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Find hidden value in 'stocks under rocks'
Research from MBA candidates who roam the Deep South in search of undiscovered microcaps has helped Hancock Horizon Burkenroad Fund to market-topping returns.
By Timothy Middleton
Its summer, time to pull a frosty drink from the ice chest. They're so much colder that way. You can thank Packaged Ice (ICY, news, msgs) for that. The Dallas company is the nations largest producer of ice cubes.
It's also a hot stock. But Packaged Ice is locked into a deal with private investors to take out public shareholders at as much as $3.62 a share, and its already trading near that price. A minuscule mutual fund found it before the deal was announced. Packaged Ice is its biggest position, which is one reason the fund is beating the market this year.
Hancock Horizon Burkenroad Fund (HYBUX) learned about this Old Economy company 19 months ago, when it was trading for $1.09. The information came from students at Tulane University's A.B. Freeman School of Business. A finance professor at the New Orleans school has been nurturing the study of what he calls stocks under rocks for a decade.
Hancock -- not the mutual fund giant in Boston but a small bank in Gulfport, Miss. -- has exploited the students research to great profit for its investors. Last year, the minuscule fund beat the market by 21 percentage points, and this year it has spurted 16.2% as of July 8.
Were looking for small companies of good financial quality located in the Deep South that are covered by five or fewer analysts, says David Lundgren, the funds manager. He doesnt rely totally on the Tulane program for his ideas, but a majority come from there, including all the top positions.
Exploring the region
These are companies with little or no exposure on Wall Street, says Peter Ricchiuti, the Tulane finance professor who has run the university program -- named the Burkenroad program for a benefactor -- since stepping down as Louisianas chief investment officer 11 years ago. They're small, with market capitalizations less than $1 billion, and often closely held. Very often, we are the first people to follow them, he says.
Microcap companies are fraught with risk, and no more so than in Louisiana, which is dominated by the natural-gas industry. Some 21% of the mutual funds assets are invested in energy companies. But Ricchiuti has an answer for that. These can trade very thinly and are highly volatile, so probably the best way to own them is as a group, he asserts.
Ibbotson Associates of Chicago has found that microcap companies have delivered the best returns since before the stock market crashed in 1929. Microcap funds have consistently dominated the small-cap growth group, as Ive noted in this column before. The best of them are closed to new investors. Burkenroad Fund, with only $2.1 million in assets, is open.
Tulanes students unearthed Packaged Ice from among about 600 publicly owned companies headquartered in six states from Texas to Georgia and Florida. They track 44 of them, issuing complete reports, including buy/sell recommendations, annually. The mutual fund, which isn't associated with the university, owns about 30 of them, as well as 25 other stocks that Lundgren selects on his own.
But the Tulane students dominate. All five of the funds top positions -- Packaged Ice, Sanderson Farms (SAFM, news, msgs), Craftmade International (CRFT, news, msgs), EnergySouth (ENSI, news, msgs) and MidSouth Bancorp (MSL, news, msgs) -- came from Burkenroad Reports, which began publication in 1993. The university claims 16,000 subscribers to the reports and says more than 300 of its graduates have landed jobs on Wall Street.
Just a quick plane ride away
Ricchiuti says that when he was with the state of Louisiana, he was frustrated by the paucity of information about small local companies. When he left for his professorship, he started the research reports to meet that need. When he got financial backing from an alumnus, he expanded the research throughout the Deep South. We follow companies we can drive to or theres a cheap Southwest (Airlines) ticket to, he says.
Most of the students are in the universitys MBA program, but some undergraduates chip in, as well. Although energy dominates the list -- which with the nation facing a natural-gas shortage isn't a liability now -- the researchers go beyond that sector. Ricchiuti says his students were the first to uncover SCP Pool (POOL, news, msgs), the Covington, La., distributor of things, from diving boards to ladders, used in the swimming-pool industry.
Wall Street doesnt know how to analyze a company like this, the professor says. It doesnt seem to fit anywhere. Do you put it with recreational vehicles and other leisure goods, or in wholesaling and distribution? Its difficult to find peers for them.
The stock, which is owned by the mutual fund, is trading near its 52-week high of $34.86 and has spurted more than 13% in the last three months.
Hancock, meanwhile, had a tiny stable of generic -- income, value and growth -- mutual funds when it seized on the Burkenroad approach to make a name for itself. Lundgren was assigned to run it when it was launched at the end of 2001.
In addition to Burkenroad names, Lundgren uses other Wall Street research to round out a group of 50-plus microcap companies. But diversification remains spotty. The fund owns virtually no technology names and has only 4% of assets in health care. After energy, the largest sector bets are in business services, finance, consumer services and industrial materials.
Letting performance sort them out
Lundgren places roughly equal bets on each name in the portfolio, allowing performance to settle out which positions become the largest. The current leaders have edged out names such as Newpark Resources (NR, news, msgs), a gas-field-services company, and Kirby (KEX, news, msgs), a marine transporter, though they remain in the portfolio.
Turnover is low, in the range of 30%, implying an average holding period of more than three years. Some of the turnover has come from takeovers; four of the funds names, including now Packaged Ice, have been taken out by acquisition or buyout.
One thing about these companies is that management and owners a lot of times are the same people, Lundgren says. The people running the company have done it for a long time, and they tend to have low debt and simple balance sheets. We dont have a lot of concern about accounting funny business going on with these corporations.
Many of the names are penny stocks, defined as those trading under $5 a share, but most aren't. Lundgren estimates 80% of the portfolio is invested in stocks that cost $10 a share or more.
But penny stocks can be the funds Achilles heel. Last summer the fund bought a small position in Piccadilly Cafeterias (PIC, news, msgs), and immediately began watching the share price wither. "They were having some cash-flow problems and the relative strength of the stock dropped pretty dramatically," Lundgren says. Four months after buying the shares around $2.50 each, the fund sold them around $1.25 each. Currently they trade at about 33 cents a share.
Regional investing like this has a spotty record. One of the best big-cap funds, period, is Mairs & Power Growth (MPGFX), which is based in St. Paul, Minn., and invests strictly in the upper Midwest. But funds investing in Californias booming economy found trouble in the bear market as technology melted down.
Hancock Horizon is, moreover, a load fund family, and the A shares of the Burkenroad fund carry a 5.25% front-end load. So its popularity with self-directed investors is limited.
But the appeal of undiscovered stocks is perpetual, and funds that can find them are rare. Moreover, as Ricchiuti says, stocks like these are best owned in a bunch. So far, Burkenroad is an attractive bunch of Southern flowers.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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