On June 30, small-cap investor Chuck Royce (Trades, Portfolio) reduced his UniFirst Corp. (UNF, Financial) position by 21.25%. Additionally, the portfolio manager of Royce Pennsylvania Mutual Fund exited his position in Fuel Systems Solutions Inc. (FSYS, Financial), selling his 1.39 million shares at a price of $5.40.
Royce and his investment strategy
A pioneer of small-cap investing, Royce has managed the Pennsylvania Mutual Fund portfolio since 1972. The Columbia University M.B.A. graduate chooses stocks based on an investment strategy focusing on style, market cap and volatility. For his fund, Royce prefers small-cap stocks that have below-average volatility and attractive/sustainable returns on invested capital.
Using the All-in-One Guru Screener, GuruFocus users can generate a screener based on Royce’s investment strategy. A sample “Chuck Royce (Trades, Portfolio) Screener” contains the following filters:
- The company’s market cap is less than $2 billion (since Royce’s fund only considers small-cap stocks).
- The ROIC (10-year median) is greater than 15% (attractive/sustainable returns on invested capital). Additionally, the ROIC must be greater than the WACC.
- The company’s beta is between 0.4 and 0.8 (below-average volatility).
Among U.S. stocks, 69 of them meet all of the above criteria and thus are potential buys based on Royce’s investment strategy.
Customizing filters
With over 120 filters, the All-in-One Guru Screener provides a comprehensive tool to find stocks based on certain criteria. However, users are not limited to these filters.
New feature alert: One of the tabs on the screener contains the word “Customized.” As the name suggests, this tab allows users to customize their filters and screen for stocks with the user-defined filters. To create a new filter, simply click on the blue “Create new filter” button located on the left side of the screen.
Upon clicking “Create new filter,” a popup screen appears, allowing users to enter the formulas for their filters. Under the words “Valid Parameters,” seven tabs organize balance sheet and valuation ratio information including long term debt (ttm), good signs, free cash flow, etc. As users type in their formulas in the large box, a dropdown menu lists the valid parameters based on the letters typed. For example, you can type “long term debt,” and the dropdown menu will list valid parameters that contain the words “long term debt.”
Two of the above filters require the use of the “Customized” tab since these filters are not listed in any of the predefined tabs. You can simply type the required formulas using the steps described above. Click the blue “save” button to add the formula into the customized filters list.
Among stocks that are listed on the screener, a few stocks are currently held in Royce’s portfolio: Dorman Products Inc. (DORM, Financial), Buckle Inc. (BKE, Financial) and Badger Meter Inc. (BMI, Financial).
Fuel Systems Solutions
As the company experiences weakening financials, Royce eliminated his position in Fuel Systems Solutions. The company’s return on invested capital is negative, suggesting value destruction and margin contraction. While the company has healthy cash-to-debt and equity-to-asset ratios, both higher than over 77% of global auto parts companies, Fuel Systems Solutions has a modest Piotroski F-score and an Altman Z-score currently in distress zones. Likely due to high cash-to-debt ratios, the auto parts company has a financial strength rating of 7.
This financial strength rating overstates the auto parts company’s business operation. In addition to weakening F-scores and Z-scores, Fuel Systems Solutions experienced contracting operating margins and per share revenue. Contracting operating margins gives a warning sign that the company’s competitive power is sharply declining and the company’s business operation is unsustainable. Additionally, the auto company’s operating margin underperforms 93% of global auto parts companies.
In its recent 10-K, the management of Fuel Systems Solutions discussed potential reasons why the company underperformed. Lower demand due to tumbling oil prices and increased competition presents one major reason for declining revenues, according to the Securities and Exchange Commission filing.
While it may not make sense to compare Fuel Systems Solutions to auto parts giants like AutoZone Inc. (AZO, Financial), we can run a competitive analysis comparison of Fuel Systems Solutions to other small-cap auto companies. Among competing firms, Fuel Systems Solutions has below-average operating margins and returns on assets. Additionally, the auto parts firm’s return on assets has declined since 2009, dropping below zero by 2011.
UniFirst
In addition to eliminating Fuel Systems Solutions, Royce reduced his position in UniFirst by roughly one-fifth despite the company having a high financial strength rating and profitability rank.
Incorporated in Massachusetts, the apparel manufacturing company has a predictability rank of five stars, suggesting a strong business outlook. With no debt and an interest coverage of 217.48, UniFirst seldom had trouble paying interest on its debt. Currently, UniFirst’s interest coverage outperforms 79% of global apparel manufacturing firms. Additionally, the apparel company’s Altman Z-score is strong: During the past 10 years, UniFirst's Z-score increased to its current score of 7.51. This suggests that UniFirst’s business outlook strengthened during the past 10 years, resulting in high upside potential.
Unlike Fuel Systems Solutions, UniFirst has expanding operating margins and high returns on invested capital. While the company’s operating margins contracted during 2009 to 2012, the margin increased 4% during the 10-year period. UniFirst’s current operating margin outperforms 83% of global apparel manufacturing companies.
Despite the expanding operating margins, UniFirst has some medium warning signs that raise potential threats to its business operation. Based on various valuation methods, UniFirst is moderately overvalued. The valuation box summarizes the fair value price of UniFirst:
- Earnings power value (EPV): $62.91 (margin of safety -78.2%).
- Net current asset value (NCAV): $21.57.
- Tangible book value per share: $42.80.
- Projected FCF: $102.20, which outperforms 55% of global apparel manufacturing companies.
- Median P/S value: $69.73.
- Graham number: $79.71 (article).
- Peter Lynch fair value: $51.31 (article).
- Earnings-based DCF: $101.08 (margin of safety -12.03%).
While the FCF-based DCF valuation suggests that UniFirst is overvalued, this valuation is not as accurate as the earnings-based DCF valuation. As mentioned in the 2008 backtesting study, EPS has a higher correlation with stock performance than does the free cash flow. Because of this, the DCF fair value uses EPS by default although users can still use FCF if they prefer.
Not only is UniFirst’s stock price overvalued based on valuation methods, the stock price is also near a 10-year high, a warning sign that the price is more likely to decrease than increase in the short term. Additionally, UniFirst’s P/S ratios are near 10-year highs, and its per-share revenue is slowing down.
As the stock price is overvalued and the company’s per share revenue is slowing down, Royce knocked off 21.25% of his position in UniFirst June 30. Currently, he owns 1,332,798 shares of the company stock.
See also
GuruFocus users can view the latest guru picks by clicking the topmost item on the “Gurus” tab. The two types of updates offered are quarterly picks and real-time picks, which is only offered to Premium members. Additionally, Premium members can access more gurus, like Royce, than free members. Premium Plus members have further access: They can view 13F, 13D and 13G investor information. Users are encouraged to sign up for a free trial for Premium and/or Premium Plus and get investment ideas from gurus.
Disclosure: I currently do not own any stocks discussed in this article.
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