My Work Is Done + Manager Review #2 - Bill Hench

I found a small cap value mutual fund that is so good I could stop looking for new ideas right now. Any investor could just take the portfolio of the First Eagle Small Cap Opportunity fund (FESCX), as his only source of ideas. In all my 35+ years of looking at portfolios, I have never seen anything so well done.

Let me explain how I found this portfolio, it is a fun story.

I started Monday morning doing a review of the Communications Services sector. It was really depressing to look at the bad balance sheets of the cable companies.

I had CNBC on in the background early in the morning, and on the screen came a young lady I had never seen before. Her name was Savita Subramanian, an asset allocation strategist from Bank of America (Merrill Lynch). A little research told me she has been with B of A since 2001, after graduating with honors from University of California-Berkeley with a double major in mathematics and philosophy.

Her main point was that after a decade of growth out performing value, we could actually see a reversal. She said we might see institutions unwinding market cap weighted index positions if the big cap tech stocks continue to have problems.

Asked for her conclusion she said:

“buy and hold small cap value”

The CNBC hosts were so stunned it seemed like she said:

“buy and hold elephants and balloons”

My god, they thought, after a decade of promoting big cap tech what will do now? CNBC quickly went to commercial and then spent the next two hours rehashing Salesforce and Microsoft.

How could investors actually buy and hold small cap value? It had been a long time since I looked at the alternatives. I turned to my Morningstar website and started with with ETFs.

Many of the ETFs were tied to the Russell 2000. The Russell 2000 is the 2000 smallest companies in the Russell 3000. The range is $5 billion market cap companies like Asbury Automotive (ABG), down to $50-80 million market cap companies like Matrix Services. However, since the index is market cap weighted the big cap stocks are much more important.

Call me old fashioned, but to me, $5 billion does not seem to be small cap investing. In fact, not that long ago I might have called it big cap investing.

I turned to the small cap value mutual funds, there were about 80 to choose from. I saw many old friends, Aegis Value, Heartland Value, Keely Small Cap, and Royce Funds, and my new friends at Victory Sycamore Small Cap Opportunity. Aegis Value is now 50% a gold fund, and the other are mostly have heavy financial sector weights. The Russell 2000 is about 25% financial stocks, and since it is the main benchmark, most of these funds are 20-30% financial stocks. I was looking for an outlier.

I clicked on a fund called First Eagle Small Cap Opportunity (FESCX). I associate First Eagle with the legendary Jean Marie Eviellard. He was a nice man that did a lot to promote value investing, but he retired, so was First Eagle up to now?

Wow.

A few years ago First Eagle hired a guy name Bill Hench away from the great folks at Royce Funds. The fund that Hench has build at First Eagle is spectacular. It has four advantages:

1. The median market cap is about $1.4 billion, well below most of the others

2. FESCX is only 6% financial stocks

3. FESCX has a Momentum rank well below the others. Hench is clearly selling his winners, and buying under-performers

4. The average ROIC of these stocks is a well below average 7%, Hench is actually buying companies with low ROIC’s and betting they will improve.

The fund has two disadvantages. Using a higher risk strategy, Hench spreads out over 200+ stocks. His largest position is only is only 0.90%. The other problems is the minimum investment is a cool $1,000,000. I guess he hopes this will keep money flow to a minimum. The fund currently has $800 million in assets, which is a little larger than ideal, but still OK.

Either save you money to invest the $1 million, or get to work finding the 20 of his stocks you like the best for your own portfolio.

Before we get to 10 great ideas, let’s ponder an important question.

Is the stock market overvalued?

At 18x, a roughly $200 estimate of 2023 earnings, the S&P 500 clearly seems overvalued. Lots of companies had what I think are “peak” earnings in 2022, so I would be nervous about the 2023 estimate. I tried to value the market in an earlier post by trying to value a big stable company like Colgate. Putting a health 12x EV/EBITDA multiple on CL’s 2023 estimate, I still thought big stocks were at least 20% overvalued.

But who needs the %$##%#ing S&P 500?

Mr. Hench has put to get a group of 200+ companies that sell at 11x earnings, 1.3x book, and 55% of sales. While this group has only a 7% current ROIC, the group has lots of interesting prospects.

Is this part of the market overvalued? I had not really looked at the valuation disparity in a long time. Certainly FESCX’s group could get cheaper if the big stocks collapse, but could I really call them overvalued today? That is a question I will have to pause and think about.

Let’s look at 10 ideas quickly because this post is getting too long. We will revisit this portfolio many times in the future.

1. Tenet Healthcare - THC - $53 - an underperforming hospital group at an interesting price.

2. Enviva - EVA - $45 - maybe an ESG play that makes wood chips, tricky

3. MKS Instruments - MKS - $99 - a great test equipment company that is digesting a big acquisition

4. Heritage - Crystal Clean - HCCI - $37 - waste disposal, has run a little

5. Lithia Motors - LAD - $252 - both Klarmen and Ackman are recent buyers

6. LGI Homes - LGIH - $108 - an entry level home builder with a unique strategy

7. Patterson - PDCO - $30 - dental supplies, I have preferred Henry Schein

8. America’s Car Mart - CRMT - $82 - how many analysts have been to Rogers, Arkansas?

9. Ultra Clean Holdings - UCTT - $33 - maybe a cheap technology stock?

10. Huntsman - HUN - $31 - interesting specialty chemicals

This is exactly how I would manage a small cap value portfolio. Would it be a better fund if assets were $50 million, and it only owned 30 stocks? Yes, that would be better, but unrealistic. You have to pay a staff to do good research and $500,000 (1% of $50 million) is not enough. $8 million (1% of $800 million) is just about right to pay the research team, accountants, compliance folks, and salesforce, and earn a return for First Eagle.

I want to hold a parade for Bill Hench and folks at First Eagle that allowed this strategy. All the other guys hugging the index can go to hell.

Let’s call the Learning Experience #3:

FESCX - $9.33

VTWV - Vanguard Russell 2000 ETF - $130.16

S&P 500 - $4016.23

Who will win? The evil S&P, the small cap value indexers, or my champion Mr. Hench. Stay tuned to this channel.