Oct. 11, 2004 — In picking stocks for the Stratton Small-Cap Value Fund (STSCX), portfolio manager Jerry Van Horn starts by analyzing up to 8,000 companies with a computer program designed to flag shares priced low relative to a business’s cash flow.
The screen then filters out companies for which earnings estimates are being revised upwards by analysts and measures a stock’s price momentum over a 12-month period. The last component of the formula is intended to keep him from considering something in the midst of a “catastrophic decline,” Van Horn says.
After the electronic part of his job is completed, Van Horn talks to companies, and their suppliers and competitors, to get a clearer picture of a potential investment. He likes to see a leading market position, or some other competitive advantage, or a catalyst, like a new product, that can boost a stock.
Van Horn has no hard and fast rules where earnings are concerned, but he “very rarely” owns an unprofitable company, he says. The exception would be one with “a long history of profitability that has maybe run into some problems that we feel they’re on the way to correcting,” he says.
Ultimately, about 50 companies with market caps of less than $1.5 billion make their way into the $71-million fund.
Under Van Horn, who took over Stratton Small-Cap Value four years ago, the fund rose 11.6% this year through September, versus a gain of 6.7% for the average small-cap value fund. For the five years ended last month, the fund returned 30.6% on average, versus 14.2% for its peers.
As a typical investment in the fund, Van Horn cites JLG Indus (JLG), a manufacturer of hydraulic excavators. The stock, which trades for less than 10 times projected 2005 earnings, is cheaper than its peers, according to Van Horn. He expects the company to benefit if the U.S. economy continues to strengthen.
JLG has been hurt lately because it has struggled to pass higher costs for the steel that goes into its products along to its customers, Van Horn says. He’s confident it will find a solution, however.
One of the money manager’s favorite stocks over the last nine months has been Yellow Roadway (YELL), the big U.S. trucking company. The stock was inexpensive when he bought it in mid-2003, and it still is, says Van Horn. Yellow is another company that stands to gain if the domestic economy picks up speed, he adds.
The fund had about 10% of its assets in homebuilders at the end of the third quarter, including its top two holdings, Hovnanian Enterpr Cl`A` (HOV) and D.R.Horton (DHI).
Van Horn said he has been reducing his exposure to the sector over the past year because it has been getting expensive, and he doesn’t want it to carry too heavy a weight in the portfolio. Still, “the economy and interest rates have a long way to go before we start to see any deteriorating fundamentals for these stocks,” he says.
Hovnanian and Horton look good, Van Horn says, because they have been able to grow robustly over the last three years, partly by snapping up smaller rivals. In addition, both operate in a wide range of geographic markets, so they are less vulnerable to a slowdown in one.
Just as Van Horn is attracted to stocks he views as bargains, he’ll unload those that become expensive. For example, he sold auto parts supplier Amer Axle & Manufacturing (AXL) in August because its shares had risen higher than he wanted them to go.
Because the stocks he buys may take a year or two to reach what Van Horn considers their correct valuation, he invests for the long term. That’s illustrated by his fund’s turnover rate, which measured 25.9% last year, compared to 70.1% for similar funds.
“We’re not hopping in, looking for a quick pop and then jumping out,” Van Horn says of his approach to buying and selling stocks.
The fund’s expense ratio of 1.67% is higher than its peers’ 1.53%, however. Van Horn attributes that primarily to his performance-based management fee. The fund manager says he has been collecting the maximum fee of 1.25% of late because returns generated by the fund have topped its benchmark, the Russell 2000 index, by more than 5% over the last two years.
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