October 10, 2006

How a Bottom-Fisher Reels 'Em In

Portfolio manager Tim Evnin talks about his fund's strategy for identifying promising turnaround candidates--and names some recent winners

Buying unloved stocks can be tricky, but Tim Evnin, portfolio manager of the U.S. Trust-advised Excelsior MidCap Value&Restructuring Fund (UMVEX), thinks buying companies that are down and out can lead to huge rewards. Before taking the plunge, he and his four-member value team research the company and industry, review its plans to recover, and meet management to decide whether they're up to the task."When we do it right, we buy value and we sell growth,"he says.

Evnin focuses on the mid-cap area, which means stocks with market capitalizations of $2 billion to $15 billion, as measured by the Russell MidCap index. His fund holds 40 issues, typically for three to five years, giving it a turnover of less than 20%. The $460 million fund is up 10.5% so far this year, 13.9% annualized for the past three years, and 13.6% annualized for five years.

BusinessWeek.com's Karyn McCormack recently met Evnin, 41, in New York to talk about his strategy and favorite turnaround candidates. Edited excerpts of their conversation follow.

What's your investing philosophy? How do you pick stocks? The philosophy for our group is in our title--value and restructuring. We find companies and/or industries that are restructuring and going through significant change. Our sense is, the market is pretty good at valuing things over long periods, but at points of transition, when companies are changing via their own hand or changes are being forced upon them by competitive dynamics, industry conditions, or regulatory issues, investors can often misjudge the future. That gives us the opportunity to ascertain what the real value is and whether the current price is reflecting the future value.

So those points of dislocation--industry change, company change, management change, restructuring--spur our interest and cause us to look further.

How can you tell whether a company is cheap or low-priced for good reason? That's really the crux of what we do. It's always company-specific. We're very much bottoms-up. So we find companies on the new low list or industries that are imploding or going through change. We spend a lot of time, after something appears interesting to us, on the quantitative side--looking at cash flow, book value, sum of the parts--to see what the business is worth. Our sense is we have an opportunity to act when other investors focus on the current conditions and the problems, as opposed to what can happen if things go right.

Then we'll look at qualitative aspects: What are the competitive dynamics of the industry? What do other companies in that business earn? What are their margins? What are the returns on capital and should they be better? Also: What do other people pay for good companies in the industry, and can they restructure and fix their way to that? We figure that the next six months might be ugly, but if they can do this, we have the patience to hold, and we think it's a great value.

When do you sell? When something hasn't done anything for six months in terms of making any progress, then we'll look at it. After a year, if there's no progress, we'll wrestle with it, again with the intent that we'll probably sell it if it can't execute.

Does bad news scare you? If we think they're making operational progress but others are misunderstanding or overreacting, that's often time to buy more. As it turns out, our first purchase isn't always our least expensive purchase, and we're more than willing to average down [in price] if the situation is on track. If there's adverse news that drives the stock down, that might be an opportunity to lower our average cost. So price movements don't scare us off.

What are some of your successes? One that's worked out very well is Brinks (BCO). When we bought in 2001-2002, it was a classic restructuring. It was a hodgepodge. It had the minerals business, the money-losing global transportation business, and the classic Brinks business, which is armored trucks plus cash management and home security. There were not a lot of synergies, and management was going to restructure, sell some businesses, and reinvest in those that were stable, money-making businesses, which was the cash and currency business as well as home security. People didn't believe they could execute and that there was value.

They have executed pretty well. We originally bought it in the 20s, and we ended up adding to it in the teens. The stock is now 50, and it's been a great holding, because it executed as they said they would. They sold off all the coal and minerals business and have taken care of a lot of the postretirement and health-care issues. And even substantially better than we had hoped, it ended up selling its global transportation business for over $1 billion. That deal closed in the beginning of 2006, and they sold it for a huge margin. It put that money back into the business, paid down debt, and did a Dutch auction for 10 million to 11 million shares.

So from beginning to end, we've already made a lot of money. We still hold it, given that there's still more restructuring to be done. The primary business that's left is the home-security business and the Brinks trucks and cash handling business. There are a couple people pushing for the sale of the entire company. We think management has done a great job and there's still some value left.

Here's one with a roadmap. It never happens exactly on schedule, but it made continual progress, executed brilliantly, exercised patience and decisiveness in reengineering the company.

What about one that hasn't worked out? One that was already beaten up was Doral Financial (DRL)--a Puerto Rico-based financial services company, primarily in mortgages. There was aggressive accounting--a lot of gain-on-sale, which is difficult to decipher. The stock had been a high-flier because of huge earnings growth, and collapsed from the 50s down to 20, then into the teens. It captured our attention. The stock plummeted, it had a reasonable franchise, the housing market in Puerto Rico is strong, and they were clearly the leader.

We bought it, and the problems continued. Like a rotten foundation, once you get under it, there were a lot more problems than we anticipated. Developments caught us by surprise. Book value kept falling as they had to write down some of their assets. So that's one we ended up selling at a loss. We were wrong about the extent of the problems. We thought we were buying something cheap and out of favor, but it turns out the fundamentals were really worse.

What are the fund's top five holdings? Devon Energy (DVN), Brinks, Harris Corp. (HRS), Aracruz Celulose (ARA), and Embraer-Empresa (ERJ). The last two are Brazilian--we have found some great opportunities internationally. If we can get comfortable with the accounting and political dynamics, we're happy to go overseas.

Aracruz is the leading eucalyptus pulp company. It's been listed on the NYSE since about 1992. It has incredibly clean corporate governance, great disclosure. It's a very high-quality company. It's as environmentally friendly as you can be. It's all plantation-grown eucalyptus trees. Because of the climate dynamics and their ability to grow the trees faster and design the plants, the cost to produce a ton of pulp is half to 60% of what it costs in the U.S. and other parts of the world with similar climates. They're running at a cash cost of about $220 to $230 a ton, vs. $400-plus in the U.S., so they have a huge pricing gap and make huge amounts of money in current conditions. We think it has a huge runway. And it pays a 5% dividend yield.

We think this is one that was misunderstood and mispriced perhaps because it was a non-U.S. company. People perceive more risk. But pulp is a dollar market and they export 98% of their production so currency issues are not significant.

Are there any new additions to the portfolio? A couple of new purchases that we bought last year or early this year that are working out are stocks that have had a significant drop in stock price--deeply misunderstood businesses. These are less restructurings and more of an opportunity when other people panic.

One is First Marblehead (FMD), a specialty finance company focusing on student loans. They service loans. One of their biggest customers is JPMorgan (JPM). First Marblehead does the securitization and buys the loans and puts them in a pool.

There's a lot of accrual earnings because a lot of these loans are long-tailed. This stock was another high-flier--it went from the 70s to the mid-20s. We assessed the earnings. It was a combination of cash earnings and accrual, and we got comfortable enough with their accounting. We met management and saw that they were doing the right thing and building the business. It was an amazing confluence of events that allowed them to have the database that they had to be able to underwrite the business in an intelligent fashion.

We bought it in the mid-20s, and reasonably quickly things righted, and the stock has risen to over 60 in about six months as their business model has continued to be validated. In their last securitization, because they renegotiated contracts with some big clients, everyone expected their margin would be squeezed. Turns out it was the opposite. The margin continues to grow, and the cash portion of earnings is higher while the deferral piece is a little smaller.

Another one in that similar vein is Tempur-Pedic (TPX). It went public in 2003, and got up into the high 20s. It had been growing rapidly, at a 30% to 40% rate. Growth began to slow, and then they ran into manufacturing problems. The stock went from mid-20s to 11 to 12.

It caught our attention. It has a great business model, with high-quality earnings with a lot of cash. We met management on site and got a level of comfort that this was a business generating huge amounts of cash that we could buy at 10 times earnings with an excellent growth trajectory.

Then we saw management buying shares with huge conviction. The board took the share count from 98 million to 84 million as the stock broke. It used all the cash and borrowed, and the stock is up to 17, so they're already well ahead on those purchases. It had been a prior LBO, so there were a lot of insiders on the board who had huge financial stakes; they bought the stock at probably half at what the business is worth. Earnings continue to grow. They've introduced models that seem to be doing extremely well. We think, even at 17, it still continues to be very attractive at 11 to 12 times next year's earnings for a business that generates huge amount of cash, buys back stock, and has great management.

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