Small Caps in a Risky Market

Heartland's Adam Peck advises thinking value.

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Adam Peck
Adam Peck

With stocks testing new annual lows, it's not an easy time to tout more vulnerable sections of the market. Yet Adam Peck, a portfolio manager with the Heartland Value Plus Fund, says it's still time to think small. His small-cap fund, with a hefty 10 percent return year to date, is a collection of small stocks that pay dividends. Peck says that type of company is holding up just fine compared with the rest of the market and could lead the rebound when stocks finally start to rise again. He spoke with U.S. News. Excerpts:

Describe the fund and its style.

The Value Plus Fund is a pure small-cap fund. Our hunting ground is [companies worth] $300 million to $3 billion. What differentiates us from most other small-cap funds is 80 to 90 percent of our names pay a dividend. We're not looking to be an income fund, but we look at the dividend as a volatility reducer, so in times of high market volatility like today the waves will be not as great. One of the reasons dividends outperform when investing in small-cap stocks is no one thinks about it, so you basically get it for free. We look for low valuation, good management teams, and a catalyst for recognition, so we don't get stuck in value traps. After last week's drop in markets, are small caps a tough sell?

If you look year to date, small caps are just about the best-performing indices this year. If you look at the S&P 500, it's down about 13 percent this year. The Dow and Nasdaq? Down. The [small-cap] Russell 2000 is down 9 percent as of Friday's close. It's outperforming all these other benchmarks. You wonder why, because everyone says we're going into or are in a recession now, and investors want to be with large companies who have more international exposure. But if you look at history, coming out of a recession, small caps outperform. They usually return 25 percent versus large caps with 16 percent [in the 12 months after a recession]. Do you see any sign of a bottom in the market right now?

If you look at the number of stocks trading above their 200-day average, we're trading near lows. It only happens about 1 percent of the time. If you look at the number of stocks trading [at a price-earnings ratio] of less than 14, we're getting close to old highs of the last bear market of the 2001-2002. That's another good sign. The one I like the best is cash as a percentage of equities. Everyone's raising cash. Most investors are scared because their house is losing value, so if they have a stock portfolio they've probably been selling because they don't want to lose that, too. As a contrarian, it's a very good buy signal. Over the next six months, I don't know what's going to happen, but I'm very confident that if you invest now with a three- to-five-year time horizon, you'd have very good returns. What sectors should be avoided?

We're still staying away from banks. We think there are more shoes to drop, and because we're investing in small caps, we don't buy the Merrill Lynchs of the world who receive capital from the guys in Asia and the Middle East. We're more focused on the community banks, and we think that's the next crisis to hit because they aren't going to get enough capital. Peck offers a few of Heartland's best recent picks:

Olin Corp.

It's a chlor-alkali producer. The byproducts are caustic soda and chlorine that go into a lot of products like PVC pipes. What's interesting about this sector is you've got major producers that control a majority of production: Dow Chemical, PPG Industries, Olin. None of them aside from Olin are growing their capacity. In fact, they're shrinking. From a supply and demand perspective, that's a good thing. As demand rises and supplies don't keep up, prices will rise. You've seen it over the last year, with the industry raising prices basically every quarter. The stock trades at 13 times earnings, and the margin of safety in this story is you don't see many caustic soda plants going up in the United States. On top of that, they own Winchester, the ammunition maker. Unfortunately, with the Iraq war, munitions has been a growth industry.