Investor Alert

Aug. 19, 2017, 10:42 a.m. EDT

This fund manager finds contrarian bargains among ‘smidcaps’

Westwood SmallCap Fund favors consumer-oriented names, energy

By Michael Brush, MarketWatch

MarketWatch photo illustration/Getty Images, Bloomberg

Pity the poor small-cap investor.

Large-cap names have been ripping higher, pushing the S&P 500 (S&P:SPX)   up 10% so far this year and leaving small and midcap stocks in the dust. The Russell 2000 (USA:RUT)   is only up about 2%.

This tells me that “smidcap” land is a good place to look for relative value and contrarian bargains in what otherwise looks like a fully priced market.

Who better to turn to for some guidance here than a fund manager with a great record in the space: Matt Lockridge of the $213 million Westwood SmallCap Fund (NAS:WHGSX) . At a time when around 80% of active managers sorely underperform benchmarks, his funds beats its competitors — small-cap blend funds tracked by Morningstar — by 2.2 and 3.4 percentage points annualized over the past three and five years, respectively, according to Morningstar.

But first, does it even make sense to think that smidcap stocks can make a comeback? Lockridge has a bias, of course, but he offers a compelling case.

Both large-cap and smidcap names recently traded for the same valuation, or 17.4 times forward earnings, using the S&P 500 and the S&P 400 as proxies for each group. But smidcap stocks have a higher projected annual earnings growth rate — 12.6% compared to 11%. “That alone should start attracting interest in the small caps,” says Lockridge.

Smidcaps will also get a bigger boost from any tax reform that lowers the corporate rate (as promised by President Trump), since they generally pay higher taxes. Plus if inflation picks up, that will help smaller companies because they tend to run leaner. So more of the revenue gain drops to the bottom line.

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So where’s the best value in smidcap land? Lockridge’s fund is overweight consumer-oriented names, energy, and the basics like industrials and materials. It’s underweight utilities and financials, though it did add a bank in the second quarter, a Mississippi-based regional lender called Renasant (NAS:RNST) .

Why this skew? “Our portfolio is a snapshot of where our analysts are collectively finding value,” he says.

Here’s a quick guide to a few of the fund’s longer-term holdings that Lockridge thinks will recover from recent selloffs as well as to fresh positions added in the second quarter.

Sidestepping the ‘Amazon effect’

Chains like Macy’s (NYS:M) , Target (NYS:TGT) , Dick’s Sporting Goods (NYS:DKS) , and J.C. Penney  have been slammed due to the “Amazon.com (AMZN) effect.” The online juggernaut is steamrolling these old-school retailers.

But Lockridge and his team aren’t adding any beaten-down brick and mortar names. “There may be opportunity for a bounceback trade. But longer term, it is a difficult place to invest,” he says. “Amazon is arguably the most disruptive company in my lifetime. There is a secular change going on.”

Read: These two companies are the biggest disrupters of our age

To gain exposure to the consumer, Lockridge favors companies that aren’t in Amazon’s crosshairs. He likes businesses that sell experiences, such as Marcus (NYS:MCS) , which operates movie theaters and hotels in small cities and towns. It’s been a tough summer for movie theaters given the dearth of hits. But that will change, he says, because Hollywood has always bounced back from lulls in the past.

Meanwhile, Marcus is upgrading theaters by adding reclining seats and better food to lure in more customers. In hotels, it’s moving to a franchise model, which should boost profit margins.

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He also likes those that have powerful brands in a niche space or offer snacks on the run, such as Sonic . Shares of the burger chain are down in part because McDonald’s (NYS:MCD)  is making such a comeback. But like McDonald’s, Sonic has a powerful brand and an asset-light model. Most of its stores are franchises. This brings higher margins, and should support a higher stock valuation, in time.

He favors J&J Snack Foods (NAS:JJSF) , which offers snacks and drinks like soft pretzels and Slush Puppies sold at convenience stores, sports venues, theme parks and movie theaters. Lockridge likes the potential for earnings and margin growth, and the big stake that CEO and founder Gerald Shreiber has in the company. “This is one of the best little food companies you never heard of,” he adds.

Finally, he likes ongoing market share gains by Hostess Brands (NAS:TWNK) , the maker of Twinkies, which started trading as a public company again in late 2015 after emerging from bankruptcy.

Energy stocks

Permian Basin energy plays were hit following what investors considered dismal results. I disagree with that view and so does Lockridge. He’s been buying here because it’s the best part of the oil patch.

Lockridge’s favored names in this space include Callon Petroleum (NYS:CPE) , his fund’s biggest position as of the end of June; Resolute Energy , the second-biggest position; and SRC Energy , the sixth-largest. A position added in the second quarter is Rosehill Resources (NAS:ROSE) .

Matt Lockridge

Industrials and materials stocks

These businesses should do well if we see continued economic growth, which Lockridge expects. One reason: Increased capital spending because business leaders are more confident. “There will be less regulation going forward, and that’s a big deal,” he says. He also cites increased government spending, possible tax reform, and moderate Fed rate hikes. “That all speaks to a pretty good environment.”

Here, he singles out Kaman (NYS:KAMN) , which sells parts used in aerospace and defense. In addition, the fund in the second quarter added positions in Albany International (NYS:AIN) , which sells textiles and materials used in cars and planes; Universal Forest Products (NAS:UFPI) ; , which sells insulation and filtration materials used in cars; Gibraltar Industries (NAS:ROCK) , which makes building products; and Innospec (NAS:IOSP) , which offers fuel additives and chemicals used in energy production and personal care products.

Industrials and materials stocks have done well this year. They are up 9% to 10%. But Lockwood says these are some of the cheaper ones in the group.

Here are the 10 largest holdings of the Westwood SmallCap Fund as of June 30:

Company Ticker Market capitalization ($mil) EPS - most recent reported quarter EPS - year-earlier Change in EPS Sales ($mil) - most recent reported quarter Sales - year earlier Change in sales
Callon Petroleum Co. (NYS:CPE) $2,026 $0.16 -$0.61 N/A $82 $45 82%
Resolute Energy Corp. $599 $0.47 -$2.44 N/A $71 $35 101%
Douglas Dynamics Inc. (NYS:PLOW) $770 $0.64 $0.72 -11% $139 $114 23%
Glacier Bancorp Inc. (NYS:GBCI) $2,673 $0.43 $0.40 7% $122 $113 8%
Apogee Enterprises Inc. (NAS:APOG) $1,456 $0.56 $0.61 -8% $272 $248 10%
SRC Energy Inc. $1,609 $0.14 -$0.89 N/A $75 $24 213%
Continental Building Products Inc. $843 $0.32 $0.31 3% $121 $117 3%
Summit Materials Inc. Class A (NYS:SUM) $3,075 $0.46 $0.21 122% $524 $445 18%
Comfort Systems USA Inc. (NYS:FIX) $1,216 $0.48 $0.47 2% $465 $428 9%
Kaman Corp. Class A (NYS:KAMN) $1,384 $0.48 $0.59 -19% $449 $471 -5%
Sources: Morningstar, FactSet

You can click the tickers for additional information, including valuation ratios, charts, ratings, filings and financials.

Michael Brush is a Manhattan-based financial writer. At the time of publication, he had no positions in any stocks mentioned in this column. He has suggested M, TGT, AMZN, MCD, KAMN and REN in his stock newsletter Brush Up on Stocks.

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