Brad Evans' favorite small-cap stocks

Jennifer Schonberger | Jul 29, 2008 9:41am EDT | Comment

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Brad Evans is a portfolio manager of the Heartland Value Plus Fund and the Heartland Value Fund for Heartland Advisors. Evans is a Chartered Financial Analyst and has more than 11 years of investment industry experience. He initially joined Heartland in 1996 as an equity research associate and was later promoted to equity research analyst focusing on, among other sectors, energy and materials. Following a three-year term with High Rock Capital as a vice president and research analyst, he returned to Heartland in 2004 to assume his current position. Evans graduated from the University of Wisconsin – Madison with honors and a B.A. in International Relations, Russian and Political Science.

What qualities do you look for in a small-cap stock? Have your criterion changed given the current macro environment?

“We are extremely valuation disciplined and look for low P/E, low price-to-cash flow, low price-to-book, low price-to-sales, a low multiple of enterprise value-to-EBITDA, discounted cash flow analysis, private market equity value and peer group analysis.

“We like to find companies that are trading at depressed valuations relative to where they traded before in the past. We find assets that are undervalued relative to what buyers are willing to pay for comparable assets based on what we call private market equity value, which is what a strategic buyer would pay for a set of assets. We do an extensive amount of valuation work. We’re bottoms-up stock pickers here at Heartland, so a lot of what we do is bottoms up and then we marry it together with our top-down view of the world.

“In this environment, you’ve got to be extremely religious in terms of your valuation work and make sure you are tracking a value company that has good growth opportunities. You need strong management teams and we’re focused on companies where insiders are buying stock, not selling it.”

What are your three favorite small-cap stocks with market caps of under $1 billion for the year and why?

“A company called Asset Acceptance (Nasdaq:AACC) is very timely here. Asset Acceptance is a $283 million buyer of charge off consumer receivables, primarily eligible credit card issuers. Asset Acceptance likes to buy bad debt. The underlying thesis is that part of this credit cycle will include delinquency trends rising for credit card portfolios. As you’ve seen mortgage equity withdrawals, people have not been able to refinance their houses. Most consumers have basically continued to spend beyond their means. I think we’re stocked with the negative wallet effect. People have been leaning more heavily on their credit cards and you can see that in terms of what’s happened with the writing levels of consumer-installed debt.

“Current earnings for the company are somewhat depressed because in the last few years when the economy was better, the delinquencies and charge offs for credit card companies were quite low and the industry had saw a fair amount of competitive activity from non-traditional buyers, i.e. hedge funds.

“What’s happening today is there has been a fairly significant explosion in delinquency trends and bad debt for the likes of Capital One, MBNA, American Express and Citi, among others. A good portion of the non-traditional buyers have left the market. What’s happened is pricing for bad debt portfolios has fallen significantly, thus Asset Acceptance has been able buy portfolios with higher internal rates of return, which should drive improved financial performance over the next year or two. This is not a ‘this-quarter stock,’ this is a company that should do well over the next 12 to 24 months.

“We think the earnings power of the company is well in excess of $1, or $1.50. The company is trading at 14 times next year’s earnings, but we think the earnings power is significant. The company is not well-followed and it’s a hated stock — one buy, six holds and three sells. The sentiment continues to be bad despite the fact that fundamentals are getting better and the company is trading at relatively low valuations relative to its historical valuation framework, so on a price-to-book and price-to-sales basis the stock is trading at about $12. A couple of years ago the stock was trading at about $30. We think that the upside is attractive at this point. Twelve to 24 months should be a pretty reasonable time frame.

“We think the management team is capable, therefore we think the stock has both attractive valuations as well as underlying fundamentals that are improving.”

“Dynamics Research Corp. (Nasdaq:DRCO) is a Landover, Mass.-based consultancy firm that has expertise in information technology and business processes, which essentially serve the Federal Government, predominantly the Department of Defense. We think the company is on the cusp of dynamic improvement in terms of its business. It has won several task orders, which means it has won the right to bid on several large pieces of business from the Federal Government. Bottom line, we think Dynamic’s business will be getting better.

“If we see a bit of moderation and some troop withdrawals from Iraq, that would actually be positive for the company because it’s been hurt by more funds supporting the war effort than helping the government either modernize or implement new programs.

“If you look at current valuation, we think the company this year should earn roughly $0.75, or about 13 times earnings. Dynamics will do about $1.50 in cash flow, so about six-and-a-half times cash flow and less than 10 times free cash flow. It has virtually no debt, a very strong balance sheet and should do about $20 million in EBITDA. The company is trading at about five times enterprise value-to-EBITDA and its peer group trades at better than eight times.

“The company is not well-followed. At this point, there’s five analysts with no bias, four holds and one sell on the stock.

“The last one I’ll mention is Intersections Inc. (Nasdaq:INTX), the leader in identity theft prevention and litigation. If you have a credit card from anybody other than American Express at this point, which is a former customer and might become a customer again, you would have received information on how to protect your identity from that credit card provider. That would have most likely been Intersections providing that information to you. Intersections is a leader in the space, under-followed and under-loved.

“This company has no Street coverage. The company has a market cap today of $157 million. The stock is currently at about $10.50. We think the company will earn about $0.80 this year — it’s a call of about 13 times earnings. We think Intersections will do over $50 million in EBITDA this year, so it puts the company at less than four times enterprise value to EBITDA. Next year we think it will do better than a $1 and will continue to grow. It’s very attractive on this year’s earnings and should do better next year. A couple years out we think the company has potential earnings power as high as $2 a share. The financials are strong. The balance sheet is in good shape. The company has a debt-to-total capital of about above 30%, but it’s got a fair amount of cash as well as debt. The company has the wherewithal to generate tremendous free cash flow, as its growing its subscribers. Again, low P/E, low price-to-cash flow, good balance sheet and good management team.

“It’s a misunderstood story that’s complicated, but we think the company is very attractive.”

What’s your typical investment horizon when you’re generally investing?

“Two to three years is our goal. We try to manage the funds as tax-efficiently as possible, and try to make it to a three-year investment horizon.”