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Micro-Cap Wallflowers Ready to Bloom

Heartland Value Fund's Bill Nasgovitz says there are still bargains among micro-cap stocks and offers two recent picks with a catalyst for growth.

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Michael Breen: Greetings. This is Mike Breen from Morningstar. I'm here with Bill Nasgovitz of the Heartland Funds. They've been around for about 30 years as a firm, and the Heartland Value Fund, which Bill runs, has been around for a quarter century just this year, I believe. How are you doing Bill?

Bill Nasgovitz: Good Mike.

Breen: You were one of the pioneers in micro-cap value investing. Maybe you can kind of briefly comment on what you have sort of seen as the trend over time in micro-cap investing. We were discussing a little earlier sort of analyst coverage, ebbs and flows in there, and you are at a certain point in time now. Maybe you can kind of comment on just the entire environment for micro-cap investing.

Nasgovitz: Well, the value fund is a barbell of small and micro-cap stocks. And micro to us is less than $250 million in market value. So if people are looking for capital gains, we believe that's the best place to look. These smaller companies are not covered by Wall Street, generally speaking, but they're one of the fastest-growing sectors in the U.S. economy and therefore, we think, a fertile ground to be hunting for values that can build one's net worth.

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Breen: So a lot of the pain on Wall Street where analysts were losing their jobs last year in some of the big shops, actually, someone else's pain might be your gain in this case where it gives you a little bit of an additional edge since you are in that space for a long time.

Nasgovitz: Certainly. Certainly. That's what we focus on.

Breen: All right, great. What have you been finding lately? We were discussing a couple of stocks earlier. Maybe you can kind of highlight a couple of the things you have been buying or sticking with lately.

Nasgovitz: OK. As value investors, we are big contrarians. So with all the uncertainty regarding health care, that has been a focus area for our firm across all three funds. In particular, the Value Fund has 27% of its assets in health care.

Things that intrigue us: demographics. Baby boomers, of which I am part of that group, are now aging and it is a fast-growing segment of our population. The nursing home industry is attractive to us because of the demographics. Certainly there is uncertainty, but one of our favorites within that group is a [nursing home] company called Ensign. It trades around $15 a share. It is one of the most conservatively financed, selling at a low P/E. A low P/E to us is less than 10 times earnings for sure at a fraction of cash flow, at a lower price to cash flow, with free cash flow, and tremendous assets and financial flexibility.

So that's one example of a company that is growing through this great recession, but has been totally missed by Wall Street and most any investing public. It is a wallflower, sitting on the sideline.

Breen: In your firm you created a 10-point grid based off sort of a Ben Graham-inspired method that you have used forever. That stock, I think, when you showed it to me kind of hit on all of the factors in the grid. Maybe you can kind of highlight what some of the other inputs are in addition to the low P/E.

Nasgovitz: Well we do like low debt to total capital within the fund, about 20% debt to total cap. So we are looking for companies that have that financial soundness, the ability to weather financial storms such as the one we have just lived through. So low debt/no debt is certainly a hallmark for small micro-cap.

But we do need a catalyst. What is going to excite other investors, whether they be growth or other value investors, to find this company. So we think, in this particular case, the nursing home industry will survive. We don't mean to be Pollyanna-ish, but the clouds will part and the area should receive more attention because of its terrific upside potential in terms of growth.

Breen: What other names are you finding interesting lately?

Nasgovitz: Well, in terms of one of our largest positions within the sector is another no-name $1.4 billion company called BioScrip. BioScrip is a leader in the delivery of specialized pharmaceuticals for hard-to-administer drugs: HIV, Hepatitis B, C, organ transplants, MS. It's a company with a new president and chief operating officer moving dramatically into infusion. Again, a company that is growing through this great recession. It's going to report higher sales, higher earnings, and we feel selling at a fairly lowly P/E of about 12 times next year's numbers.

Breen: Your shop also runs a select value fund, which is an all-cap fund. I know that's another team. You have a 25-year record on the micro-cap focus, small-cap fund, and that is great. And actually, the Select Value has an equally strong record. So what differences or challenges have you seen applying the methods to a different cap size? Any difference?

Nasgovitz: No. We're really all on the same page. All of the investment management department, 15 of us, operate on the same fundamental value basis, the same 10-point checklist, looking for low P/Es, low prices to earnings, cash flows, book values, solid balance sheets.

And you can certainly find those in big-cap land, too. One of the favorites there in the Select fund was Wyeth. They owned Wyeth, which is now Pfizer, and they are still holding the stock.

But we collaborate. There is a culture of collaboration at our firm. So all of us talk daily about what is going on in a particular industry, certainly sharing stock ideas, whether it be small, mid, or large.

Breen: OK. So it's probably a little more difficult than six months ago to find values with the market runup. It sounds like you're still finding plenty of them.

Nasgovitz: Well the market has appreciated dramatically, hasn't it? But there are still inefficiencies within this marketplace, certainly in the small micro side, and also from the macro view, the growth momentum style or styles still seem to be in vogue to us, are the dominant investment speculative process today. So for value investors who can look out more than a quarter, perhaps a year or two, there are always disappointments that we feel present possible buying opportunities for longer-term investors.

Breen: OK. Fantastic. Thank you for your time.

Nasgovitz: OK. Thanks Mike.

Michael Breen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.