

What do you mean by "intense research"?

It entails visiting the company and its various operating sites, talking to management first hand, talking to competitors and industry insiders, and analyzing financial statements. We do not rely on other firms' research. We are applying a level of research that is generally only done on the largest companies and we are applying this to small companies that have maybe never been under the microscope to this degree. Companies often tell us we're the only one that has looked in-depth. Many times they tell us we are the only one to have ever visited them. We dedicate a lot of firm resources to research with two portfolio managers and three analysts. Our investment committee is made up of six people, which helps to raise all the questions.

There's at least one of us on the road every week, and there are times when we'll visit 15-20 companies in one week. In addition, we'll go overseas to see companies every once in a while. We put a lot of weight in meeting face-to-face with management. There is no substitute for visiting the company. It is important to see how the company performs over time relative to what management discusses with us. We've held positions for well over 10 years because management has consistently delivered on their objectives, an ideal situation. Over time you build up a trust and relationship with management where you understand their strengths and weaknesses.

Many small caps lack research coverage. Does this make your job harder?

Yes and no. With no analyst coverage, there's not as much information out there, so you've got to devote a lot more time and a lot more resources to uncovering the information, but once you do you'll be happy to be the only one who has it. The problem with relying solely on the research, especially of the Wall Street firms, is you know the idea has been spread around quite a bit and the stock is priced more efficiently.

We like to operate in the inefficient market of small and micro caps. That's why we're there. Our chairman and the architect of our investment style, Fred Astman, who founded the company in 1977, actually got in the business in 1961 and has been utilizing this style ever since. We don't think we can add much value in the largest companies because those are thoroughly followed. In small and micro caps, because there's so little coverage, we can be the only one to take a hard look and add value due to the pricing inefficiencies.

Can you talk about a few companies?

First off, I'll mention the pawnshop and payday advance companies. These are companies that primarily had multiple pawnshops in multiple states and leveraged their infrastructure and clientele to offer payday loans. One of the companies is First Cash Financial (FCFS). This is a company that's grown its earnings and revenues tremendously over the years. They've paid down their debt substantially and recently came out in the third quarter and said they're not only going to meet their estimates, they're going to beat them, which is pretty unique these days. It's trading at below 10 p/e and could have their debt paid off within the next two years, depending on growth objectives.

One of their growth areas apart from the payday loans is development of pawnshops over the border in Mexico. It takes a very small investment to get them up and running and they start to pay for themselves in just a few months. So there' s huge opportunity for them to open up more pawn shops in Mexico.

Another company in that area is Easy Pawn (EZPW), which operates pawnshops and offers the payday loan product. It's a company whose cash flow is very good, with they're growth coming from the payday loans. They're trading at a little bit less than a 10 p/e on next year's projections. They've been improving their balance sheet and recently was able to lower their interest rate on their debt. Even though rates have lowered, there are a lot of companies having trouble getting a better rate on their credit lines, so we were impressed with that.

What happens to these companies when the market turns up?

They perform well in a downturn, but they also seem to do just fine in an upturn. It's not a situation where in a downturn they'll grow at 20% and in an upturn their growth will stall. There are a lot of other factors involved. I would say the pawnshop industry is fairly mature and has virtually no growth. The payday advance loan product is the growth story, and it's up to the company's ability to increase payday advance outlets. You may have noticed that in the last few years you take a drive anywhere and you notice payday stores at almost every corner in the cities, so it's a real growth area.

What other areas are you focusing on?

An area we've been focused on for a while is Asian-American banks, primarily located here in Southern California in our own backyard. We discovered them by driving by and noticing a branch and then hearing some news stories about them. These were companies trading well below 10 p/e's, with 50% growth and almost no loan defaults. The demographics of the Asian-America community are strong with generally higher average income, higher education levels, and very low defaults on loans. It's an area with great growth, strong credit, very low valuations, and even now, although the p/e's are coming up to a more reasonable level, they're still undervalued.

Can you mention a few?

Right now we own three Korean American Banks. All these companies have half to three-quarters of a billion dollars in assets and serve primarily the Southern California markets. One is Center Financial Bank (CLFC). They've really grown their branch network in the last year. CLFC had to expand their branch network to match the communities Korean Americans are living in. They were on the Bulletin Board until this month when they were finally listed on the Nasdaq National Market. They qualified for it for some time-- it was just a matter of going through the filing process. Next year they should earn $1.40 and should produce 20% growth, and they're trading around 13 right now.

The second is Wilshire State Bank (WSBK), which serves a similar market. It trades about $12/share and should earn about 1.30 this year. It has strong growth and despite a sluggish economy, it has not shown any signs of a worsening loan portfolio.
The other is Nara Bank (NARA), trading at about $20, with $2 earnings for next year, so again under 10 p/e. They purchased branches in New York, so they're on both coasts now, and opened loan offices in Seattle, Chicago and could enter Texas.

Everybody would agree who follows the industry that there needs to be a merger between some of these public Korean-American banks. There are a lot of synergies and it's just a matter of time before someone buys another out. We think it's a little longer after that that a larger bank like an HSBC will try to get into this growing area. It's one of the fastest growing populations for banking in the state!

Another point about the demographics is that this is a community that has stayed together, and the first or second generation tends to go with their parents bank. Immigrants, of course, like to bank where they can speak to someone in their own language.

You certainly play themes.

We're bottom up stock pickers, but when we find one that's good, we will take a comprehensive look of the whole industry. This can lead to an industry that's undervalued and we get to know it well after several years. Another counter cyclical company is Asta Funding (ASFI). They purchase credit card receivables and other receivables from companies and try to collect on them. They finance large portfolios of receivables through internal funds and often with Greenwich Capital who comes up with the purchase price and they split the profits. It's been very profitable obviously with a lot of retailers having problems. There's a strong pipeline of receivables available, and they have a lot of experience at purchasing and collecting. They are accurate in forecasting the collectability of their portfolio. Their fiscal year ends in September. They've given EPS guidance of $2.40. The stock's trading at about $9/share. The company's got a strong balance sheet and the environment is good for continued growth, so this is definitely an undervalued name in a good area.

What can we expect of small caps coming out of this recession? Do they tend to outperform large?

We've definitely seen the studies that show that. We also find they're a little more nimble, they're able change their focus in response to the their market. When you have somebody with 250 employees it's much easier for them to scale things back and adjust to the economy, whereas if you have thousands of employees, it's a bit more like turning a battle ship. Also, these small companies are often run by their founders who have been through every type of economy and have the drive and creativity to make things happen.

The other thing that's important to note is that the median stock return was actually flat in the bull run of the late 1990's, in the studies we've done. The bull market was confined to the largest S&P companies and some technology companies obviously, but when the downturn came it primarily hurt the largest stocks and tech companies, although since this summer the market's been selling off just about anything.

The point is there are two tiers to the market ? the largest companies and then the rest of the companies. We did another study looking at about 9200 companies in Multex's databse. If you look at the number that have under $1 billion market cap, it's about 7700. Almost 85% of all public companies are small cap and micro cap. Those companies have gone through a completely different market cycle than the ones over $1 billion. Going from 2000 until, say, June of this year, a lot of the micro caps had a very good run. Going into July, the market sort of gave up on everything and sold off all the way through September. At this point the small and micro caps are still relatively undervalued to the large caps and have a lot of catching up to do.

Overall, an important factor is there's a lot of money in savings and money market accounts that people are less than satisfied with. So I think there's a huge amount of money on the sidelines ready to jump in. It may initially go into the larger companies, but the valuations definably favor the smaller companies.

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© 2002, The SmallCap Manager, An AdviceTrade Publication, Sponsored by JM Dutton & Associates www.jmdutton.com