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Small-Cap Banks Might Be at Inflection Point

Greg Carlson

Greg Carlson: Hi. My name is Greg Carlson. I'm a mutual fund analyst with Morningstar. I am joined today by Mark Roach. He is the comanager of the DWS Dreman Small Cap Value fund. Mark, thanks for joining us today.

Mark Roach: Thank you, Greg.

Carlson: Now, I want to tackle a few topics while we have a chance. One of the things I want to touch on before we get into the portfolio's positioning is can you talk a little bit about the fund's recent relative underperformance? I mean, it's posted pretty nice absolute gains in 2010 and '11, but it's lagged the small fund category a bit.

Roach: Absolutely. It has lagged a little bit. And the reason for that is a couple of things that are a little bit out of our control, including some market-cap and valuation perspectives in the marketplace that have been a headwind for us rather than a tailwind. If you look at the high-multiple names in the Russell 2000, they have actually outperformed the low-multiple names, which is akin to our process and philosophy day in and day out.

In addition, compounding that is the stocks under $300 million, the most illiquid names in the market place. Again, these are names you really can't invest in because of the liquidity constraints that are imposed on any portfolio manager, but they have actually been leading the market, as well. I think those two factors have compounded to hurt us against the benchmark relative and against the Russell 2000.

We've also seen a couple of our names that have had some temporary overreactions in the marketplace. One name in particular, Medisys, has hurt the portfolio as the firm was under investigation for some Medicare reimbursements. We've taken that opportunity to double down on the stock and we've since lowered our cost basis to around $21, and the stock is currently trading around $29 today. So, again, we think that will be a name that will come back and help us down the road in about the next 18 to 24 months.

Carlson: You also mentioned earlier that there have been a couple of companies that have been big winners, but you've had to dissolve them as they have exceeded your market-cap limit?

Roach: Absolutely. We have a strict $4 billion market-cap limit, so when our stocks do perform well, we've ended up selling those stocks maybe a little too early. A stock like IAMGold, which we sold at $4 billion, went on to become a $8 billion company. So we've seen some of that, as well, hurt the performance of the product, in that we've had to sell our winners a little too soon, just given the great opportunities we had to buy them. Joy Global, which we bought at the beginning of 2009 was another big winner. When it reached $4 billion, we were moving it out of the portfolio, and it since has moved on to a $7 billion, $8 billion, $9 billion market cap. Again, it was another double that we were not able to fully participate in on the small-cap side.

Carlson: But that phenomenon has in turn helped your mid-cap fund?

Roach: Absolutely. Our mid-cap fund has been able to invest in that, and we've been holding onto those names as well. So, it certainly helped our SMid and our mid-cap products, as well.

Carlson: Now, we should talk a little bit about the portfolio's positioning. I think it's pretty interesting, as you mentioned, the fund has invested substantially in technology during the last year or two, and obviously, your firm as many people who know it, has not invested much in technology over the years.

Roach: Absolutely. It's very rare for a value manager, especially the value manager, to find opportunities in the tech space, but when you look back at what has been moving the market, especially this year, that's been one of the areas that's been an outperformer. But if you rewind to sort of the beginning of 2010, we've been finding a lot of opportunities in that space, whether it be NCR which makes ATMs; that stock's up 35% year to date.

So, again, we look for those types of names where they are not exactly high-tech names and cutting-edge. One of the names that we owned in 2010, Jabil Circuit, which is a contract manufacturer, one of the first movers in a inventory rebuild to move quickly. We bought that stock very nicely in the low single digits, midsingle digits, and it moved into the mid-20s and so forth. So, we found some great opportunities and unique opportunity sets in technology trading at very attractive valuations; in some cases, single-digit multiples, which we haven't seen in quite some time.

Carlson: I think you also mentioned there could be some more takeouts?

Roach: Absolutely. I think when you look at the cash-rich larger caps and mid-cap names that are looking for growth and to get into a particular area, they need to either build from scratch, which can take them several years to do or they can make an acquisition for somebody that has a strong market share position. We've seen that with Intel buying some of the security firms. So, we think that trend is going to continue, as a lot of these technology firms continue to have very strong balance sheets, they're very cash-rich, and they're looking to grow their opportunity set for investments during the next couple of years.

Carlson: Maybe we should also touch on the fund's growing position in banks. Now, with small-cap banks, I know you successfully avoided a lot of them in the past, and the fund held up a bit better than average in the bear market, for example, partially due to that.

Roach: Absolutely. We have been pretty bearish on all the financials since '06 and '07 in particular, when we were taking advantage of some of the bubble period to liquidate some of our positions there, and we've been bearish ever since on the banks, attesting to no real definition of what the capital requirements are going to be.

What we started to notice is that the banks have become much more efficient and that their returns on assets have started to improve. We think that could lead to some better valuations down the road, as we get centered around what the government's going to do from a capital perspective and what the capital requirements are going to be, but also what the leverage is going to be. But we're seeing a 20- to 30-basis point improvement in some of the banks.

In particular, there's also a couple of banks out there that we own in our portfolio, that the FDIC has come in and asked them to make some FDIC-assisted acquisitions. So, the government's taking a chunk of the portfolio losses on its shoulders and allowing the banks to make very accretive acquisitions, grow their market share, and expand their footprint in a very attractive way with very good return perspective coming with these acquisitions.

So, from our perspective, we think the banks, while we're still underweight, might have had an inflection point near the bottom here. We're not necessarily calling the bottom right now, but it looks to be improving from where it has been, and so we've been adding to our position there.

Carlson: So, you would say probably that this is still in the very early stages and you've probably taken a pretty long-term view here?

Roach: Absolutely. It's a very long-term view. We tend to take a three- to five-year time horizon when we make our investments. We don't turn the portfolio over. It's typically between 30% and 50% turnover a year. So, when we make an investment, we're definitely making it for the long term.

Carlson: Can you also provide a little clarity for us or for people who may not know the inner-workings of the firm? David Dreman obviously founded it a long time ago. He's led the effort on large-cap portfolios ever since then. He has a very long and successful track record there. On the small-cap side, he's been less involved, but also he's been scaling back his role recently.

Roach: Absolutely. I think David is still very involved with the firm. He is the chairman of the organization. He's very engaged on a day-to-day basis, but in terms of his managing of the portfolios, he runs a quantitative product, The Over-Reaction fund, and he continues to run the High Opportunity mutual fund. Cliff Hoover, back in September, took the sole chief investment officer role, and then back in September, David sold a portion of the firm to Cliff and myself. So we collectively own about 25% of the firm today, and that will be growing during the next couple of years. David will be diluting down to about 50% or 55% when it's all said and done.

So, again, from a transition standpoint, in 2006, David looked to find the what you might call a second-generation of contrarians at his shop. He hired Cliff and myself to come in, and we've been working shoulder-to-shoulder with him, growing the business together ever since then.

Carlson: Thanks very much, Mark.

Roach: Thanks, Greg.