Issue #6, March 2002

The Price of Value:  T. Rowe Price's Preston Athey

By Richard Hefter, Editor, Small Cap Manager

With a B.A. from Yale, M.B.A. from Stanford, nine years with the T. Rowe Price New Horizons Fund and the last 11 years managing its Small-Cap Value Fund, Preston Athey has an enviable educational and professional pedigree.  He also has the benefit for managing a fund that is up approximately 7.9% year-to-date, with a trailing one-year return of 25.5%, ranking it in Morningstar's first quartile.  Money has been pouring in, with the Small-Cap Value Fund's assets now at $2.4 billion, but it wasn't always this way and Athey is well aware of market cycles, including those within small caps themselves.

Those numbers are a far cry from when we last spoke a few years ago.

That's exactly right.  1998 and 99 were very difficult years for value in general, small-cap value in particular.  There was a period there from August 1998 through February 2000 when the gap between small value and small growth, I think, was the biggest it had ever been, probably over 100%.  This led an awful lot of people not only to take money out of value funds but to really question the whole scenario of whether we were in a new era and these value guys didn't get it.

Are we overvalued now?

I'm not going to kid you ' there were extraordinary values available during 2000 when an awful lot of companies had been knocked down to 8 and 9 times earnings because of the dot.com phenomenon and many of those are now selling at 12 and 13 times earnings.  Does that mean they're bad values?  Well, still relative to the market and relative to a lot of other companies, I think they're pretty good values. 

The values are out there, and I will tell you that in my experience, the smaller the company the better the value.  If you look at two companies in the same industry with relatively the same growth rates and same profitability ratios, etc., the $200 million market cap company will probably sell at 2 multiple points less than the $800 million market cap company or the billion dollar market cap company.

Why is that?

The reasons are that the smaller company may be considered more risky because perhaps it's more concentrated in its niche, and undoubtedly with a smaller market cap is has a poorer float, poorer trading characteristics and many investors don't want to fight that.  And of course it has less research and less exposure because there'll be less trading volume for the sponsoring company to be able to do business in.

What makes these companies attractive to you?

My attitude is if you have a very low turnover, then it's perfectly appropriate to buy these little companies and hold them forever assuming they're still doing reasonably well, because you don't have to worry about getting in and getting out all that quickly.  There are those who say, 'Oh my gosh, there isn't enough market value or there isn't enough trading volume for me to buy something,' but what they're really saying is there's not enough for them to buy in two days and sell tomorrow if they change their mind.  They deny themselves ownership in a lot of great small companies that frankly may be better quality than what they have for a lower price.  I recognize that the negatives are poor liquidity, poor trading volume, very little coverage by Wall Street, but I'll work around those.  I'll be patient.  It could take me months to put up a position in a stock, but if I do it at a very good price, in the long run my shareholders see the advantages.

As a result, I have one of the lowest turnover rates of any manager in America, certainly in the bottom decile.  I run on average 15-20% a year.  If you're a taxable investor, that's great because I'm not taking that necessary capital gains.  And it also means I'm not giving up a lot of money to the brokers in terms of bid-ask spread or market impact when I trade just for the sake of making a trade, and I think that's important to recognize.

Writing to be Right:  Exposing Value the Right Way:  A Message from Our Sponsor

By John Dutton, Director of Research, JM Dutton & Associates, LLC  www.jmdutton.com

This month on our Web site, we

interview our analyst Les Childress, whose interest in special situations leads him to a range of companies.  Les notes, 'My approach to research is very eclectic.  I don't eliminate a company because it doesn't fit a  'style.'  I look at growth situations and I look at value situations with equal interest.  I go into each assignment with absolutely no bias about the company.  The challenge in a special situation, no matter the market cap, is being able to determine the issues and the story.  Sometimes there is no story; it's just out of favor and cheap.  But whatever it is, I somehow must properly communicate the story and be able to do that concisely.'

In many ways, Les's description applies in general to what we do at J.M. Dutton & Associates.

Our research program, modeled after Standard & Poor's credit rating program, enables any company that believes in its story -- even though it may fall outside of Wall Street's screens -- to have credible, widely distributed research coverage.  These are companies that are orphaned not only because their size and trading volume don't meet the payback criteria of brokerage- and investment banking-dependent research departments, but that these companies often times simply are not understood.

The oversight can result in value opportunities of great magnitude.  We most recently issued an initial report on Cap Rock Energy (AMEX: RKE $10.10).  Conversion of insurance companies from mutual to stock companies provided investors the opportunity to make substantial money. Cap Rock is the first electric cooperative to covert to an investor owned utility (IOU) company, and began trading on March 14th. It has a strategic plan to become a national electric utility distribution company with community-focused local operating divisions or profit centers both in Texas and around the country. Revenues of $78 million are projected for the current year (12/31/02) with EPS of $1.92 and EBITDA of $20.3 million. A sale/leaseback of its electric transmission assets for $40 million net cash is underway. RKE shares are substantially undervalued in comparison to the valuation criteria of a public peer group of IOUs. The lowest valuation multiples of EPS and EBITDA/market cap of this peer group suggest a three to four times higher per share valuation of Cap Rock. Our report suggests a conservative target of $15 - $20 as investors become familiar with Cap Rock in this first year, and it establishes a track record as a public company.

Cap Rock is one of more than 20 companies that are now covered by Dutton & Associates in only six months since we were formed (our team having worked together for years at a different firm).  It is a story, that, like many of the other companies we cover, needed thoughtful, detailed independent analysis to tell.  When a company hires Standard & Poor's to give it a credit rating, it knows that S&P's only objective is to be right.  Likewise, we at Dutton & Associates write to be right.  There are great numbers of high-quality companies under-looked by Wall Street that come to us to tell their story, believing that we will do our homework and tell it right.  Recently, several investment banks commissioned us to write research in areas they don't have the resources to cover.  Some of the exchanges have recommended their member companies to us, knowing that more exposure benefits everybody.  The AIMR invited us to present in this month's newsletter the argument why analysts should not own shares in companies they cover.

As Les Childress says, we 'go into each assignment with absolutely no bias about the company.'  And what's more, our reports come out reflecting the quality and integrity of our independent analysis.

Please read disclaimers at www.jmdutton.com.

Can you name a few companies you like?

One company is in some respects going to seem almost too late for the party.  It's Right Management out of Philadelphia (RMCI).  This is the world's largest outplacement consulting firm.  Outplacement is, of course, with people who are laid off.  The companies doing the layoffs often provide these laid off employees with counseling on how to write their resume, how to get another job, interviewing techniques, role playing, psychological counseling, etc.  Right Management been a great stock over last couple of years, because as people worried about going into a recession they looked for recession-resistant companies or those that would be helped by a recession and this was clearly one of them.  But it's come off of its highs.  In November the stock got to 27, and in Feb it was over 25, and today it is 19 '.  There's no good reason I can see other than we're starting to get a rotation in the market to companies that are more tied to a cyclical recovery.  But this company is probably going to earn something in the $1.75 range for calendar '02. They're making an accretive acquisition of their largest counterpart in Britain, a company called Coutts, which was strong in countries where Right Management was weak.  This now very definitely fills out Right Management's world platform and makes them largest in the world.  At a price of over 11 times forward earnings for a company that's pretty profitable, I think that's a decent deal.  I recognize that growth will probably slow a little bit in the future because eventually we'll come out of it, but there are an awful lot of layoffs that are still occurring, there's an awful lot of business for them still to get.  With a $318 million market value, it's got enough size that people can actually buy it, and as a company with a return on equity in the last 12 months of 25%, it's pretty attractive.

Any others you want to mention?

I'm also partial to a retailer, Stein Mart (SMRT), which has discount apparel stories of nice quality in the South.  This stock has come off the bottom nicely.  It was down in the 7 range at the bottom in September and is currently at 10 '.  It has been affected by the slowdown in the economy, and like many retailers has not had a great last 12 months.  It actually lost a little money in the fiscal year that just ended, but this a company that last year earned 91 cents and estimates for the current year are 50 cents plus.   But frankly if the economy comes back a little bit more and they get the fashion, Stein Mart could easily earn 60-70 cents.  And at 10 ', it's not particularly expensive.  Also, it's selling today at 2.3 times book value with no long-term debt.  This is a company that when times are good consistently earns in the mid-to-high teens return on equity.  And with an unlevered balance sheet.  So again a pretty good quality company that just needs to get through some slow times.  But value investors are used to looking beyond the trough at the sunnier days in the futue, and I think SMRT has some good days ahead.

Do you focus on any particular industries?

I'm completely diversified with 240 holdings.  I like the idea of owning stocks in nearly every single industry out there.  I seek diversification mainly because it helps me to stay abreast of what is going on in the economy and it keeps me from getting too tightly tied to any one area.

Your stand, then, is clear in the ongoing debate about concentration versus diversification.

It depends.  If you're an institution, a pension plan, and you've indexed 60% of your assets and now you've got specialty managers on the periphery, like a mid-cap manager, a couple of small-cap managers, and then a couple of active managers in your large caps where you're looking for their best insights, it makes sense for the large-cap managers to be told, 'Look, I'll take your 20 best ideas and don't worry about diversification,' because they're only a small piece of the total. 

However, if you and I both agree that I'm you're only small-cap manager or your only small-cap value manager, what you're really hiring me to do is capture the effect of the area.  Don't blow it if it does well.  If I outperform the index by a bit that's great, but the last thing you need is to go into 2000-2001 and small-growth growth is getting killed, and somehow I'm not reflecting the good performance of the small-cap value space.  I'm there as part of an asset allocation situation.

Another reason for diversification is that let's say my favorite bank happens to run up five points in the last two weeks.  You don't want me chasing after it, as small-cap value is about price.  What you'd rather do is have me buy my second favorite bank.   On any one day when I have cash flow or a new account, I can't count on the fact that my favorite stock is going to be appropriately priced, so I need other options.

What is your outlook for the small-cap value area?

I think small caps will outperform large because valuations are pretty low, and good valuations combined with excellent cash flow, particularly cash flow into a small area like this where people are struggling to put it work, probably means we will way overshoot fair value.  So my outlook for the area is still pretty good.

But should you be chasing after small-cap value which has been the best area in the market for the last two years?  I think we're going to do fine this year, but I don't think now's the time you put more money into small value.  I think now's the time you look at small growth and selected technology funds, and international, which has basically been vulnerable for years.  Those are the areas I'd be buying.

Why?

It's important for any investor in small caps to remember this is a cyclical area.  It goes in cycles, and within small caps there are cycles between growth and value.  There was an article mentioned recently in the Wall Street Journal that originated, I believe, in the Journal of Finance on a study of some investors.  The study determined that if the market was up 16% over time, these investors had managed a 5% return.  It wasn't that they were just bad stock pickers, but invariably they chased after what was working and bought high and sold low.

It's important to be diversified in whatever asset pool you've got and within that diversification remember you should, if anything, put more money into those things that are doing poorly and take money out of those things that are doing well, and rebalance once or twice a year.  As long as you're not rebalancing in an individual issue which may have gone down because the company is doing poorly but instead rebalancing among mutual funds where you've got managers you trust whose area just happens to be doing poorly, you're going to do much, much better.

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