This Stock Fund Manager Outperforms with 'Fixer Uppers'

“We're looking at getting $1 of assets for less than $1,” he said during an interview.

Small cap veteran

Hinch is head of the small-cap team at First Eagle Investments in New York and portfolio manager of the $1.7 billion First Eagle Small Cap Opportunity Fund FESCX. He has been following value strategy since 2002 when he worked at Royce Investment Partners. He and his team joined First Eagle in April 2021 – the same month the First Eagle Small Cap Opportunity Fund was created.

Since that date, the fund's institutional shares were down 1% through Friday, net of expenses, which is in line with the performance of the Russell 2000 Value Index XX:RUJ.,
But before the 10% drop for the full Russell 2000 RUT.

Needless to say, this period was not good for small businesses. Because the First Eagle Small Cap Opportunity Fund is less than three years old, it has not yet received a Morningstar rating.

Brett Arends: Small-cap stocks beat these indexes last year — again. Here's what they're buying now.

But Hinch had a strong long-term track record at Royce, as the Royce RYPNX Opportunities Fund, which he co-managed, had a 15-year return of 296% through March 2021, compared with returns of 191% for the Russell 2000 Value Index and 256% for the Russell 2000. Completely.

Identify trades

Hinch takes a broad approach, typically owning stocks in between 180 and 300 companies. He and his team typically identify companies whose shares are trading low in terms of book value or revenue, not because the companies are not widely known in the market, but “because something is wrong.”

“We look for companies that are struggling in the short term, and that's normal. Sometimes it's their mistakes, sometimes it's the economy.”

Hinch does not consider companies' price-to-earnings ratio valuations when making initial purchase decisions because the companies are not as profitable as he believes they could become.

“We are looking for a cheap reason and a reason to get them back to normal,” he said.

He also believes that the word “quality” is overused in the investment community. “This term can be used when an investor overpays,” he said. The idea is that you may be willing to pay a high price for stability, but you may also benefit from lower prices, because for most businesses “things aren't always great all the time.”

Looking at the early stage of the Covid-19 pandemic, Hinch said: “You had traditional growth stocks selling at similar valuations to value stocks. At that time, I was able to buy things like Dunkin' Donuts or Texas Roadhouse TXRH,
-0.48%,
Which were usually in value funds at low multiples and they went back to where they normally sold, which is where we exited.

Hinch said about a third of the companies in the portfolio had reached maturity and had been held for about a year and a half because they were improving, as he expected. Another third “have just turned a corner, with fundamentals improving or the economy is on the back burner,” and the remaining third includes companies that are “in the thick of it,” or improving as their worst problems subside.

“Everything in the wallet gets in there because something is wrong, something is not working,” he said. If we think they have a good chance of fixing it, we'll take a stand. Then we do maintenance to ensure the progress we want.” As he gains more confidence in the company's progress, he will add to his position. He will sell it if the expected improvement does not occur. Once the company is far enough through the improvement cycle that the shares reach what Hinch believes is their fair value, he will sell.

“These things take time to work,” he said, especially if one of the companies he is investing in has a new management team.

Current fixer upper

Rob Kosowsky, an associate portfolio manager on the Hench team, provided an example of a holding that could still be considered a fixer-upper due to operational issues: Stericycle Inc. SRCL,
+1.72%.

Stericycle's main business is the collection and disposal of hazardous waste from hospitals and other medical facilities. It also provides document shredding services.

Stericycle was once a “Wall Street darling” that acquired hundreds of smaller competitors from 2000 through 2015. While this “classic accumulation” built a significant revenue stream, it caused the company’s profit margins to collapse, Kosofsky said. Because she never did.” “It's fully integrated.”

Cindy Miller became CEO of Stericycle in 2019, after a 30-year career at United Parcel Service. Since then, Kosowski said, she has been leveraging her logistics background to “simplify the business and improve profit margins.”

Because the acquisitions were not fully integrated, “there was an outdated and incoherent ERP system,” he said. This means that while trying to route trucking fleets across the United States and in 16 other countries, management has had difficulty obtaining real-time information to improve efficiency and pricing. Once the new ERP system is in place, management can act quickly to improve efficiency, and the company's sales representatives will have an easier time understanding Stericycle's full business relationship with each corporate customer.

Another holdover from Stericycle's acquisitions is the confusing collection of about 150 different-sized standard containers for collecting hazardous medical waste, according to Kosowski. The company plans to reduce this number to about 20.

He also said Miller's decision to do some divestments helped Stericycle pay off debt.

Stericycle remains in a “risky state,” Kosowski said. But he expects a steady improvement in the company's profit margin over the coming years.

Three holdings that improved its financial performance

Hinch named three properties from the fund that had already moved beyond the milestone with operational improvements.

• R Air Company,
  +1.26%
  It provides various services to government and commercial aircraft operators, including fleet management, spare parts, inventory and repair, and also provides various containers and shelters for use during military and humanitarian deployments. It goes without saying that the company has struggled during the Covid-19 pandemic, and although air travel has recovered, Hinch still sees room for continued improvement. There is a global shortage of new aircraft, with high demand. This means that the air fleet is aging, which is great for a company in the aircraft maintenance, repair and overhaul business. “Even though it has gone up a lot, AIR is still a prominent part of our portfolio,” Hinch said.

• Healthstream HSTM Company,
  +0.48%
  Provides external training, certification and related regulatory services to the healthcare industry. “They provide software that allows you to go online and take the test; [access] Training manuals, get certified online, or track assignments at work, Hinch said. He added that the stock is trading at a lower valuation than many other SaaS (software as a service) companies. It's unusual for a value fund to hold shares in a growth-stage company, but a valuation of 2.25 times estimated annual sales made this stock look “really cheap,” he said. He described HealthStream as a scalable business that would not require significant capital investments to continue growing quickly.

• Chuy's Holdings Inc. CHUY,
  +0.21%
  It operates a chain of more than 100 Tex-Mex restaurants from its base in Austin, Texas. The company opens between 10 and 14 new locations each year, Hinch said. Chuy's is not a franchise company, it owns all of its restaurants. Hinch said the company's senior management is directly involved in the opening of each new restaurant, that “the food is really good,” and that they “care especially about what they serve, how they serve it, and cleanliness.” At a forward price-to-earnings rating of 16.5 (based on consensus earnings estimates among analysts surveyed by FactSet), Hinch said this stock could be placed in the “growth at a reasonable price” category. But he believes the P/E ratio could rise as the company continues to grow.

Top holdings

Here are the top First Eagle Small Cap Opportunity holdings as of November 30:

Click on the trends to learn more about each company.

Click here for Tomi Kilgore's step-by-step guide to the wealth of information available for free on the MarketWatch rates page.

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