This stock-fund manager outperforms with 'fixer-uppers'

By Philip van Doorn

A company with a temporary problem can be a bargain opportunity for long-term investors in the stock market

Small-cap stocks can help investors diversify from the S&P 500, which is heavily weighted to the largest U.S. tech players. Investors may imagine small-caps as up-and-coming companies focused on increasing their sales and taking market share from rivals, or ones facing binary events, such as drug trials, that can set up windfall profits.

But Bill Hench, the head of small-cap investing at First Eagle Investments, takes a value approach, looking for companies that need to be fixed.

"We look to get a dollar of assets for less than a dollar," he said during an interview.

A small-cap veteran

Hench is the head of the Small Cap team at First Eagle Investments in New York and portfolio manager of the $1.7 billion First Eagle Small Cap Opportunity Fund FESCX. He has been following a value strategy since 2002 when he was working at Royce Investment Partners. He and his team joined First Eagle in April 2021 - the same month that the First Eagle Small Cap Opportunity Fund was established.

From that date, the fund's institutional shares were down 1% through Friday, net of expenses, which was in line with the performance of the Russell 2000 Value Index XX:RUJ, but ahead of the 10% decline for the full Russell 2000 RUT.

Needless to say, this period hasn't been a good one for small-caps. Since the First Eagle Small Cap Opportunity Fund is less than three years old it doesn't yet have a Morningstar rating.

Brett Arends: These small-cap managers' stock picks crushed the indexes last year - again. Here's what they're buying now.

But Hench had a solid long-term performance record at Royce - the Royce Opportunity Fund RYPNX, which he co-managed, had a 15-year return of 296% through March 2021, compared with returns of 191% for the Russell 2000 Value Index and 256% for the full Russell 2000.

Identifying bargains

Hench takes a broad approach, typically holding shares of between 180 and 300 companies. He and his team typically identify companies whose shares are trading low to book value or revenue not because the companies are little-known in the market, but "because something is wrong."

"We look for companies that experience difficulties in the short term, which is normal. Sometimes it is their mistakes, sometimes it is the economy," he said.

Hench doesn't consider companies' price-to-earnings valuations when making initial purchase decisions because the companies aren't as profitable as he believes they can become.

"We look for cheap and a reason they will get back to normal," he said.

He also believes the word "quality" is overused in the investment community. "The term may be used when an investor overpays," he said. The idea is that you might be willing to pay a high price for stability, but you also might take advantage of lower prices, because for most companies "things are not always great all the time."

Looking back to the early phase of the COVID-19 pandemic, Hench said: "You had traditional growth stocks selling at similar valuations to value stocks. Back then, you were able to buy things like Dunkin' Donuts or Texas Roadhouse (TXRH), which were typically in value funds at low multiples and they got back to where they had typically sold, which is where we exited."

Hench said about a third of the companies in the portfolio are maturing and have been held for about a year and a half because they are improving as he expected. Another third "have just made the turn, with fundamentals getting better or the economy at their backs," and the remaining third includes companies "in the thick of it," or improving as the worst of their problems have abated.

"Everything in the portfolio goes in there because there is something wrong, something not working," he said. "If we think they have a good shot at fixing it, we will take a position. Then we do maintenance, to make sure of the progress we want" he said. As he gains more confidence in a company's progress, he will add to a position. He will sell it if the expected improvement isn't taking place. Once a company is far enough through the cycle of improvement for the shares to have reached what Hench believes to be their fair value, he will sell. "These things take time to work out," especially if one of the companies he invests in has a new management team, he said.

A current fixer-upper

Rob Kosowsky, an associate portfolio manager on Hench's team provided an example of a holding that can still be considered a fixer-upper because of operational problems: Stericycle Inc. (SRCL).

Stericycle's main business is the collection and disposal of hazardous waste from hospitals and other medical facilities. It also provides document shredding services.

Kosowsky said Stericycle was formerly "a Wall Street darling" as it acquired hundreds of smaller competitors from 2000 through 2015. While this "classic roll-up" built a large revenue stream, it caused the company's profit margins to tumble "because it had never been fully integrated."

Cindy Miller became Stericycle's CEO in 2019, following a 30-year career at United Parcel Service. Since then, she has been leveraging her logistics background "to simplify the business and improve margins," Kosowsky said.

Since the acquisitions hadn't been fully integrated, "there was an outdated and incohesive enterprise resource planning system," he said. This meant that while trying to route trucking fleets across the U.S. and in 16 other countries, management had difficulty getting real-time information to improve efficiency and pricing. Once the new ERP system is in place, management can act quickly to improve efficiency, and company salespeople will have an easier time understanding Stericycle's full business relationship with each corporate customer.

Another leftover from Stericycle's acquisitions is the confusing array of about 150 different standard container sizes for the collection of hazardous medical waste, according to Kosowsky. The company plans to trim this number to about 20.

He also said Miller's decision to make some divestitures had helped Stericycle pay down debt.

Kosowsky said Stericycle was still in "a risky state." But he expects steady improvement to the company's profit margin over coming years.

Three holdings that have improved their financial performance

Hench named three holdings of the fund that had already turned the corner with operational improvements.

AAR Corp. AIR provides various services to government and commercial aircraft operators, including fleet management, parts, inventory and repair, and also provides various containers and shelters for use during military and humanitarian deployments. Needless to say, the company suffered during the COVID-19 pandemic, and even though air travel has recovered, Hench still sees a runway for continuing improvement. There is a global shortage of new airplanes, with rising demand. This means the air fleet is getting older, which is wonderful for a company in the aircraft maintenance repair and overhaul business. "Although it has moved up a lot, AIR is still a prominent part of our portfolio," Hench said.HealthStream Inc. HSTM provides outsourced training, certification and related regulatory services to the healthcare industry. "They provide software that allows you to go online and take a test, [access] training manuals or get certified online, or keep track of tasks at work, Hench said. He added that the stock trades at a lower valuation than many other SaaS (software as a service) companies. He said it was unusual for a value fund to hold shares of a growth-stage company, but that a valuation of 2.25 times estimated annual sales made this stock appear "really cheap." He described HealthStream as a scalable business that would not require major capital investment to continue growing quickly.Chuy's Holdings Inc. CHUY runs a chain of more than 100 Tex-Mex restaurants from its base in Austin, Texas. The company is opening 10 to 14 new locations each year, Hench said. Chuy's is not a franchise operation - it owns all of its restaurants. Hench said the company's senior management is directly involved with the opening of each new restaurant, that "the food is really good," and that "they are particular about what they serve, how they serve and cleanliness." At a forward price-to-earnings valuation of 16.5 (based on consensus earnings estimates among analysts polled by FactSet), Hench said this stock could be placed in the "growth at a reasonable price" category. But he believes that P/E ratio could move up as the company keeps growing.

Top holdings

Here are the top holdings of the First Eagle Small Cap Opportunity as of Nov. 30:

   Company                              Ticker   % of the First Eagle Small Cap Opportunities Fund 
   Air Lease Corp. Class A                AL                                                 0.83% 
   Goodyear Tire & Rubber Co.             GT                                                 0.81% 
   Chefs' Warehouse, Inc.                CHEF                                                0.81% 
   Tenet Healthcare Corp.                THC                                                 0.81% 
   AAR Corp.                             AIR                                                 0.80% 
   Louisiana-Pacific Corp.               LPX                                                 0.80% 
   Stewart Information Services Corp.    STC                                                 0.80% 
   QuidelOrtho Corp.                     QDEL                                                0.79% 
   Alaska Air Group Inc.                 ALK                                                 0.76% 
   Herc Holdings Inc.                    HRI                                                 0.74% 
                                                                   Source: First Eagle Investments 

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