Why Small Caps Are Sizzling

Fund manager Scott Barbee discusses the small-company rebound and his recent investments.

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Funds that invest in small companies typically lead the pack in a market rebound, despite the fact that they're often the hardest hit during downturns. The Aegis Value fund, which aims to buy small-cap stocks on the cheap, is currently riding the market upswing. The fund suffered deep blows in 2008, with a negative 51 percent decline, but it has risen quickly and steadily so far this year with a 61 percent return—ranking it in the top-five-performing diversified U.S. stock funds. Recently, U.S. News spoke with manager Scott Barbee about why small-company stocks bounce back quickly and what companies he likes now. Excerpts:

[See Where Bargain Investors Can Still Find a Deal.]

If small-company stocks are hit the hardest during steep market declines, why do they tend to rebound ahead of the pack?

In the latest banking crisis, we believe small-cap value stocks were hit because they were, compared to larger-cap companies, disproportionately owned by levered financial institutions and hedge funds facing margin calls and investor redemptions. In general, [small] companies are very sensitive to economic conditions. They tend to be value investments. In the down markets of 2002-2003 and 2008, those companies got crushed. When those companies came back, a big portion of their recovery had to do with the fact that these companies are economically sensitive and able to come back when the economy improved.

[Also see Funds Stage a Comeback: Time to Forgive and Forget?]

How do you pick stocks?

We screen the market for deeply discounted bargain-price securities. We eliminate those that are cheap for a good reason, such as companies that may be earning a lot of money because they had a contract at a good rate but that contract may expire soon. We try to find the ones that pass our screens. We're primarily focused on book value—we look at what a company has and subtract what a company owes to get the price of the book value per share. We want to buy it when that price is below the adjusted book value per share. We want to avoid hidden liabilities, such as lawsuits, and discover their hidden assets, such as an undervalued piece of property.

What are you investing in now?

One of our recent investments was in Alliance One International, a tobacco-leaf dealer that buys tobacco from farmers around the world. They then process and ship it on to sellers like Philip Morris or Japan Tobacco. Their business is sustainable. Their main source of business is from Brazil, where they purchase the product with Brazilian real, and when the Brazilian real exchange rate dropped last year and the dollar stayed strong, they were getting a good deal.

Their business is a lot less risky because a lot of the tobacco they have in inventories has been presold and produced in agreement with tobacco sellers. We like the fact if you own the whole company, you're really not paying too much for the goodwill of the company and you are getting assets at their book value. It is well managed and in a business with fairly stable demand.

Another company we have invested heavily in is Horsehead Corp. Horsehead is a company that recycles zinc that is used in steel minimills. At the time when we were buying it, we were buying shares for as low as $3. You are buying it at such a discount. Now the zinc market is coming back. The company was dependent on the auto and industrial production in the U.S. Share values have come up recently as zinc prices have increased from approximately 50 cents per pound to above 80 cents per pound. The stock price has increased as these fundamentals showed improvement.

What is your outlook on the market?

I think that overall within the market, I am concerned with inflationary overshoot, in terms of the government response to handling the money supply. In the macro view, we will see a weaker dollar and higher inflation and interest rates in the next couple of years. The Fed has printed a lot of money to try to re-inflate the economy. There's a risk if they don't pull out that money in an appropriate way.

We're focused on bottom-up investing, which is based on stock-by-stock fundamentals. Those individual stocks are much easier to analyze than the industry or the market at large. When you screen stock by stock, you have to make some decisions in terms of the long-term view on strength of the consumer and so forth.

A large percentage of your assets are in the financial service industry. What's your outlook for these stocks?

Overall, much of what is going on in the financial service industry is because a big portion of these banks' leverage was short-term borrowing. If the market of people lending money shuts down, you're in trouble. There were a lot of big companies that had a model that was predicated on people lending to them at low interest rates. The minute that that stopped, you could never liquidate what they owned. It's almost like a trap.

The companies that Aegis looks at are not companies that rely on short-term funding to ensure that their business model stays intact. Much of the different types of companies that we invest in have long-term borrowing agreements in place, so they do have their funding. Some portion of our financials are insurance companies, such as Specialty Underwriters' Alliance, a workers' comp insurance company we have owned shares in for a couple of years. These insurance companies are such a different business than Citi or Lehman. With these insurance companies, you've got a big pool of money. It's not the same kind of risk.