Small Stock Fund Provides Safe Haven Amid Trade War
“Small-caps have the wind at their back,” said Sandy Villere, one of the portfolio managers of the New Orleans-based Villere Balanced Fund (VILLX). “Small caps are not as exposed as large-caps. Every time the market is up or down it’s trade policy related, not Fed (U.S. Federal Reserve Bank) related. Small-caps have the wind at their back with deregulation, lower corporate taxes and this trade war. “
President Trump’s calls for tariffs on imports have led to retaliatory moves by other countries, ramping up trade frictions. This sent the S&P 500 Index, the barometer for the market of large-capitalization stocks, down 1% last week and 1.4% on Monday, June 25 to 2,717.07. It was the index’s worst day since April 6, when it fell 2.19%.
“Five of the 11 S&P 500 sectors also closed in correction, or down at least 10% from their 52-week high,” according to CNBC.com.
Meanwhile, the Russell 2000 Index, the benchmark for the small-capitalization market was flat last week, up 0.1%, but sank 1.7% on June 25. Go figure.
Villere’s Balanced Fund owns small-cap companies, less than $5 billion market cap and mid-cap stocks, less than $10 billion. It’s up 9.7% year-to-date through June 25. It’s not just beating its Morningstar category, the Moderate Target Risk Group, which was down 0.43% year-to-date, but it was also beating the S&P 500, which was up 2.6%, and the Russell 2000’s gain of 8.54%.
Not bad for a fund that holds between 25% and 40% of its portfolio in short duration bonds. These are currently corporates near the low end of the investment grade and some junk bonds to maximize returns.
Balanced funds typically hold both stocks and bonds as a total diversified portfolio in one package. The stocks give the growth and the capital appreciation you want when the market moves higher. Then when the market contracts, the bonds are supposed to temper the losses by offering a negative correlation. However, this negative correlation can dampen the fund gains. So, it’s a bit of a low volatility mutual fund for the high volatility small-caps.
If you want to see how it tempers gains and losses, compare it to the other fund Villere co-manages. The Villere Equity Fund (VLEQX) is up year-to-date 12.2%, 25% higher than it’s brother fund. However, in 2015, Equity plunged 11.2%, 37% more than Balanced, which fell 8.2%. So, more risk, more return.
The Balanced Fund has outperformed its Morningstar benchmark over the 1-year, 10-year and 15-years on an annualized basis, but underperformed over the 3-year and 5-year periods.
This plays into Villere’s strategy. He looks for good, cheap companies flying under the radar with a growth rate higher than their price-to-earnings (P/E) multiple. If earnings are growing at 15%, then he wants to buy the stock at a discount to the growth rate, around a 12 multiple, or a price-to-earnings-to-growth rate, or PEG ratio, of less than 1.
The fund holds about 23 companies for least five years on average. The annual turnover is between 15% and 20%
“It’s a very concentrated small- to mid-cap fund,” said Villere. “It’s a balanced fund on steroids.”
Currently, the fund has $288 million in assets under management, and charges an expense ration of 0.94%, similar to an active ETF.
Is Villere right that this could be small stocks’ year? They’ve been flying under the radar, while large-caps have gotten all the attention and most of the gains. Now with the tariffs attacking multinationals, stocks that are focused on the domestic market have the advantage. He’s been holding his favorite picks, now he’s waiting for them to break out.
“In general, we think five minutes talking about the economy is five minutes wasted,” said Villere. “We roll up our sleeves and look at earnings. If we can be right on where a company is going in three to five years and watch those earnings improve. We’re not top-down oriented on what Trump is doing, because it could all change tomorrow. It doesn’t bother me not knowing where the policy is going. If you have great companies with moats around them, high barriers to entry, they can do well in any environment.”
One of his recent best performers was Axon Enterprise (AAXN), formerly known as Taser International, the maker of electric stun guns. The company is moving into other products for law enforcement and the military. Villere especially likes the growth prospects for the company’s body-warn cameras, or BWCs.
He said the company is giving the cameras to police departments for free in exchange for the contracts to store the information.
“The future is bright for these guys,” said Villere. ” The departments pay a monthly fee, and all the profitability is in the storage and the website. In the meantime, the stun guns provide the cash flow to support the body camera initiative. We owned Taser for four years and it didn’t do much. Then went from $18 to $68 in 18 months.”
“We’re willing to buy-and-hold,” said Villere. “We’re patient, watch the earnings come in, visit the CFO, watch it happening, then boom the price goes up.”
He likes LKQ (LKQ), a Chicago provider of refurbished and recycled auto parts sold to insurance companies that need to fix cars as part of their policies. Villere says the company’s acquisition of Stahlgruber, a German distributor of aftermarket spare parts and equipment has weighed on shares, making them a great opportunity.
In 2017, LKQ earned $120 million, on revenue of $2.5 billion, a 40% increase over the previous year.
“We think the shares are temporarily out of whack,” said Villere. “They think they can improve their earnings before interest taxes, depreciation and amortization, (EBITDA) margins. I think it’s going to blow people away. I can see a year from now. You can make 40% on your money.”
He also likes Howard Hughes (HH), a Dallas-based real estate company, which is the landlord for New York City’s South Street Seaport.
“They’re a land bank,” said Villere. “They’ve got all this acreage everywhere and they are going to keep building it out. People don’t realize the assets they have, 28,000 acres north of Houston, in the Woodlands. Their major tenant is Exxon and it’s an entire community with all kinds of retail and restaurants. It’s a little city.”
For the first quarter, Howard Hughes earned $1.8 million, on revenue of $161 million, down from $5.6 million on $232 million, in the same quarter last year.
In it’s May 1, earnings release, the company said, “During the first quarter of 2018, our total revenues were $161.7 million, a decrease of $70.1 million compared to the first quarter of 2017, driven by a decline in our Strategic Developments segment primarily due to a required change in accounting method as to how we must now recognize revenue in our condominium projects. We adopted the new revenue recognition standard on January 1, 2018, as mandated by the Financial Accounting Standards Board for all public companies. The adoption mandated a change in revenue recognition for our condominium sales from percentage of completion to recognizing revenue and cost of sales for condominiums only after construction is complete and sales to buyers have closed. This change relates only to the timing of revenue recognition and will more closely match the actual cash flows from the sale of units. As a result of this accounting change, condominium revenue will be recognized later than it previously had been and will be lumpier as revenue will only be recognized as unit sales close. The substantial majority of our closings have occurred at the time of building completion as a result of presales and units sold while construction is under way. The reduction in revenue from this accounting change and lower MPC land sales during the quarter were partially offset by higher hospitality revenues, increased minimum rents and other rental and property revenues.
Because we have two condominium buildings that have not been delivered, but for which revenue has been previously recognized, we have made a downward adjustment to our cumulative retained earnings of $69.7 million. We will recognize the revenue on these units as the buildings are completed and the unit sales close.”