James W. Oberweis // Portfolio Manager // Oberweis Emerging Growth (OBEGX)

Comments & Outlook

At the Oberweis Funds, we’re fundamental, bottom-up stock pickers. Of course, we still pay attention to the global macroeconomic environment because it can affect the stocks that we own. But sometimes there are dislocations in the marketplace where prices change for reasons that aren’t really going to affect the underlying businesses that we own. These are actually great buying opportunities.

Europe basically has two choices for resolving its sovereign-debt crisis: Either Germany pays for a bailout or eventually at least some countries end up exiting the Euro. A resolution could actually involve a combination of both scenarios, with Germany and France imposing a strong firewall via a regulatory regime with which not every country has the financial strength to comply.

But neither scenario will happen quickly. After all, the US is a unified country with a single governing body whose politicians engaged in political brinksmanship before finally arriving at a plan of action for our own debt crisis. By contrast, the European Union is comprised of numerous players with disparate interests. But European leaders finally understand the severity of the situation and the need to act.

If the EU slips into recession, businesses could suffer from declining European demand for US exports. The sovereign-debt crisis has also reduced investors’ appetite for risk. This hurts small-cap growth stocks because much of their value is based upon future earnings.

But these periods of uncertainty often are the best time to buy small-cap growth stocks.

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I have a graph that I update every week that shows the median valuations for small-cap growth stocks, which we define as companies with market capitalizations below $1 billion that reported year-over-year growth in excess of 30 percent in their most recent quarterly earnings report. I plot the average price-to-earnings (P/E) ratio of that universe, which includes about 700 companies, and when that P/E hits two standard deviations below its mean–a decline of roughly 40 percent–I personally go out and buy.

Of course, the market tends to look pretty ugly whenever stocks trade 40 percent below their mean valuations. And while I can’t say for sure how stocks will perform after hitting such lows, I can say with statistical certainty that the probability that an aggressive growth fund will subsequently outperform the broader market increases dramatically when valuations are extremely low.

Large-cap stocks can’t avoid the macroeconomic headwinds. These stocks tend to decline in tandem with gross domestic product (GDP) because these companies are so large that GDP actually drives their earnings growth.

By contrast, GDP growth matters far less in the small-cap arena. There are always niche businesses with high-quality products that can produce substantial earnings growth regardless of the economic environment. In some cases, smaller-cap companies even create new markets where none previously existed.

What to Buy Now

Acacia Research Corp (NSDQ: ACTG) buys patent portfolios from companies and then licenses those patents to other companies. If a company violates a patent by not purchasing a license, Acacia sues to enforce the patent.

In the last year, Acacia has signed multimillion-dollar licensing agreements with companies such as Oracle Corp (NSDQ: ORCL) and Microsoft Corp (NSDQ: MSFT). These large licensing agreements have now given Acacia a huge amount of credibility, so the cost to enforce their subsequent patent cases is actually declining.

Historically, large companies have rampantly infringed upon patents held by smaller companies because they have the legal budgets to effectively block smaller companies from enforcing their patents. But smaller companies now have a means to protect their intellectual property by bringing in a partner like Acacia.

Acacia benefits from a weak economic environment because companies hope to raise cash by monetizing the value of their patent portfolios.

As I mentioned earlier, Acacia’s success has helped it forge partnerships with the very companies that previously faced its litigation. After Acacia won a large settlement with Microsoft, the tech giant actually became a partner with Acacia to monetize its own intellectual property.

We think Acacia may reach a very large settlement with Apple (NSDQ: AAPL) over the course of the next 12 months that could be as much as $100 million.

We’ve held Acacia’s stock in our portfolio for years, but it’s widely ignored because analysts have difficulty modeling its earnings on a quarterly basis. That’s because Acacia’s earnings are tied to the uncertain timing of settlements. But we looked at the potential value of Acacia’s settlement pipeline and determined the company is worth more than the market’s current valuation would suggest.

The firm’s revenue grew by about 60 percent in 2011, and we believe sales should grow by about 30 percent in 2012.

HealthStream (NSDQ: HSTM) provides a platform that trains hospital personnel with regard to regulatory compliance. They create some content themselves, and purchase some content from third parties.

Additionally, HealthStream is working on a program that uses mannequins to provide simulations to train medical professionals. In the past, medical professionals learned cardiopulmonary resuscitation (CPR) with instructor-based training that involved both a mannequin and a written test. By contrast, the HealthStream program uses a mannequin that has sensors networked with its software platform, so an instructor is no longer needed to conduct the training. This approach allows a more effective training program at a much lower cost to the hospital.

HealthStream’s software-as-a service business model produces high recurring revenue. Over the next 12 months, revenue should grow roughly 25 percent, with 65 percent growth in earnings.

HMS Holdings Corp (NSDQ: HMSY) helps Medicare and Medicaid audit claims for proper classification and payment and earns a fee for the errors it identifies.

HMS Holdings also coordinates benefit services to ensure the proper insurance plan is billed. For example, consider someone who has Medicare, but is still working and also has private insurance. That person might hope to avoid paying the deductible to their private insurer, which should be the primary payer, so they submit their claim to Medicare. HMS has an enormous, industry-leading database to verify coordination of benefits, so it would catch that misclassification.

States are focused on containing health care costs and are increasingly requiring plans to be audited. That’s a substantial growth driver for HMS Holdings.

Richard Eisinger // Portfolio Manager // Madison Mosaic Mid-Cap (GTSGX)

Comments & Outlook
 
We take a bottom-up approach to investing, so our security selection is rarely based on our economic outlook. We’re more risk focused. That means we try to avoid bubbles, but we don’t try to project gross domestic product (GDP) growth.

Nevertheless, the consumer-debt bubble that led to the last recession has transformed into a government-debt bubble. The consumer is making progress on their balance sheets; some of that progress is voluntary and some of it is involuntary, such as when it occurs via foreclosures and personal bankruptcies.

But this deleveraging process will take more time. Historically, the recoveries that follow a credit bubble tend to unfold in a slow, painful process.

In addition to consumers, financial companies, such as banks, have improved the quality of their balance sheets and are writing off a lot of bad loans.

One of the things I’ve learned as a mid-cap portfolio manager is how large a role the construction industry plays in the domestic economy, especially among the smaller businesses in the US. So we think housing is going to play a big role in the eventual recovery. When household formations reach equilibrium with household starts, the domestic economy should start to improve. But there’s a lot of excess housing inventory that needs to be sold first.

On the corporate side, management teams feel constrained by the uncertain political environment both in the US and Europe. The European sovereign-debt crisis causes anxiety because the whole world is now interconnected. And in the US, the government is imposing greater regulations and may increase taxes. That hampers corporations’ willingness to invest in new capital projects. It’s a vicious cycle because it reduces hiring, which increases unemployment.

On the other hand, US corporations have extraordinarily strong balance sheets.

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We favor mid-cap stocks because they’re large enough to have established strong competitive advantages, yet they’re not so large that their size inhibits growth.

Currently, the fund I manage along with Matt Hayner is tilted toward higher capitalization mid caps because we’re finding more compelling values there. Beyond the mid-cap arena, there are a lot of good values in large-cap stocks right now.

I’m very influenced by Warren Buffett, so I tend to approach my analysis from that perspective. Our approach to security selection is consistent regardless of the economic environment. Of course, different economic environments present different opportunities. This year, as the market approached conditions of extreme fear, we found opportunities among more economically sensitive businesses.

Risk reduction is merely a by-product of our process. We’re not actively thinking about how to reduce volatility. But preserving capital is a big part of our investment process and distinguishes us from a lot of other managers in the small- and mid-cap categories.

We look for high-quality companies that have a sustainable competitive advantage, predictable and growing cash flows, organic growth and low debt levels. And we buy these stocks when they sell at reasonable valuations. Such stocks also tend to be less risky than their peers.

We also want management teams who have high levels of inside ownership and are skillful allocators of capital.

There are three major facets of our investment process.

The first part is our business model analysis. We want to see companies possess characteristics such as a sustainable competitive advantage. In Buffett terms, we call that a wide moat. A wide moat results from market leadership in an industry, high barriers to entry, pricing power and strong brand names.

Brown-Forman Corp (NYSE: BF-B) provides a great example of the power of a strong brand. Jack Daniel’s is the Louisville, Ky.-based liquor manufacturer’s flagship brand. That brand has been in existence since the late nineteenth century and gives the company a tremendous competitive advantage. In fact, the brand even has a substantial presence overseas, with 50 percent of their sales occurring outside the US.

So it would be difficult for an upstart entrepreneur to create a product that’s going to compete against that. In the technology arena, by comparison, it sometimes isn’t all that difficult to invent a better website or gizmo.

Another important fundamental characteristic is predictable and growing cash flow. We want a high degree of certainty in a company’s ability to generate future cash flow because we value companies using discounted cash flow analysis and our valuation work is only going to be as accurate as our ability to predict that cash flow. In the case of Brown-Forman, their strong brand portfolio makes it easier to predict that they’ll be able to produce such cash flows for many years to come.

We also carefully examine the source of a company’s earnings-per-share growth, whether it’s derived from acquisitions, share buybacks, or organic growth, which happens to be our preference. It’s also important for a company to have the ability to expand its margins.

Finally, we avoid companies with overleveraged balance sheets. A company’s debt should be easily serviced by their cash flow. However, we’ll tolerate a higher debt level with some companies, such as Brown-Forman, because there’s more certainty regarding their cash flow than with some of their peers.

The second step of our process is our assessment of a company’s management team.

Great managers will always know their company best, so we prefer to give them the benefit of the doubt with regard to their strategic decision-making. But not all managers deserve that level of deference, so we carefully examine the management team first to ensure we’re confident about their ability to properly allocate capital.

We look for management teams who have some skin in the game either through direct ownership or incentives. Just recently, I had one of our analysts review the management ownership of the companies held by our fund, and I wager that we probably have higher management ownership among the companies held in our fund’s portfolio than the average fund manager. High levels of inside ownership inspire a management team to focus on the long term instead of trying to beat consensus estimates each quarter.

But the main metric for assessing the quality of a management team is their ability to allocate capital, particularly cash flow. They can use cash flow to buy back stock, pay dividends, reinvest in the company, pay down debt, or make acquisitions. But not all of those actions make sense at any given point in time. For instance, we might frown upon share buybacks if management buys back shares of their company’s stock when it’s trading at an all-time high.

The final step of our investment process is valuation.

We want to buy stocks at reasonable valuations where we can look into the future and see decent returns on our purchase. Discounted cash flow analysis is one of the main methods we use to value companies, but we also look at other data to corroborate that analysis. Often this analysis depends upon the context of the industry in which a company operates. In the insurance industry, for example, we focus on valuation metrics such as price to book, price to earnings, and price to sales. We’ll also look at private market transactions to see the price at which companies are being acquired.

There’s another analytical approach that I also find useful: Economic value-added (EVA) analysis. I look for companies that earn a return on invested capital in excess of their weighted average cost of capital. If you can find companies that can sustain that advantage for long periods of time, you’re going to have a lot of winners in your portfolio.

What to Buy Now

Ritchie Bros. Auctioneers (TSX: RBA, NYSE: RBA) is the world’s largest industrial auctioneer. The firm sells used equipment at auctions through a network of over 110 locations in 25 countries. The Internet is responsible for 60 percent of the company’s revenue and has facilitated its growth globally.

The company operates in a fragmented industry and only holds a 3 percent share of the global market. So the firm has tremendous growth potential and few regulatory constraints to hinder its expansion.

Ritchie Bros. depends on its reputation for fairness and integrity. Reputation is of paramount importance for auctioneers because skeptical buyers and sellers know there are numerous ways in which they could potentially get pinched for extra money.

Ritchie Bros. only holds unreserved auctions, which means items are sold to the highest bidder. The company generates revenue by charging a commission rate on the auction proceeds. They take 10 percent on average of the gross auction proceeds.

Ritchie Bros. has very few capital expenditures. The Internet is responsible for roughly 60 percent of their sales. But when the company needs physical sites to hold their auctions, they buy land in low-priced real estate areas.
The depressed global level of construction activity creates a buying opportunity for investors. Once credit becomes more available again and construction activity resumes, Ritchie Bros. will be leveraged to that recovery.

Currently, we’re trying to normalize what we think their earnings will be. Ritchie Bros. has a lot of depreciation, so we analyze it on an enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization) basis instead of a pure earnings basis. Based on our normalized estimate of EBITDA, the company’s stock trades at about 11 times enterprise value to EBITDA, which is quite reasonable for a growth company.

Markel Corp (NYSE: MKL) is a specialty insurer that covers hard-to-place risks, ranging from daycare centers to equine interests. The specialty insurance business is far less regulated than the standard insurance market, so that gives specialty insurers greater flexibility to raise prices. We’ve owned shares of the insurer’s stock in our fund for over a decade. Management is conservative with regard to reserves and remained disciplined during the downturn by not writing unprofitable business.
 
Similar to Berkshire Hathaway (NYSE: BRK-A), Markel invests a portion of its premium float in the stock market. Tom Gayner, the company’s chief investment officer, has even started a private equity unit called Markel Ventures that buys mundane companies—such as dredging and bakery equipment—that boast strong cash flows. At one point, Gayner was actually mentioned as a possible successor to Buffett at Berkshire Hathaway.

Markel’s approach to investing its float means the company experiences solid growth in book value over time, particularly if the stock market is performing well. But Gayner’s investments have even performed well during tougher periods in the market. Although I don’t know his exact performance figures, he’s beaten the S&P 500 handily over the years.

As I mentioned earlier, management’s discipline with regard to not writing unprofitable business has been an important part of the insurer’s growth story. An insurer is often better off idling on the sidelines during a weak market for pricing if it can’t find a profitable manner in which to write new premiums. Insurance pricing is very cyclical and we’ve been in a soft market for several years. While the insurance market dropped hard during the downturn, pricing is finally stabilizing. And Markel should be leveraged to future price increases because they’ve diligently invested in international growth.

One of Markel’s primary objectives is growth in the firm’s book value. Markel has grown book value 19 percent annually for the past 20 years. Presently, its stock is trading at 1.2 times book value. For years, the company’s shares traded between 1.7 and 2.3 times book value. We think the market has unfairly punished the stock simply because it’s involved in the financial sector.

The insurance sector is also under pressure because of their substantial bond portfolios, which are mandatory to meet regulatory requirements. Interest rates are abysmal right now. So the sector should benefit once interest rates finally revert to normal levels.

Can you tell us more about your fund’s higher-than-average cash allocation?

Our cash allocation is transitory. We don’t try to time the market or raise cash. Our cash allocation probably averages between 6 percent and 7 percent. It’s rare for our cash levels to rise to double-digit levels.

Your fund has a substantial weighting in financial services. Is that largely driven by your focus on insurers or is that more opportunistic given the travails of that sector?

Right now, we have 24.5 percent of our fund allocated to the financial sector. Insurers comprise roughly half of that allocation. Because of their defensive qualities, we think of the insurers in our portfolio as almost anti-financials.
 
At 4 percent of our portfolio, Brookfield Asset Management (NYSE: BAM) is one of our fund’s largest allocations to a single company. Brookfield Asset Management is basically a capital allocation story. The firm’s management thinks of themselves as an infrastructure company, with interests in commercial real estate, hydroelectric plants and other forms of infrastructure.

The company has a tremendous balance sheet. Like Berkshire Hathaway, Brookfield Asset Management has the financial strength to provide distressed companies with capital during periods of economic duress. As an example of that, the firm provided equity financing to General Growth Properties (NYSE: GGP) as part of a consortium’s effort to recapitalize the mall operator following its Chapter 11 bankruptcy filing.

Even the banks that your fund owns seem defensive in nature.

We separate the financial sector into insurance financials and non-insurance financials because they’re really very different businesses. Because of the housing crisis, we avoided banks for a long time. But we did initiate some positions in banks last spring.

M&T Bank Corp (NYSE: MTB) is very conservative, so investors pay a bit of a premium for that. But it’s known as one of the best-managed banks in the country. Throughout the financial crisis, M&T remained stable because of their superior loan quality.

What is it about the technology sector that keeps it from having a greater role in your portfolio?

We’ve never been comfortable with holding businesses that specialize in high technology because many of the companies in that sector simply don’t meet the fundamental criteria that I outlined earlier.
So the type of technology companies that we do own are firms such as Western Union Co (NYSE: WU), which is a money transfer business, and Broadridge Financial Solutions (NYSE: BR), which provides back-office solutions to the financial sector and has a near monopoly on the mutual fund proxy process.

The closest we get to high technology is our position in Amphenol Corp (NYSE: APH), which designs and manufactures interconnect products for the communications and information processing markets. But Amphenol is not as technology driven as a smartphone manufacturer or an Internet company because its products don’t face the same risk of obsolescence.