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How a Small-Cap Value Fund Finds Winning Stocks in Trying Times

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With 20 years under his belt as a value investor, Jonathan Edwards has learned to take advantage of the so-called disconnects, when a company’s stock price and fundamentals don’t align.

The small- and mid-cap companies he focuses on are a particularly good place to hunt for stocks trading below their intrinsic value. Smaller firms typically have fewer analysts covering them, often leading to less accurate stock assessments. Edwards has used such opportunities to help his $2.3 billion
Invesco Small Cap Value
fund (ticker: VSCAX) sit at the top of its category since he became senior portfolio manager in 2010.

Small Cap Value’s 10-year annualized return of 11.6% puts it in the top 2% of its small-cap peers, Morningstar notes, and well above the Russell 2000 Value benchmark’s 8.3% return. The fund also resides in the top 4% of its category for the past one, three, and five years. It has a lower-than-average expense ratio of 1.09%, while its A shares carry a 5.5% load.

One disconnect-turned-investment that has paid off is
Northern Oil & Gas
(NOG), now the fund’s No. 1 holding. In 2019, Edwards first bought shares of the nonoperating oil-and-gas-exploration company, which invests in the three main shale-oil regions. Its model is buying into projects for a percentage of revenue and paying a portion of the field costs.

He added meaningfully to the position when the pandemic struck in 2020, as oil prices fell sharply—dragging down the stock, even though Northern’s fundamentals remained the same. He snapped up more shares at around $5 each in late 2020 when hopes for Covid-19 vaccines were high. Edwards says the stock, now around $30, is still undervalued, as it trades at an estimated free-cash-flow yield above 20%. That’s above average versus its peers, assuming an average West Texas Intermediate price of $75 a barrel.

The process for Northern Oil exemplifies the intrinsic-value philosophy that many value managers follow, but Edwards believes Small Cap Value’s process stands out among its peers. The team has a proprietary database that Edwards has built over his career to help identify real-time opportunities; it contains the estimated intrinsic value for more than 2,000 companies. The team also uses a “win-risk scorecard” with 30 qualitative attributes that can identify factors that could lead to outperformance.

Another factor behind the fund’s success is finding companies in the lower part of their business cycle, especially when the market thinks such weakness is a new normal.

“That’s when we get really exciting opportunities,” Edwards, 51, says.

This disciplined and data-driven approach enables the fund manager to avoid short-term market noise that can scare other investors, such as an earnings miss or short-term operational issues. His typical three-to-five year outlook for holdings also helps the portfolio ride through market swings.

The Houston-based Edwards started at Invesco in 2001 as a corporate associate after earning his M.B.A. from McCombs School of Business at the University of Texas at Austin. He and his team, including portfolio manager Jonathan Mueller and three supporting analysts, also manage
Invesco Value Opportunities
(VVOAX), a $1.2 billion mid-cap fund using Small Cap Value’s same philosophy.

Like most funds, Small Cap Value has had its share of short-term weakness, such as in late 2018 when the Federal Reserve raised interest rates and China trade-war fears heightened, and during the 2020 pandemic swoon. But Edwards has used those times to buy names that have ultimately bolstered performance, as seen in this year’s 1.3% return versus the category’s 11.5% loss.

Take No. 8 holding
Univar Solutions
(UNVR), a global chemicals distributor. The fund bought the stock in spring 2020 at around $10. Edwards likes the company’s highly diversified customer base across multiple end markets. While the stock was caught up in the pandemic selloff in 2020, “we saw a solid long-term business that generates great free cash flow, and even generates good free cash flow during an economic downturn,” he says.

The stock now trades around $33, and Edwards expects further gains. Univar recently initiated a stock buyback program equal to 20% of its market capitalization and set an earnings target of $4.50 a share for full-year 2025, which he says seems attainable. The stock is trading at just seven times price-to-earnings on that target.

Total Return
1-Yr 5-Yr 10-Yr
VSCAX 6.7% 8.6% 11.6%
Small Value Category -7.9 4.5 8.4
Top 10 Equity Holdings
Company / Ticker % of Assets
Northern Oil and Gas / NOG 2.8%
American Equity Investment Life Holding / AEL 2.8
Aecom / AEM 2.5
Grand Canyon Education / LOPE 2.3
Universal Health Services / UHS 2.2
MasTec / MTZ 2.2
Teck Resources / TECK 2.1
Univar Solutions / UNVR 2.1
Flex / FLEX 2.1
Ovintiv / OVV 2.0
TOTAL: 23.1%

Note: Holdings as of Nov. 30. Returns through Dec. 19; five- and 10-year returns are annualized.

Sources: Morningstar; Invesco

While the fund maintains a long-term approach, Edwards isn’t averse to going in and out of a stock if opportunities arise. During the fourth quarter of 2018, he first bought shares of the global electronics-manufacturing services firm
Flex
(FLEX) after a new, fiscally disciplined management team had just taken over. At the time, the stock was under $8; the fund later sold it profitably in the second half of 2020. Small Cap Value jumped back in around $17.50 in late 2021, as share prices faltered amid pandemic-induced supply-chain constraints.

The company is now the fund’s No. 9 holding, with shares trading around $21 a share. Flex stock trades at 7.5 times Edward’s 2024 earnings estimate, and he expects it to have a 9% free-cash-flow yield in 2024.

Looking ahead, there’s plenty of uncertainty going into 2023 that could bode well for a stockpicker seeking market disconnects, as both inflation and interest rates remain elevated and a possible recession looms.

“There’s no shortage of short-term concerns now,” Edwards says, “so it’s an opportunity-rich environment, which is great for us long-term investors.”

Email: editors@barrons.com

Credit: marketwatch.com

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