This stock-fund supervisor outperforms with ‘fixer-uppers’

“We look to get a dollar of assets for less than a dollar,” he stated throughout an interview.

A small-cap veteran

Hench is the pinnacle of the Small Cap group at First Eagle Investments in New York and portfolio supervisor of the $1.7 billion First Eagle Small Cap Opportunity Fund FESCX. He has been following a price technique since 2002 when he was working at Royce Investment Partners. He and his group joined First Eagle in April 2021 — the identical month that the First Eagle Small Cap Opportunity Fund was established.

From that date, the fund’s institutional shares have been down 1% by way of Friday, web of bills, which was according to the efficiency of the Russell 2000 Value Index
XX:RUJ,
however forward of the ten% decline for the complete Russell 2000
RUT.

Needless to say, this era hasn’t been one for small-caps. Since the First Eagle Small Cap Opportunity Fund is lower than three years outdated it doesn’t but have a Morningstar score.

Brett Arends: These small-cap managers’ inventory picks crushed the indexes final yr — once more. Here’s what they’re shopping for now.

But Hench had a stable long-term efficiency report at Royce — the Royce Opportunity Fund RYPNX, which he co-managed, had a 15-year return of 296% by way of March 2021, in contrast with returns of 191% for the Russell 2000 Value Index and 256% for the complete Russell 2000.

Identifying bargains

Hench takes a broad method, usually holding shares of between 180 and 300 corporations. He and his group usually establish corporations whose shares are buying and selling low to ebook worth or income not as a result of the businesses are little-known available in the market, however “because something is wrong.”

“We look for companies that experience difficulties in the short term, which is normal. Sometimes it is their mistakes, sometimes it is the economy,” he stated.

Hench doesn’t take into account corporations’ price-to-earnings valuations when making preliminary buy selections as a result of the businesses aren’t as worthwhile as he believes they will grow to be.

“We look for cheap and a reason they will get back to normal,” he stated.

He additionally believes the phrase “quality” is overused within the funding neighborhood. “The term may be used when an investor overpays,” he stated. The thought is that you just is likely to be keen to pay a excessive value for stability, however you additionally may reap the benefits of decrease costs, as a result of for many corporations “things are not always great all the time.”

Looking again to the early section of the COVID-19 pandemic, Hench stated: “You had conventional development shares promoting at comparable valuations to worth shares. Back then, you have been capable of purchase issues like Dunkin’ Donuts or Texas Roadhouse
TXRH,
-0.48%,
which have been usually in worth funds at low multiples they usually acquired again to the place they’d usually bought, which is the place we exited.”

Hench stated a couple of third of the businesses within the portfolio are maturing and have been held for a couple of yr and a half as a result of they’re bettering as he anticipated. Another third “have just made the turn, with fundamentals getting better or the economy at their backs,” and the remaining third contains corporations “in the thick of it,” or bettering because the worst of their issues have abated.

“Everything in the portfolio goes in there because there is something wrong, something not working,” he stated. “If we think they have a good shot at fixing it, we will take a position. Then we do maintenance, to make sure of the progress we want” he stated. As he features extra confidence in an organization’s progress, he’ll add to a place. He will promote it if the anticipated enchancment isn’t going down. Once an organization is way sufficient by way of the cycle of enchancment for the shares to have reached what Hench believes to be their truthful worth, he’ll promote.

“These things take time to work out,” particularly if one of many corporations he invests in has a brand new administration group, he stated.

A present fixer-upper

Rob Kosowsky, an affiliate portfolio supervisor on Hench’s group supplied an instance of a holding that may nonetheless be thought-about a fixer-upper due to operational issues: Stericycle Inc.
SRCL,
+1.72%.

Stericycle’s principal enterprise is the gathering and disposal of hazardous waste from hospitals and different medical amenities. It additionally offers doc shredding companies.

Kosowsky stated Stericycle was previously “a Wall Street darling” because it acquired lots of of smaller rivals from 2000 by way of 2015. While this “classic roll-up” constructed a big income stream, it precipitated the corporate’s revenue margins to tumble “because it had never been fully integrated.”

Cindy Miller turned Stericycle’s CEO in 2019, following a 30-year profession at United Parcel Service. Since then, she has been leveraging her logistics background “to simplify the business and improve margins,” Kosowsky stated.

Since the acquisitions hadn’t been absolutely built-in, “there was an outdated and incohesive enterprise resource planning system,” he stated. This meant that whereas making an attempt to route trucking fleets throughout the U.S. and in 16 different international locations, administration had problem getting real-time info to enhance effectivity and pricing. Once the brand new ERP system is in place, administration can act rapidly to enhance effectivity, and firm salespeople may have a better time understanding Stericycle’s full enterprise relationship with every company buyer.

Another leftover from Stericycle’s acquisitions is the complicated array of about 150 completely different normal container sizes for the gathering of hazardous medical waste, in accordance with Kosowsky. The firm plans to trim this quantity to about 20.

He additionally stated Miller’s determination to make some divestitures had helped Stericycle pay down debt.

Kosowsky stated Stericycle was nonetheless in “a risky state.” But he expects regular enchancment to the corporate’s revenue margin over coming years.

Three holdings which have improved their monetary efficiency

Hench named three holdings of the fund that had already turned the nook with operational enhancements.

• AAR Corp.
  AIR,
  +1.26%
  offers varied companies to authorities and business plane operators, together with fleet administration, elements, stock and restore, and in addition offers varied containers and shelters to be used throughout navy and humanitarian deployments. Needless to say, the corporate suffered in the course of the COVID-19 pandemic, and regardless that air journey has recovered, Hench nonetheless sees a runway for persevering with enchancment. There is a worldwide scarcity of recent airplanes, with rising demand. This means the air fleet is getting older, which is great for a corporation within the plane upkeep restore and overhaul enterprise. “Although it has moved up a lot, AIR is still a prominent part of our portfolio,” Hench stated.
• HealthStream Inc.
  HSTM,
  +0.48%
  offers outsourced coaching, certification and associated regulatory companies to the healthcare trade. “They provide software that allows you to go online and take a test, [access] training manuals or get certified online, or keep track of tasks at work, Hench said. He added that the stock trades at a lower valuation than many other SaaS (software as a service) companies. He said it was unusual for a value fund to hold shares of a growth-stage company, but that a valuation of 2.25 times estimated annual sales made this stock appear “really cheap.” He described HealthStream as a scalable enterprise that may not require main capital funding to proceed rising rapidly.
• Chuy’s Holdings Inc.
  CHUY,
  +0.21%
  runs a sequence of greater than 100 Tex-Mex eating places from its base in Austin, Texas. The firm is opening 10 to 14 new places annually, Hench stated. Chuy’s will not be a franchise operation — it owns all of its eating places. Hench stated the corporate’s senior administration is straight concerned with the opening of every new restaurant, that “the food is really good,” and that “they are particular about what they serve, how they serve and cleanliness.” At a ahead price-to-earnings valuation of 16.5 (primarily based on consensus earnings estimates amongst analysts polled by FactSet), Hench stated this inventory might be positioned within the “growth at a reasonable price” class. But he believes that P/E ratio might transfer up as the corporate retains rising.

Top holdings

Here are the highest holdings of the First Eagle Small Cap Opportunity as of Nov. 30:

Click on the tickers for extra about every firm.

Click right here for Tomi Kilgore’s detailed information to the wealth of knowledge out there without cost on the MarketWatch quote web page.

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