Two Value Funds to Watch
The past year has been a cruel one for value investors ranging from Legg Mason's Bill Miller and Oakmark's Bill Nygren to the folks at Dodge & Cox. So we've been searching for new blood in the bargain-hunting crowd, and we think we've found it in a young value-investing outfit in the New Haven, Conn., suburb of Guilford.
Prospector Partners Asset Management launched its first two mutual funds in September 2007, and so far, so good, considering the rather dire market conditions. Prospector Capital Appreciation Fund (symbol PCAFX) lost 8% from its inception through September 8, compared with a 12% decline for Standard & Poor's 500-stock index for the same period. Prospector Opportunity Fund (POPFX), which focuses on small and midsize companies, is off 1% since its launch, versus a 9% decline for the small-company Russell 2000 Index.
The funds are new, but Prospector is not. It has been around since 1997 and runs nearly $4 billion of institutional money and hedge funds. Two of the managers, John Gillespie and Richard Howard, ran money at T. Rowe Price earlier in their careers; the third, Kevin O'Brien, managed funds at Neuberger Berman. The group comes to us highly recommended by a discerning private-wealth manager we know who's familiar with Prospector's track record with private money.
Like most value managers, Prospector is heavily oriented to bottom-up fundamental analysis of companies. But the managers practice a few techniques that distinguish them from other investors.
Gillespie says Prospector studies financial statements in the reverse order of most analysts and investors. They place most weight on a company's balance sheet, followed by the cash-flow statement, before looking, last but not least, at the income statement. "Managements spend the least amount of time manipulating the balance sheet," he says, "and the most time massaging income statements." Gillespie explains that by studying a series of balance sheets over different points in time, you're able to gain a truer financial picture of the business.
The single most important criterion he and his colleagues use to value a company is private-market value-an assessment of the price at which the entire business would trade between willing buyers and sellers. Part of this analysis is to estimate the replacement cost of a company's assets.
Financial analysis like this has helped Prospector invest in many companies that have been bought out at large premiums to market prices. For instance, UST (UST) is the largest holding in Opportunity. Shares of UST, the dominant player in smokeless tobacco, soared over the past week on the news that Altria (MO) intends to acquire the company for more than $10 billion. Gillespie notes that UST had everything Prospector likes to see in a company-a tremendous balance sheet, robust free-cash-flow generation, pricing power, high profit margins and executives who have shown skill at allocating capital.
Another device Prospector deploys is to acquire convertible stocks to hedge risk. For instance, Howard says, he likes a number of health-care stocks but realizes that they are subject to political risk at least until this fall's elections. So he's invested in converts of stocks such as Amgen (AMGN) and Medtronic (MDT). The move allows Prospector to capture some of any upward movement in the stock, limit downside risk and garner above-average yields.
How has Prospector fared in financial stocks, which have crushed so many value funds? Not too badly. Gillespie says the towering debt levels and accounting murkiness in money-center and investment banks were two reasons he steered clear of the big banks. Instead, Prospector prefers to invest in small regional and community banks with low leverage and strong, low-cost deposit bases. Sure enough, a number of big banks looking for cheap sources of funds have acquired some of Prospector's small-bank holdings, such as Union Bank of California (recently bought by its Japanese parent).
Prospector also has a long tradition of investing in property-and-casualty insurers. A current favorite is Lancashire Holdings, a London-based company that insures offshore drilling platforms in the Gulf of Mexico. This is a growing, highly profitable business but one that must contend with the obvious risk of hurricanes. "It's not for the faint of heart," says Gillespie.
The stock appears cheap. Gillespie says the company earns a 20% return on capital, and the shares trade for less than book value (assets minus liabilities) and at a single-digit price-earnings multiple. You can't predict hurricanes, of course, but he projects that Lancashire can compound book value per share plus dividends (his preferred method of valuing insurers) at 15% annualized over the next few years. "We prefer a lumpy 15% return to a smooth 12%," he says, adding that a smooth 12% return smacks of managements massaging earnings to meet Wall Street expectations.
Keep an eye on these funds. Both come with annual expense ratios of 1.5%.