10 Questions With Merrill Lynch Small-Cap Guru Dan Szemis

Dan Szemis spends his days picking through the dustbin, and he's starting to like some of the tech stocks he's finding there.

In an odd twist, sometimes it takes a value investor to signal the end to the growth style's pain. Szemis has run the (MASPX)Merrill Lynch Small Cap Value fund since 1996 and he looks for bargains among stocks trading in the bottom 20% of their historical range. That pool is now full of ravaged tech stocks that have poisoned growth portfolios over the past year -- and he says he's finding some gems.

There's reason to believe he's right, given his track record. Szemis has topped his average peer each year since taking the fund's reins. What is he buying? How is he avoiding value traps and when will growth come back into favor? Read on.

Talking With: Dan Szemis

Fund: (MASPX)Merrill Lynch Small Cap Value

Managed Since: Feb. 12, 1996

Assets: $2 billion

1-Year Return: 9.5%/Beats 88% of Peers

5-Year Return: 16.3%/Beats 96% of Peers

Maximum Load/Sales Charge: 5.25%*

Expense Ratio: 1.04% vs. 1.52% category avg.

Top-Three Holdings: Tech Data(TECD) Orthodontic Centers of America(OCA) Charter One Financial(CF)

*Sales charge on Class A shares. Returns through Oct. 31. Source: Morningstar and ml.com.

1. Small-cap value funds have had the wind at their back, what's the case for the style now and what do you see from here?

I think that from here you'll probably have performance divergence that isn't quite as wide between value and growth. But in terms of small-caps vs. large-caps, I think there's still some opportunity for small-caps to do well.

Small-caps have done better over the last 18 months, but they still haven't made up all that ground they lost in the past five years. If you compare their current price-to-book or price-to-sales [multiples] to the long-term average that they've had in comparison to large-cap stocks, they're still at a discount. In price-to-book terms, small-cap stocks would have to rise 46% to get back to the long-term average compared to large-caps. And on price-to-sales basis, small-caps would have to rise 36% to get back to their norm vs. large-caps. That was at the end of September. So I think small-caps still look attractive.

2. How would you describe your style?

We look for stocks that are trading at the bottom 20% of their historical valuation range. We use enterprise value sales and price-to-book as our primary [valuation] measures because price-to-earnings multiples will be distorted for these companies because their earnings are at a depressed level. We usually look at 10 years of history when a company has been public that long and we try to stick to companies that have the leading market share, even in new industries, to have a little more [downside] protection.

Companies that haven't been public for that long and aren't leaders are a little bit riskier. That's not to say we won't consider them, but in those cases we look for companies that have a lot of net cash on the balance sheet and are trading at multiples that have been very attractive in previous down cycles for companies that are in the same industry.

A Pretty Picture Since taking the reins in 1996, Szemis has beaten his average competitor.

Source: Morningstar. Returns through Oct. 31.

3. A perennial concern with value investing is the value trap -- a stock that looks cheap but keeps falling. How do you discern between cheapness and value?

The main question you need to answer is whether the company is cheap because of a temporary interruption in its long-term growth rate or a permanent change. For a company that's been around for a long time, there's a benchmark for what the company's historical earnings power has been. You can look at things like market penetration or try to determine whether they've been leapfrogged.

Stocks can be cheap for a number of reasons that may be unrelated to the company's market position and effectiveness. With some tech companies, for example, it's more likely that it's an external thing relating to the economy or the cycle of [information technology] IT spending. Sometimes it's something as simple as an accounting change that can cause companies to get more conservative with their revenue recognition, making it look like their growth slowed. Some folks just get unwilling to hold those stocks and they sell off.

4. Now that more money has come into value funds and sectors, is it tougher to find ideas now than it was then?

Our process of looking at companies that are trading at the low end of their own historical range is a little bit different from a traditional value investor's and it gives us more flexibility. A traditional value investor might say they're not going to buy any stock that's trading at greater two times the company's book value, or greater than 15 times its earnings, or greater than one times its revenues or something like that. That can be a limiting factor after the value style has done well for a period of time. There are 1,279 stocks that meet our criteria: a market cap between a $200 million and a $2 billion, at least an average of $1 million a day in stock trading and at least 12 months as a public company. Of those, 715 actually are trading in the bottom 20% of their historical valuation ratios. That's 56% of our stocks hitting our criteria.

It's Cool to Be Cheap The bargain-hunting value style has the wind at its back -- but for how long?
	Avg. Small-Cap Value fund	Avg. Small-Cap Growth fund
YTD	3.8%	-20.5%
2000	18.1	-4.5
1999	5.6	59.2
1998	-6.7	3.9
1997	31.2	19.1
Source: Morningstar. Returns through Oct. 31.

5. Are your screens leading you to a lot of battered tech stocks?

A good chunk are technology stocks, as you would expect. Of the 240 tech stocks we look at, 173 of them are trading in the bottom 20%. Within that group, we've focused on companies that have solid market share and a strong balance sheet.

A lot of companies that are trading at low valuations are software companies, so we do have a pretty decent weighting there. We feel pretty protected because of their balance sheet strength. These aren't very capital-intensive industries so they can ratchet back on their spending pretty easily. That way they're not burning through their cash too quickly.

E.piphany (EPNY) is an example of a company portfolio that we feel has a pretty good risk/reward proposition. The company is a leading provider of customer relationship management software solutions. The stock is at $5.85 and they have greater than $4.00 per share in cash on the balance sheet. They were a very high-growth company until recent conditions slowed them down. The company probably won't show profits for six quarters, but they won't be burning that much cash either. We think there's little downside risk, and if the market begins to recover, the stock should do well. It still has a relatively modest base of sales so it can have pretty good growth off that base once the economy gets going again.

We've also invested in Maxtor(MXO), which is a leading disk-drive manufacturer. A $5.50 stock, this company has about a little more than $2.00 a share of cash on the balance sheet. I think we can be pretty confident that eventually there will be the PC upgrade cycle, likely sometime over the next 18 months. In addition, we would expect continued high growth in new consumer markets such as set top boxes, personal video recorders that can add to the traditional demand that you get from the PC market. The other major players are IBM(IBM) and Western Digital(WDC). One of the companies that used to be in this market, Fujitsu, dropped out, so I think we're reaching a point where you've got few enough players where these guys can actually make some decent profits.

6. Beyond technology, what other sectors and companies are turning up in your screens?

Well, we had a pretty good chance to buy some consumer discretionary stocks. The biggest industries in that group are retailers, restaurants, and again in a bear market, we want to buy the best companies -- the companies that have the best business models, the best returns, the best growth, the best management, best balance sheets. And a list of companies that we had a chance to buy at very attractive prices includes Coldwater Creek(CWTR), Charlotte Russe(CHIC), American Eagle Outfitters(AEOS), and Factory 2-U Stores(FTUS). Four high-growth, specialty retail concepts that had very good growth rates and very good return on equity business models over the last five years selling at inexpensive prices.

7. Growth funds actually topped value peers last month. Do you think the tide might be turning back to growth for a while?

I think that's definitely possible. The names that are showing up on our screen are broken growth stocks. They're clearly out of favor and clearly trading at the low end of their own historical range. If it turns out just to be a temporary interruption for some of these companies, there's a lot of headroom for them to move up into the high ends of their historical valuation range when the economy gets better.

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8. A lot of people are looking at broken growth companies today. What are one or two red flags that might tell an investor that a company is cheap for good reason?

The traditional balance sheet indicators are very useful to look at. If accounts receivable are rising or if the company is seeing an increase in inventory, that's bad. Or if cash flow is not increasing with earnings or if it's declining faster than earnings, those are some negative indicators. Also, executives leaving the company abruptly is definitely a bad sign.

9. Have last month's terrorist attacks changed your approach?

We went into the month having about 15% cash, our normal range is 5% to 15%, with the plan to drop that to about 5%. We were selectively buying before Sept. 11. While the markets were closed, we went through the stocks that we owned and are on our active watch list and got more conservative in our estimates and expectations. As a result when the markets reopened, some stocks hit our valuation parameters that we had set for them, but it wasn't an overwhelming number. We were net buyers putting about 25%-30% of our cash to work through the couple of weeks following the reopening of the market. Then the market started to recover and some of these stocks bounced up. We held back and even traded out of some of the positions a little bit to take advantage of what we felt was too significant of a bounce to be sustained as companies had to go through the process of lowering guidance in their earnings announcements at the end of the quarter.

We're not sure what the impact will be of war or terrorist attacks and we want to be a little bit more conservative than we would otherwise be. I think most people say it pushes out the recovery by approximately six months, and that would be something that we'd agree with. It's very possible that we have to see the anniversary of the events of Sept. 11 until we can start showing growth again.

10. If you had to choose two or three companies you'd be confident buying today and holding for five years because they're solid businesses selling for less than they're worth, which would they be?

The companies that you're most confident in tend to be the ones where you're not going to get the highest returns because they haven't declined as much. The ones where you're going to get the best performance are the ones that are down the most because people are worried that they might go out of business. If you're asking which ones I could sleep best with, I'd pick Tech Data(TCD). It's the second largest worldwide distributor of information technology products. Now, the stock has lifted about almost 50%, so it's not going to be one of the ones you'll get the highest returns out of, but over the next five years I do believe this company is going to provide very good consistent returns. A couple of years ago, they got through the worst year for their industry in terms of competitive pressure and actually showed increase in operating earnings. Three of the top six companies in the industry were put into bankruptcy. So, I think Tech Data is a very high-quality company. They can do well over five years.

Another I'd choose is Panera Bread(PNRA), which is up dramatically too. They're probably only a quarter of the way penetrated in terms of the number of restaurants they could serve. The business still is going to have very good growth over the next five years, and you're paying a decent multiple to get that right now. For growth investors, they might be willing to own that one.

If you're willing to take on a little more risk, I think I'd look at E.piphany and Maxtor. I feel like those will give a lot better performance than the two I named, but there might be a little bit more risk involved at this point.

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