Look for Cash Flow in Small-Cap Stocks

John Coumarianos: Hi, this is John Coumarianos, Senior Mutual Fund Analyst at Morningstar, and I'm very happy to be joined at our conference this year by Manager, Steve Scruggs, who manages the Queens Road Value Fund and the Queens Road Small Cap Value Fund.

Thanks so much for joining us here in Chicago today.

Steve Scruggs: Thanks a lot, John. It's nice to be here.

Coumarianos: Great. Steve I wanted to start with the small cap fund because that's the one you started initially and I know your passion lies with small cap value stocks. Your style is really to choose a lot of niche companies that are very high cash generators, but you complement them here and there with companies that are really more asset plays, who aren't generating cash yet but should be in the future. Give us an example of each kind of stock that you have in the portfolio?

Scruggs: Okay. And that's exactly right. The core portion of the portfolio is in high generating cash flow firms. A good example of that would be Hurco Industries. They are a machine toolmaker. They sell machines that make tools and dies and molds. They have a bulletproof balance sheet. They have fabulous products, good management and as you can imagine that industry right now is really hurting. They are near the bottom of the cycle.

We hope that things – things have been picking up, but they do generate for the size of the company enormous cash flows and its one of the larger holdings in the portfolio.

Coumarianos: And then one of the asset plays, well you own a couple, I think that could qualify there. One is the Hilltop Holdings. Tell us about that?

Scruggs: That's another atypical member of our portfolio. They used to primarily sell modular home insurance in Texas. They still do that to a small degree, but basically it is a blank check company type situation, which would usually we're not big fans of– usually pretty scared of those, but the kicker is that the Chairman of the company is Gerald Ford of S&L fame, who is a very shrewd, well-connected, long-term member of the banking community.

Coumarianos: Of course, he made a fortune back in the S&L crisis in the '90s?

Scruggs: He did. And I hope that he is going to make another fortune in this crisis and we're going to be able to participate with him and that he is a very large owner of the equity. We're competing with him. He has a private equity firm as well that's doing the same thing and they've announced some purchases, but I think there is going to be enough good assets that FDIC is going to be willing to subsidize that I think he'll make some shrewd investment there that are filtering out for us.

Coumarianos: One more of the typical plays if we might do. A new holding looks like prestige brands if you could talk about that a little bit?

Scruggs: Yeah, we've been buying that throughout the year. Again as a company that generates lots of free cash, discretionary cash flow, they don't have to put a lot of capital back into the company. It's a consumer brands company. They have a broad portfolio. They would make a nice acquisition for a larger consumer products company, especially at the current valuation. But again it has the attributes that we'd like to see. It's a cash generating business with little capital need, a good management, a very broad array of brands.

They spin well to support their brands, but as I say it's not capital-intensive. So it creates a lot of free cash flow for the owners of the firm.