Out-of-favor companies can pay off

Odds are you haven't heard of the Hotchkis and Wiley Small Cap Value Fund, (800-796-5606). It's a small fund, $97 million in assets, that can be purchased only through a financial advisor or broker and has a long-term performance record worth looking at. According to Morningstar, the fund's 3-year average annualized return, ending June 30, was 14.32 percent; it's 10-year return, 12.96 percent; and year-to-date through June 30, the fund was up 10.5 percent.

James Miles has been the fund's portfolio manager since 1996. He says one of the reasons for its positive performance is current market conditions. "People are appreciating that if you pay a low price for sustainable earnings or cash flow that that ultimately is the best way to protect yourself in a market that's' going down."

With 79 stocks in the portfolio, and an average market cap in the portfolio of $1.1 billion, here's more about the Hotchkis and Wiley Small Cap Value fund (HWSIX):

Q: What kind of companies do you like to invest in?

Miles: There are two types of stocks that we search for in the small-cap market. One is that undiscovered or thinly researched one where not a lot of people know about the company. The other is out-of-favor or unloved stocks. Here the industry might be out-of-favor or there is some short-term issue that's generally caused the stock price to be depressed.

Q: Can you give me an example?

Miles: At one point home builders was an industry that was very depressed and people were worrying about what would happen to the economy and those stocks. Our view was that if you looked at a recession scenario, the stocks were priced for that. So, even if a recession occurred, they still seemed to be undervalued.

We still own some home builders today, not at the same size---they've come up in price and valuation---but there still is a case to be made that they are a reasonable valuation. But, not as cheap as they used to be.

Q: What about an undiscovered industry or company.

Miles: Oil tankers and TeeKay Shipping. Not a lot of guys cover the shipping industry and these guys (TeeKay) ship crude oil from places like the Middle East into the Western hemisphere. It's a very basic business and you can count how many oil tankers there are in the world.

When oil prices are low, the price that people pay to charter these boats goes down and there is not a lot of earnings visibility. But the business tends to be cyclical and short-term in nature so if you do your homework you can find some very good investment opportunities.

Q: What are the top three holdings in the fund right now?

Miles: Ventas, Lonestar Steakhouse and LNR Property.

Q: How about taxes and portfolio turnover.

Miles: We manage the portfolio for performance, target about 50 percent turnover, but we've been as high as 100 percent.

Q: With all the bad news about corporate accounting practices, can you trust what you read in a company's balance sheet?

Miles: That's where fundamental managers, like us, come into play. Our job is to research the companies and look at their balance sheets. We can't protect against absolute outright fraud, but a lot of the signs of fraud show up pretty readily in the financial statement.

For example, if you see a company that's reporting a lot of net income but they don't have a lot of cash flow from operation, it means that for some reason this company is recognizing profits but it's not generating the cash that you would expect it to generate.

Q: And that's a red flag?

Miles: It's a huge red flag. So you say, okay, many times companies are growing so they consume cash in order to grow and that makes sense. But sometimes you find companies that really aren't growing very fast yet they are consuming an awful loft of cash, Generally that's an indicator of revenue recognition problems.

(Note. Small-cap value funds, like every other type of equity mutual funds---can be very volatile. For instance, on June 30, this fund's year-to-date total return was a plus 10. On July 15 it was -0.31 percent.)

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Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.