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By Laura Lallos | 01-31-2014 10:00 AM

Where to Find Small-Cap Winners

Growth and geopolitical concerns have mining and energy names looking attractive, while it's a good time to trim back on health care, says Heartland manager Brad Evans.

Laura Lallos: Hi, this is Laura Lallos. I'm a mutual fund analyst here at Morningstar. And today we have with us Brad Evans from Heartland. He is the lead manager on [Bronze-rated] Heartland Value Plus and comanages [Neutral-rated] Heartland Value, as well, two funds in the small-cap space.

Brad, thanks for joining us today.

Brad Evans: Great to be here.

Lallos: I know a lot of our viewers are interested in small and micro-caps right now. They had a fabulous run last year. I'm wondering if there's more value to be had there? What is your perspective?

Evans: I think Heartland is built on a process that has stood the test of time: our 10 principles of value investing. We are dyed-in-the-wool contrarians, and for that reason, there's always opportunity to find value in the marketplace. There are always going to be sectors that are really exciting and overvalued, and there are going to be sectors and stocks, in particular, that are deeply undervalued.

Today, as always, we're not having difficulty finding opportunities to put any money to work, and I would highlight areas like for-profit education and energy stocks as being areas that are very attractive today, as well as other sectors within the materials space. Gold mining is an example of an area that has been beaten up pretty meaningfully, as well. So, there is always opportunity for a contrarian to put money to work.

Lallos: You're mentioning some areas that people are quite fearful of right now, and you're venturing in?

Evans: We are. When you look at, say, certain sectors today like energy as an example, I know as we understand right now it's very unpopular place to be investing. There's a lot of fear about around geopolitical factors globally as well as commodity prices. You have to put that aside and look at the underlying values of what the companies are and what the opportunity set is. And we're able to find companies that are deeply undervalued on their earnings, their cash flows, their book values, and net asset values with good balance sheets. Those are really the valuation criteria that we're focusing on. So, we're able to find opportunity in energy, in particular.

Lallos: A name that we discussed earlier was Commercial Metals; steel being another area that other investors are shooing. You're seeing an opportunity.

Evans: Steel has been a terrible place to invest over the last few years. There are a lot of concerns, geopolitically again, concerns about Europe and China, and oversupply. There are opportunities to find value in areas that are hated, and that's part of our process.

I mean, Commercial Metals is an example. When we made our investment in the company, we found a company that was deeply undervalued on normalized earnings, undervalued on current cash flows, and trading near book value, with a rapidly improving balance sheet, very attractive debt profile and a low debt/EBITDA ratio, significant earnings power and free cash flow, and a catalyst, to boot, which would be an improving commercial construction cycle here in the United States and an industry that's a fairly rational oligopoly, competing against companies like Gerdau and Nucor.

It's a company that is just flying below the radar screen and not well-liked by the Street with fairly limited sell-side coverage. Again, our modus operandi is to really zig when the market zags and invest in lonely areas of the marketplace and be patient. We have a two- to three-year investment horizon, and Commercial Metals is a perfect example of a Heartland stock.

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