Joel Wells // Co-Portfolio Manager // Alpine Emerging Markets Real Estate (AEAMX)

Comments & Outlook

From a growth perspective, emerging markets are the place to be. Developing countries have strong balance sheets, youthful demographics, rising incomes and increasing urbanization. And emerging market real estate is in lockstep with many of these growth dynamics.

We continue to see lower inflation prints from a lower base in some of the emerging markets–we just saw a relatively benign print out of Brazil and the Philippines–and that has helped allay some of the fears about emerging market performance.

The possibility of a slowdown in China has been an obvious concern among investors. But the Chinese government has skillfully managed its economy. They’ve purposely dampened their real estate market and that’s had a very negative impact on volumes and average sales prices within certain markets. But they’ve loosened some policy measures, so we still see some strength there, particularly on a localized level. Once the market realizes that China’s growth story remains intact, that should help support its real estate market.

As the US economy strengthens, that should have a favorable ripple effect on emerging market equities and real estate.

Recommended Strategies

We use emerging market real estate to play consumption and demographic themes. We look for situations where supply and demand are at an extreme imbalance, and then determine where credit growth is flowing.

We look for companies with growth in margins and earnings, high returns on equity, and the potential for future cash flow growth. We then balance those investments by adding securities from industries that offer some inflation protection, such as malls that have leases indexed to inflation.

Although we try to balance growth and inflation protection, we’re currently tilting toward the growth side a little more given where we are in the cycle. The mall and commercial real estate companies were relatively good plays last year given their rental protections. But in the first quarter of this year, more cyclical residential plays have been outperforming.

What to Buy Now

Along with the themes I just mentioned, we also like homebuilders, particularly in Brazil and Southeast Asia. In Brazil, investors have to be extremely selective and right now we’re targeting low-income housing builder Direcional (Brazil: DIRR3).

Direcional focuses on those who earn three times or less the minimum wage, a segment of the population that’s a substantial source of housing demand. At present, there are about 7.2 million units of latent demand in the Brazilian housing system, and most of that is on the low-income side. The government is extremely supportive of low-income housing and provides stimulus to the sector. Direcional is one of the purest plays on the trend because it has the management and engineering capabilities to operate in that market.

Direcional trades at an attractive valuation of just 6.5 times price to earnings and 1.5 times price to book. The company produces a roughly 18 percent return on equity due to its fast cash cycle, which makes it extremely attractive relative to its peers.

In the Brazilian mall space, we favor mall owner and developer General Shopping (Brazil: GSHP3). Because malls tend to be a more defensive sector in terms of inflation, the valuations for many of the large-cap mall companies in Brazil have become slightly stretched. General Shopping has lagged these firms because it’s a smaller-cap company, but it has growth characteristics that are very similar to the larger operators.

It’s also one of the largest mall owners in Sao Paulo and has expanded into outlet malls, an area in which it faces limited competition. General Shopping trades at a reasonable valuation and offers a hedge against inflation.

Steve Scruggs // Portfolio Manager // Queens Road Small Cap Value (QRSVX)

Comments & Outlook

The market is currently very momentum-based and valuations are quite stretched. Earnings seem to be peaking and operating margins have increased to near-record highs.

Unfortunately, the increase in hiring could hurt short-term earnings. New employees tend to be less productive because companies must first invest in their training. Indeed, productivity has declined in recent quarters as companies ramped up hiring.

Recommended Strategies

Roughly 22 percent of our assets are currently idling in cash. The last time we were fully invested was in February 2009, when we adhered to our valuation discipline despite the fact that the financial system seemed to be unraveling. Prior to that, we had spent most of 2008 with a decent-sized cash position, then started buying in late 2008 until we were 98 percent invested by February 2009.  

But now the risk-return tradeoff isn’t in our favor, so we’d rather hold onto cash than make a bad investment.

The normalization of operating margins is key to our investment process. We try to estimate the economic earnings power of a company over a full business cycle by examining how it performed historically from trough to peak. As part of this effort, we strip out non-recurring items by focusing on operating margins because the non-recurring items don’t show up in the operating numbers.

Once we get a normalized operating margin, we run a discounted cash flow model to get an estimate of what we think the company’s worth. The basic inputs for determining a company’s intrinsic value are revenue growth, operating margin, capital available for reinvestment, capital expenditures and working capital.

Our estimates of intrinsic value are not hard and fast valuations, but a range of estimates that we think are reasonable. Our investment philosophy means that we typically sell when a company exceeds this range, and that can be frustrating when you sell something and see it continue to rise. But we’d rather sell something before it’s topped out rather than hold onto it for too long. We realize that momentum can propel a stock higher in the short term, but in the long run it always reverts to its underlying fundamentals.

What to Buy Now

Steris Corp (NYSE: STE) is one of our larger holdings. It makes sterilization and disinfection systems. Steris has a good management team and a strong balance sheet. The company recently endured two years of legal wrangling with the US Food and Drug Administration because it had failed to seek approval for modifications it made to an endoscope sterilizer. However, the product was never linked to any cases of infection or injury.

Steris employs a razor-razorblade business model: Its sterilization machines are relatively inexpensive, like a razor, while the disinfectant they use is priced at a premium, similar to razor blades.

Hilltop Holdings (NYSE: HTH) is sitting on about $600 million in cash, which the company plans to use to purchase either failed banks or distressed loans. Company chairman Gerald J. Ford is an extremely shrewd investor who’s best known for buying and selling distressed savings and loans. So we feel that we’re getting his expertise without having to pay the fees that the investors in his private equity companies would have to pay.

The company also owns a very small specialty insurer that’s an operating business within the business. It’s nominally profitable.

Although the company has yet to make any significant purchases, we’re confident in the management team and believe it’s a strong, long-term investment. 

We also like Scholastic Corp. (NSDQ: SCHL), which is best known for its children’s book publishing division and distribution via school fairs. This segment accounts for just over half of total revenue. The success of “The Hunger Games” series should really benefit the company’s performance this year. They’ll probably earn $3 per share.