The Daily Interview: A Slow and Steady Approach to Long-Term Gains

Small-cap value manager Lawrence Baumgartner describes the strategy that's led to peer-topping returns.
By Lee Barney ,

Most investors today are worrying about poor earnings and whether the economy will improve in the fourth quarter of this year or the first quarter of next. But Lawrence Baumgartner, portfolio manager of the

(PSOAX) - Get Report

One Group Small Cap Value fund, is simply betting that things will improve sometime within the next two to three years.


Lawrence Baumgartner
Portfolio Manager,
One Group Small Cap Value

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With this in mind, Baumgartner says he tries to pick depressed stocks that he expects could double sometime over the next three to five years, which would provide him with 15% annual compounded returns. Here, Baumgartner, whose fund is up 13.5% in the year to date and has delivered an annual 13.94% return over the past five years, explains his approach to investing and where he's putting his money now.

TSC: You've said that many people misunderstand value investing, that it can be as exciting as technology investing. Can you explain why you find it so interesting?

Baumgartner:

You can hear growth or technology managers talk, and they throw out all these acronyms and terms -- PDA, PLD, broadband fiber-optic cables -- and it's all leading edge, all things that are going to change our lives. And you just sit there and you say, "Wow! This is really cool," and you feel like you have to invest in it.

And there becomes an expectation that because these things are leading edge, because they're new and exciting, they should be good investments. And that's where you have to draw the line.

You get these runs in technology and high-growth stocks every few years. Those are the years that people concentrate on, and they think that it's a sustainable rate of growth, when it isn't.

We start with very realistic expectations on the value side. We're trying to generate 15% returns with lower-than-average risk. We're not trying to make you rich overnight. We know that if we generate 15% returns over the long term, that a client is going to be very happy, especially if you can do that with reasonably low risk, meaning that you have less risk of capital loss, which is what you get on the value side vs. the growth side.

So if we start with realistic expectations, you can take companies which seem mundane, which deal with the everyday and don't have the ability to wow you into thinking that this is going to be the next great industry of America, yet can generate 15% returns for you long term.

TSC: What stocks are you buying now and why?

Baumgartner:

Our top positions haven't changed in the past few weeks. There's a theme in the fund to be very economically sensitive, probably more so than the indexes or other small-cap value funds. We realize that the economy is very slow right now. Earnings are under tremendous pressure. But the valuations that you are paying for these very economically sensitive companies, which are under pressure with their earnings, are very low. If the economy improves at any time in the next three years, these stocks have substantial upside. So we can take a little bit longer-term view if we're only trying to generate a 15% return.

Think about it this way. If a stock doubles in five years, that's a 15% compound annual return. Most of the stocks that we own, when we buy them at the bottom of their cycles at deep value prices, they have at least a double to a triple return when their particular industry improves. If you take the approach of buying a stock you expect will double anytime in the next five years, you get your 15% annual return. It's rather easy to walk into some of these industries, which are out of favor currently.

TSC: So what industries or what stocks are you looking at right now?

Baumgartner:

Heavy-duty trucks. Orders and production are down 50% year over year. But the fact of the matter is, you still need heavy-duty trucks. This is not a business which is going away. It's just that this industry is experiencing a hangover from too much production. But eventually, if it gets better in the next three years, we'll get a double out of these stocks. And that would include

Cummins Engine

(CUM)

,

Paccar

(PCAR) - Get Report

and

ArvinMeritor

(ARM)

, which supplies components to the heavy-duty truck industry.

We also have a fair exposure on the capital spending, industrial basic industries, including trucking companies, as in the companies that drive the trucks down the road, because right now, again, that industry is seeing volumes running down 15% year over year. If things get better in the next three years in trucking, which they always do, we'll get doubles out of these stocks and that will give us the return that we think is realistic for a fund.

We also are invested in a couple of uniform-rental companies, including

UniFirst

(UNF) - Get Report

and

G&K Services

(GKSRA)

. These provide more steady growth than some of the industrials we just talked about, but they, too, are experiencing some cyclical slowdown -- although not to the extent of the industrial companies. These are the guys that rent the uniform to the guy at the gas station, to people at hotels and motels. Anybody who wears a uniform probably gets it from

Cintas

(CTAS) - Get Report

, G&K or UniFirst.

Another one is

Mohawk Industries

(MHK) - Get Report

. They make carpeting. They have been experiencing a slowdown over the past couple of years as they worked off excess inventories, but we think that's going to be a pretty good business over the next two to three years.

TSC: It seems as if you tend to like infrastructure and materials. Is that what you concentrate on?

Baumgartner:

We take what the market gives us. There might be a time when REITs

Real Estate Investment Trusts are extremely out of favor, or financials are out of favor. But right now the big theme on the fund, and what we are anticipating in the next three years, is that the

GDP numbers and the potential recession scenario that people are talking about will subside. Things will improve. And those scares which are currently hanging over all these stocks will go away.

Right now the Street's out there downgrading all of these stocks. Well, everybody knows that things are slow. It's a little late to be thinking about getting out. It's time to be thinking about what's going to happen in the next three years.

TSC: Are the depressed valuations on so many stocks making your job easier at this point?

Baumgartner:

I think so. Again, it starts with a realistic expectation of the returns you can generate. To get 15%, all I need is a double out of each of these individual stocks over five years. And that makes it easy to step into some of these industries right now because I know that their cycles will get better at some point -- in the next two to three years, I believe. I don't have to wait the whole five years.

TSC: What criteria do you consider besides a depressed P/E? You've said that you also look at the book value. How do you go about selecting these stocks?

Baumgartner:

We probably use

price to book as much as P/E because at times like these, when companies' earnings are under a lot of pressure, the earnings side of the P/E will shrink and the P/E will go up because the earnings are going down. At that point, we depend on book value for very cyclical companies. This represents the net worth of the company in an accounting sense. And if you have solid book value -- no intangibles, but cash and hard assets -- those things will tend to give the stock support even when earnings are under pressure.

So it's a way to manage our risk in the fund by concentrating as much on book value when we are buying companies that are out of favor, as well as P/E.

But everything that drives what we do is based on valuation. If stocks aren't at depressed prices, we won't buy them. That's what starts everything. That goes back to my earlier comment. We get paid to be right on price, not on fundamentals. What the Street tends to concentrate on is whether earnings are growing currently, and whether a stock has strong earnings momentum. But there are other ways to value companies, based on hard assets or book value. It may be cash. It may be plant and equipment. You look for tangible assets, even though a company may not be making any money currently. That tends to give a support level to a stock and prevent it from falling any further.

You can take a company like Cummins Engine right now. The earnings estimates have gone from $4 to $5 a share four months ago for 2001, to break-even right now. Meanwhile, the stock has gone from $28 to $44 because it reached a point where it had hard assets, the value of which were greater than the value of the stock in the market. So if I were just to play earnings momentum, I never would have owned that stock. But instead, we bought it when stocks were depressed. The stock was trading at a discount to book value and has rallied very nicely in anticipation that things will get better in the next two to three years.

Eventually, earnings growth will return over the longer term, but in the short term there are other methods of determining when to enter a stock.

TSC: Do you expect small-cap value stocks to remain in favor for a while now?

Baumgartner:

If you look historically, these cycles tend to last anywhere from three to five years. The last time small-cap stocks did well was in 1991, '92 and '93, and then again in '96 and '97. Both of those periods were during and after a

Fed easing, where the economy again accelerated. And I think we are again on the cusp of that period when the Fed has been easing. The economy is going to eventually get better, and because of the companies in our part of the world -- small, cyclical companies -- performance should continue for a while.

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