Outsized Returns from the Small and Mundane

July 23, 2003 — Bruce Baughman admits he invests in companies engaged in rather ‘mundane’ businesses, but there’s nothing routine about the performance of the $236-million Franklin MicroCap Value Fund (FRMCX). For the three years ended June 30, the bulk of the bear market, the fund gained 18.0% annualized, versus 8.7% for the average small-cap value fund, but with less volatility. For the five-year period, it rose 7.5%, versus 5.3% for its peers.

Still, there’s no denying that his favorite stocks fail to attract much interest from Wall Street: His top holdings include a vegetable canner, a T-shirt maker, and a shoe seller. However, part of the appeal of investing in microcaps is that they are below the radar of brokerages and, therefore, enjoy inefficient pricing and provide the potential for outsized returns, Baughman argues. “These stocks are too small to become the grist for Wall Street’s mill,” he says. “Merrill Lynch will not make any money by putting out research on most companies that I’m interested in.”

The investing public, however, has been increasingly interested in microcaps since the beginning of 2000, when larger-cap equities began their three-year decline. Franklin MicroCap, which reopened to new investors on June 30, 2003, after being closed for more than a year, seeks out well-established, financially-sound companies with market caps below $300 million, preferably those trading at a discount to tangible book value, and where book value is steadily rising. “We are very value conscious,” Baughman says. “Our investment approach is focused on the balance sheet and we are patient investors.”

Baughman has managed the fund since its inception in December, 1995, along with William Lippman and Margaret McGee. He employs a strictly bottom-up investment approach, largely ignoring macroeconomic concerns and Wall Street chatter, and refrains from making predictions about future market activity.

Underscoring his insistence on buying cheap stocks, Baughman notes the fund’s average price-to-book ratio is about 1.1, while its average P/E is approximately 15.5. Since he is patient enough to buy stocks at good discounts to their book values and wait it out, once book value rises, either through a takeover or excitement over changes in an industry or market recognition, share price typically goes higher with it. Then, unless something happens to change his view on the company, he sells.

As of June 30, 2003, the fund’s top ten holdings comprised Seneca Foods Corp. (SENEA), 3.0%; Delta Apparel Inc. (DLA), 2.52%; Hardinge Inc. (HDNG), 2.4%; Haggar Corp. (HGGR), 2.4%; Standard Commercial Co. (STW), 2.4%; International Shipholding (ISH), 2.4%; Courier Corp. (CRRC), 2.4%; Atlan Tele-Network Inc. (ANK), 2.3%; American Pacific Corp. (APFC), 2.3%; and Brown Shoe Co. Inc. (BWS), 2.2%. These ten stocks represented 24.2% of the fund’s assets.

Baughman’s top holding, Seneca Foods, is a leading vegetable processor which recently increased its operations by purchasing the vegetable canning assets of Chiquita Brands International Inc. (CQB). Although the stock rose to the upper teens from a low of about $11 last autumn, Seneca’s price-to-book remains an modest 1.12 on a fully diluted basis. Another top holding, shoe retailer Brown Shoe, has seen its stock price double to $30 since last September — yet its price-to-book remains just 1.72.

True to his value approach, Baughman buys stocks for the long haul — the fund’s turnover rate last year was a modest 28.4%, versus 70.0% for the peer group. “You can make money on microcaps if you hold onto them for the long term,” he says. “Microcap stocks may remain dormant for several years, and then, suddenly, they’ll experience a spurt in price. There’s no way to predict when these price jumps will occur, so you have to do your homework and then be patient.”

Tractor Supply (TSCO), which operates retail farm and ranch stores, was a major holding that Baughman disposed of in late 2002. “This company is a beneficiary of a new demographic in this country — more and more upscale people are choosing to live far from urban centers,” he said. “As such, they are buying such items as livestock, agricultural products, lawn and garden power equipment, clothing, trailer and towing products, etc.”

Baughman initially purchased Tractor Supply in February 2001, when the stock’s price-to-book was about 0.83. He sold the stock in the fourth quarter of 2002 when price-to-book reached a lofty 2.40. “During the time we owned the stock, the company’s book value increased by 25% — driven by great earnings — and we recorded a 258% total return on it.”

Despite increased investor interest, microcaps still remain beyond the pale of most investors. However, that does not mean they are not accessible, given selections such as this one from Franklin. Though funds devoted to microcaps aren’t considered core holdings for investors since the stocks they own are thinly traded and can be very volatile, they can bring diversification to portfolios heavily weighted toward large-cap stocks when used in the right measure