Hidden Gems in Small Caps
John Hancock Small Cap Intrinsic Value Fund
US > Small-Cap > Value
May 21, 2010
-
-
-
-
Inception Date
Sep 03, 1996
Q: Could you give us a brief overview of the fund?
A : The John Hancock Small Cap Intrinsic Value Fund was launched five years ago and currently has about $450 million of assets under management. The team has used the same philosophy and process for the last 9 years to generate high alpha with a keen focus on margin of safety.
Q: What is your main investment objective?
A : Our main investment objective is to seek long-term capital appreciation. The fund usually invests at least 80% of its assets in equity securities of small cap companies, and it may also invest up to 35% of assets in foreign securities and up to 20% of its assets in bonds of any maturity rated as low as CC/Ca and their unrated equivalents.
Q: What is the investible small-cap range for the fund?
A : Our benchmark index is the Russell 2000 Index. Even though the definition of small cap in the index is dynamic and is now below $5.5 billion, we believe the sweet spot for small cap socks is in the range of $1 billion to $2 billion.
Q: What is your interpretation of the term “intrinsic value” in the fund’s name?
A : Intrinsic value is what we assign to the free cash flow in the business multiplied by a conservative multiple, which varies depending on the growth and sustainability of the business. Here, by free cash flow we mean cash flow after deducting capital expenditure, taxes and interest expenses.
Q: How do you go about screening your universe?
A : Our philosophy is to buy great stocks with superior investment returns and to hold a concentrated number of positions in the fund with a high degree of conviction. We have a team of six analysts that contribute ideas to our high conviction strategy. All of these analysts have expertise in specific sectors.
Generally, we seek companies that have superior investment returns and are trading at a discount to their long term values. We are looking for companies with strong competitive advantage that have been in the business for a long period of time, succeeding both in up and down markets. A company’s performance over a whole business cycle means a lot to us.
In our view, if such companies have financial resources to acquire competitors, that will only help them to expand and grow. Then, we look for some near-term catalysts that will help them grow in the next six-month to a three-year period.
Q: Would you elaborate on your research process?
A : Our universe consists of the 2,000 names in our benchmark index plus a few more international securities that are primarily ADRs. That gives us around 2,500 names to begin with. The idea generation is the first step in the investment process.
We have our own proprietary financial models and we start with in running our quantitative screens that highlight low valuation when measured on rations of price-to-book, price-to-earnings, price-to-cash flows, and enterprise value-to-EBITDA. As a core part of the screening process, we will highlight names that have attractive valuations on a sector-by-sector basis.
The models have been built to identify names that have attractive valuations by sectors so that we can target our research to select names. These screens allow us to focus on names that have been sold off heavily and are trading at a deep discount to their intrinsic value. We look at these screens on a weekly basis.
In this way, the screens generate about 20% of the names in the portfolio and our analysts will provide the rest of names. Additionally, we rely on independent research analysts and industry sources that also provide a list of companies to research further.
The second step is talking to management, and sell-side analysts that cover these stocks and reading all of the SEC filings. Our research process looks to verify data from multiple sources and confirm the patterns or trends we see in the industry or the marketplace.
Then we build investment models for each company. These models look at the company profiles and both upside and downside risks. We look for hidden assets in the balance sheet and also look at the debt profile and the payment schedules. It is important for us to identify a near-term catalyst that will unlock value by driving higher earnings growth.
Q: Could you give some examples to illustrate the process?
A : One of the names that we were drawn to a couple years back was Washington Post Company. We had been tracking the well-known media conglomerate for more than three years and we started more detailed work when the stock declined with the media sector in 2008. Warren Buffett’s Berkshire Hathaway is a significant shareholder in the company.
Along with the heavy declines in the media sector, Washington Post was hit during the recent market downturn. We started looking at the company in the middle of 2008, after one of our analysts had brought up the name and the valuation it was trading at.
Washington Post has hidden asset that the market overlooked in the downturn and it also very stable cash flows. For example, their online education division, Kaplan University has been very profitable and generates a substantial free cash flow. Investors always view the media conglomerate simply as a newspaper publisher, but the company also owns and operates its cable TV and media broadcasting network. Moreover, they have a good balance sheet, no long-term debts and an over-funded pension. Yet, with the downturn the analyst coverage had sharply fallen off.
Based on our hidden asset valuation and cash + investments, we estimated that the stock was mispriced and traded at a significant discount to our estimate, providing us a good margin of safety.
Another example would be DG Fastchannel, Inc., a provider of digital technology services that enable electronic delivery of video, audio and images to news outlets like radio and TV stations. When someone needs a commercial ad to be aired on TV, the company actually connects the ad agencies with the television broadcasters. In fact, DG Fastchannel operates two digital networks across the nation, which link more than 5,000 ad agencies with more than 2,000 radio and TV stations besides cable networks and print publishers. It is evident that they have a dominant position in this marketplace.
During the recent market downturn, they were able to acquire the second-largest player in this space and now control 90% to 95% of market share in linking advertisers with digital broadcasters. Apart from this, the company has collaborations with Google and Microsoft for online advertising.
DG Fastchannel has been trading as a public company since 1996 and it went through hard times until 2005. But since then the company has delivered a comeback with their sharp focus on delivering digital ads to several outlets. That is how after several acquisitions it now has over 5,000 advertisers, including 75 of the top 100 largest advertisers. The company is also focusing on the HD TV ad delivery, which tends to generate higher gross margins.
The government mandate to convert analog video and audio stream to digital was the single most important catalyst for this company that increased revenues and earnings sharply. They had a surge in their margins after the conversion and that we believe are sustainable.
Q: How many names do you keep in the portfolio?
A : We tend to have 55 names in the portfolio. The top ten names usually represent 30% to 35% of the assets, and the top 20 names would typically represent about 60% of the assets under management.
Q: What is the turnover of the fund?
A : The long-term target for portfolio turnover has been between 30% and 50%, however, the turnover has recently increased to 100% as many stocks have traded to our target price.
Q: How do you define your sell discipline?
A : We sell stocks for one of the four reasons: when the stock hits our price target price, when we our investment thesis changes, if the business fundamentals in the company we invest in deteriorate or if we find better opportunities.
We set the price targets during our investment process and rarely change them unless there are dramatic changes in the fundamentals. The investment thesis is built around our philosophy around excellent businesses at very compelling valuations. If anything material changes in that thesis we will sell the position. In the second step of the investment process, we make projections on revenue growth, earnings growth, margins, etc. When the reported earnings are drastically different than these estimates we will exit the position. Lastly, we are always looking for better opportunities with excellent risk / reward. When we find these new names we will sell existing positions that have less conviction by the team.
Q: What are some of the risks that you monitor and how do you mitigate them?
A : As mentioned earlier, we consider the upside and downside risks apart from the risk analysis that we do for each holding in the portfolio. One of the main concerns that we have at any time is liquidity. We invest in small cap companies and many of them are not liquid enough, so we look for companies that have market cap between $1 billion and $2 billion to make sure that our positions are not larger than ten days of trading volumes.
We also take into account the correlation in the names in the portfolio in order to avoid names that are closely linked in trading patterns along with sharp corrections with the market downturns.
At John Hancock, we have a risk management team at the headquarters, where we meet once a month to review several risk factors highlighted in the portfolio analysis using Northfield and Barra tools.
Q: How deep is the analyst coverage of the holdings?
A : At present, there are three names in the portfolio where there is no analyst coverage at all. But there are many more names in the portfolio where the coverage is just superficial, which works in our favor. We feel that our detailed research work on these names is one of our distinguishing features in the market.
Annual Return
|
|
2024 | 2023 | 2022 | 2021 | 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |
in percentage