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Making the Right Calls

John Walthausen launched his namesake firm and first mutual fund just as the housing bust was unfolding. Prescient moves since then are getting him noticed by small-cap investors.

Rob Wherry, 07/24/2014

New York City is home to some of the mutual fund world’s largest players. But not every manager prefers Manhattan. There is a series of well-regarded investment firms that have chosen to set up shop in towns just north of the city, such as Purchase (Alpine Woods Capital Investors), Mount Kisco (DSM Capital Partners) and Cobleskill (Fenimore Asset Management). Geography hasn’t been a disadvantage. Technology keeps these firms wired-in to market happenings, and they certainly hold their own against their Big City counterparts when it comes to quality of management and performance.

Another such firm is Walthausen & Co., which has quietly built a reputation for keenly investing in small- and mid-cap stocks. It’s based in Malta, N.Y., a town about three hours outside of Manhattan near the Vermont border. John Walthausen founded his namesake firm in August 2007, after 13 years as a portfolio manager at Paradigm Capital Management. That tenure included a stint running Paradigm Value PVFAX between 2002 and 2007, a time when the fund gained an annualized 28.2% versus 16.9% and 17.9% for the small-value category and the Russell 2000 Value Index, respectively. The entire team that helped him generate that record followed him to the new firm.

Walthausen’s road to fund company founder is a familiar one in the industry. Many mutual fund managers have left established firms to go it on their own, including David Winters, who launched Wintergreen WGRNX after a long career at Mutual Series, and Dale Harvey, who used to run money at American Funds before forming Poplar Forest Partners PFPFX. The risk with taking this route is that the new firm toils in obscurity until it develops a track record, and even then assets can be hard to attract. Many firms fail.

“There is always an unknown that [a manager] may not be able to make it work,” says Steven Krawick, president of West Chester Capital Advisors in Johnstown, Pa. He has looked at the Walthausen funds but isn’t an investor.

John Walthausen and team have been able to avoid the pitfalls that have befallen other firms, despite some poor timing. The firm’s first fund, Walthausen Small Cap Value WSCVX, was launched in early 2008 just as the stock market was tanking. A poor first year can doom a new mutual fund. But the team navigated the downturn better than most peers and then posted outsized performance in the subsequent recovery, which attracted the attention of investors as it crossed the three-year mark near the top of the category rankings. The fund closed to new money in December 2012 after swelling to more than $550 million in assets. A second fund, Walthausen Special Value WSVRX, was launched in 2010. It has also met with success using similar investment criteria on stocks up the market-cap spectrum and remains open to new investors. Walthausen chalks up the firm’s early accomplishments to several factors—an experienced team and a sensible strategy focused on long-term performance being chief among them. The firm also thinks its small-town location can give it an edge.

“We like it up here. The team has been very stable,” says DeForest Hinman, the firm’s director of research. “We try to avoid situations where we may get into a group think. We like to shift our focus from how the next quarter will look to what could happen to this company over the next couple of years. That helps us make better judgments.”

Sailing into a Storm
In the first letter to shareholders, a manager would prefer to tout the fund’s success during its inaugural year versus having to explain away some disappointments. Walthausen had the unenviable task of describing both situations to his investors. Walthausen Small Cap Value lost 29.5% its first 12 months through Jan. 31, 2009, which looked terrible at first glance but was considerably better than the 36.5% loss for the Russell 2000 Value Index. Walthausen didn’t exactly do a victory lap.

“It is with little pleasure we report the [fund’s] performance,” he wrote. “As disappointing as that was on an absolute return basis, it is worth noting that the Fund did better than its benchmark.”

What gave the fund an edge was a strategy that emphasized quality stocks run by strong management teams. Walthausen and team use a bottom-up process that slightly varies depending on the industry. For example, an initial valuation screen will use price/book ratios to evaluate banks, enterprise value/EBITDA for technology companies and appraised value of reserves for energy companies. The team builds a portfolio of 75 to 100 stocks with market capitalizations between $100 million and $2 billion. It prefers companies with high returns on invested capital, a key marker for small companies since it shows management’s ability to smartly invest in the business. Balance sheet strength is also a critical component as is free cash flow generation. The team’s value bent means it wants to buy shares when they are trading at a significant discount to intrinsic value.

In 2008, that strategy translated into a fund that was overweight consumer-focused stocks— an average 21% of assets that year versus 15% for the Russell benchmark, according to Morningstar data—the team thought had products that would remain in demand even if consumer spending stalled. Stocks such as PetMed Express PETS, Monro Muffler Brake MNRO, and Family Dollar FDO were some of the fund’s best performers.

Another prescient decision was to largely limit the fund’s financial holdings to regional banks where the housing bust was subdued. Holdings First Financial Bankshares FFIN and Commerce Bancshares CBSH are regional banks with large operations in Texas and several states across the Midwest, respectively. It also helped that the fund avoided real estate investment trusts since those companies traditionally have low returns on invested capital. At the time, REITs made up almost 10% of the Russell index and were one of the worst performing sectors that year.

Heading into 2009, Walthausen thought the likelihood of the U.S. economy slipping back into another recession was unlikely, so he took profits in some positions (financials dropped to an average 15% of assets that year) and gradually raised the fund’s exposure to energy, basic materials, and consumer discretionary stocks, helping the fund gain 42% in both 2009 and 2010 as the rally kicked in. (The 2010 figure put it near the top of the small value category.)

More recently, the fund has cooled off a bit in terms of peer-group comparisons. Its 20.5% gain the past 12 months through April 15 landed it near the middle of the small-value pack. The fund saw its position in materials firm GT Advanced Technologies GTAT increase threefold the past year after the company announced a deal with Apple AAPL to supply certain iPhone components. Gains, though, have been countered primarily by poor stock selection in the consumer-cyclical sector.

Adding to the Lineup
As Walthausen Small Cap Value started attracting assets—it took in a net $167 million in 2010, according to Morningstar fund flows data— it became clear the fund may have to close at some point in the near future. Meanwhile, the team was interested in launching a second fund, one that was more concentrated and invested up the market-cap range. They were also hearing from clients interested in such an offering. That year, the firm launched Walthausen Special Value. The current portfolio has 40 holdings, each position roughly equal-weighted. The fund’s average market cap is $2.5 billion compared with $1.5 billion for the Small Cap Value strategy. Both funds, though, follow similar stock-picking strategies.

“We felt it wasn’t right to take a more concentrated approach [in the small cap value fund],” Walthausen says.

Again, Walthausen experienced a difficult inaugural year, this time due to concerns about the sovereign debt crisis in Europe and slow growth in the United States. He held the belief the U.S. economy would not fall back into recession. The new fund’s portfolio had an average 21% of assets in cyclical stocks its first year versus 13% for the Russell 2500 Value Index, and exposure to financials that was roughly in line with the benchmark. Insurance companies such as Proassurance PRA gained roughly 33% in 2011. But technology positions such as Vishay Intertechnology VSH were disappointments as shareholders bailed on stocks they thought would suffer from a dip in corporate IT spending. While the fund landed in the middle of the pack that year with a 2.7% loss, it has since remained near the top of the small-blend peer group. Walthausen’s stock-picking in the technology sector has been particularly strong the past 12 months. This fund also had a substantial position in GT Advanced Technologies. In addition, Lexmark International LXK performed well as the printer company reported decent earnings. Holdings in the consumer-defensive, financial-services, and healthcare sectors were also contributors.

He recently added Big Lots BIG, Mueller Industries MLI and Cooper Tire CTB to the portfolio. He re-established a position in Cooper after a busted acquisition agreement. He likes the tire company’s free cash flows and thinks it can regain market share.

Still Room for Improvement
While the performance of the funds is an attractive calling card for Walthausen & Co., one area where there is room for some improvement is expenses. At $40 million, it is understandable the Select Value’s 1.45% expense ratio is rated Above Average by Morningstar. The Small Cap Value fund, though, now has almost $850 million in assets, and its expense ratio is ranked Average by Morningstar. There are similarly-sized peers who charge lower fees. To its credit, Walthausen & Co. has been dropping the expenses as the fund has attracted assets.

Given that his name is on the door, Walthausen isn’t going anywhere any time soon. Indeed, he has more than $1 million and between $500,000 and $1 million of his own money in the Small Cap Value and Select Value funds, respectively. Despite having a stable staff supporting him, Walthausen remains the sole manager on both funds, which raises succession issues. The firm, though, has plans to use a more team-based approach in the future, an effort that is being spearheaded by Hinman.

Rob Wherry is a mutual fund analyst with Morningstar.

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