Wallace ForbesContributorAN INTERVIEW WITHSteven H. Scruggs, CFA
Director of Research and Portfolio Manager for the Queens Road Small Cap Value Fund and RIA firm, Bragg Financial Advisors
Steve Scruggs: We are a family-owned, Charlotte based investment management firm. The firm was started over 50 years ago and firm-wide, we manage about $1.2 Billion in assets. We started the Queens Road Fund Small Cap Value fund 14 years ago and have a little over $150 Million in the fund. I’ve been the manager since inception and I have analyst support from our investment committee.
We have the same philosophy and process throughout the firm. The philosophy is a pretty straightforward Graham and Dodd style approach: bottom up, fundamental analysis. We are trying to find companies that we think are undervalued in the market. In searching for those we usually find one of two types of companies.
The first type are those really boring companies that are underfollowed. Typically, they’ll have a strong balance sheet, generate a lot of free cash flow, and have a business model that has a good track record of producing long-term economic profits — meaning that they have returns on invested capital that are greater than their cost of capital.
A second type of company that we’ll often find is a company that has recently had some type of firm-specific risk or maybe some industry risk or industry news that’s beaten it down. These types require a great deal of study to properly assess the risk. Often investors have over-reacted to some news and we can take advantage of an opportunity to buy a good company on the cheap. When we’re looking at these companies, there are two primary considerations: a quantitative aspect and a qualitative aspect.
The first thing we look at is balance sheet. We want companies that have strong balance sheets, meaning they’re not dependent on capital markets for their existence. These are companies that are going to generate free cash flow to fund their growth and have low debt to equity measures as well as good interest coverage. So, the strong balance sheet is one of the first things we look at.
The other quantitative aspect is valuation. Primarily we’re using free cash flow discount models for that. In our modeling, we always use a normalized operating margin over a full market cycle. It won’t be the most recent 12 months or a projected number. We look over a full economic cycle to see what we think is the company’s normalized operating margin, which would give us what we think is a better measure of the true economic earnings power of the company.
If the balance sheet is strong and the valuation looks attractive, we then move on to qualitative factors. We look for tenured managements with a track record of laying out a strategy and executing to that strategy. We like to see managements that are willing to take measured risks, even if at times those risks don’t work out — as long as they acknowledge them and communicate openly.
Wally Forbes: And you say you concentrate on small cap companies.
Scruggs: That’s correct. In the Queens Road Small Cap Value fund, our sweet spot is kind of in the $500 million to $3 billion market cap range. We’ll go down lower than that and we also have some that are larger than that. But generally speaking, that’s where we’re looking. The weighted average market cap of the portfolio right now is just under $2 billion.
Forbes: Great. Now some specifics you want to get into.
They’re the third largest and arguably the most efficient poultry producer, fully integrated, from turning corn into feed, to packaging, to processing birds, and getting them delivered. They have no debt on their balance sheet and have roughly $250 million in cash.
Forbes: Are they regional or national?
Scruggs: Well, they’re international. Production is primarily in the southeast. But they distribute nationwide and, as I said, internationally. A couple interesting things that are affecting the company right now. One is cheap corn and soybean prices that really helps them.
Also, pork and beef prices have risen dramatically and chicken prices have kind of gone up in spite of sort of a small over supply. The chicken prices have held up really well. One other factor made the price attractive. China had an avian flu scare in fall of 2014 and banned imports of poultry. China is usually about 10% of Sanderson’s export business. But we feel that the ban should be lifted by the end of the year, which would further help the company.
They’re found in Apple phones or the iPhones. And we think that’s one of the reasons the stock’s been beaten up this year because of a lot of the uncertainty around iPhone sales. But if you look deeper into it, the percentage of their operating income that they generate from iPhones, we think it’s really overdone.
When we look at the market growth over the next five years for their products, we expect to see very significant growth. One of the areas that they lead in is in biometrics, which is the touch sensor — the fingerprint sensor on a smart phone that secures the smart phone using biometrics.
We think that’s going to be adopted in a lot of other applications. And again their product is a market leader in that as well as the general continued growth in touch screens generally. The projected growth in those markets are in the mid-teens. It’s hard to find anything these days going quite like that.
It’s competitive but, again, with their position within the market and the quality of products, we feel really good about how much market share they’ll be able to maintain or capture.
Forbes: Very good. Well I think you have time for another one if you have one.
They made a strategic acquisition this year of a company called LoJack. It’s a theft deterrent device. And we like that acquisition, not necessarily because of the technology that they got, but it’s more from the marketing channel that LoJack has very well established. They sell their products through roughly 4,000 car dealerships in the United States. And we think that’s going be a great opportunity for CalAmp.
Forbes: What was that again? It’s a security system?
Scruggs: It’s a theft deterrent device. Basically if you got a LoJack device on your car and your car is stolen and if you’re in certain areas, the police can track it using radio frequencies. While that is an attractive product, what we really like about the acquisition of LoJack is the distribution channel that comes with it. And again, it’s not the most high-tech technology out there, but more of a marketing channel that LoJack provides.
Scruggs: It’s a theft deterrent device. Basically if you got a LoJack device on your car and your car is stolen and if you’re in certain areas, the police can track it using radio frequencies. While that is an attractive product, what we really like about the acquisition of LoJack is the distribution channel that comes with it. And again, it’s not the most high-tech technology out there, but more of a marketing channel that LoJack provides.
The incentive structures on these devices, it’s very profitable for the dealer and the salesmen to market these, to sell these. And as I said, they have a whole portfolio project of products that compliment that. We’re excited about them being able to market through that channel.
Forbes: Sounds very interesting and a different kind of a setup.
Scruggs: Yeah, a little under the radar. And that’s another interesting thing about our portfolios is that most of what we own are very boring, underfollowed stock companies, which we like and we like to say that they don’t make headlines, they just make money.
Forbes: This has been very good, Steve.
Scruggs: Thank you for talking with us, Wally.
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