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.”
What Your Peers Are Reading
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.