Our Deep Value Strategy, which we developed in Royce Opportunity Fund, is an opportunistic approach to investing in small-cap companies with low P/B and P/S ratios that also possess a catalyst for future earnings growth that Bill and his team uncover in the form of new management, a more favorable business cycle, product innovation, and/or the potential for margin improvement. They then categorize their holdings into one of four themes: Turnarounds, Unrecognized Asset Values, Undervalued Growth, and Interrupted Earnings.
The Fund has historically produced strong results, particularly during up market periods, outperforming its benchmark, the Russell 2000 Value Index, during all five trough-to-peak periods since its inception (11/19/96).
We spoke to the team about four holdings—two that are enjoying success in the recent market rebound and two that have lagged but whose long-term prospects inspire the team’s confidence.
II-VI (IIVI, Financial) has been a success so far this year in our Deep Value Strategy. The company makes lasers and optical components chiefly for telecommunication and data center applications. We categorize the stock in our undervalued growth theme.
II-VI (Nasdaq: IIVI)
The market soured on the stock following the company’s announcement in 2018 that it was acquiring Finisar. The general consensus on Wall Street was that the deal was flawed as Finisar was a lower-margin business with historically uneven financial performance. A lengthy regulatory review process for the acquisition added more difficulties given that Finisar’s business was put in limbo while trying to operate in fast-moving technology markets.
Our view, on the other hand, was that the deal made strategic sense. It gave II-VI both more scale and greater access to technology. We also believed that II-VI had a very capable management team who could effectively execute the acquisition. II-VI finally closed on the acquisition late in 2019 while its shares remained range bound at around $30 per share.
In early May of 2020, however, II-VI reported a positive quarter, demonstrating both bookings strength and acquisition savings that were running ahead of schedule. These favorable developments sent the stock into the mid-forties. The growth was driven both by new products, such as facial recognition lasers, and higher demand for data communications equipment due to the enormous increase in people working from home. And both deft supply chain management during the chaos of the coronavirus pandemic and the successful integration of Finisar were key to boosting profitability.
Although the stock has rallied through this year’s strong second quarter, we continue to hold shares. We think the company has the chance for sustained growth given its fresh new products, expanding market applications, and ongoing synergies from the Finisar deal. Further, we would welcome another acquisition once Finisar is fully folded into the mix based on our confidence in the integration skills of II-VI’s management team.
Newpark (NR, Financial) was among the bottom ten holdings in performance through the end of May 2020. The company primarily makes drilling fluids for oil and gas production. As an oilfield services provider, Newpark fell directly into the crosshairs of the dramatic decline in oil prices. While just north of $2.00 per share into early June, Newpark reached a nadir of $0.65 in early April when oil prices were in freefall—and this was actually a few weeks before oil prices troughed in negative territory.
Newpark (Nasdaq: NR)
Newpark fits into our undervalued asset category, and our commitment to the position is grounded in what we see as strong underlying asset support. Indeed, as of the company’s fiscal first-quarter 10-Q filing, Newpark had current assets greater than all liabilities, with the excess surpassing the market cap several times during the quarter. Also important is that this calculation accords no value to the firm’s property, plants, and equipment. Loosely defined, Newpark is a Ben Graham “net-net”— theoretically worth more liquidated than alive! With such strong asset support, we remain comfortable owning Newpark’s shares, even amid negative energy headlines.
Beyond being a relatively safe asset play in the otherwise perilous oil patch, Newpark has an interesting portfolio of products and services that can drive earnings in more normalized markets. On the oilfield side, the company is a leading provider of drilling fluids with a global presence and therefore not simply a Permian shale play. Further, Newpark has recently expanded into completion fluids, which promises to increase wallet share from its customers. Given these factors, we think the near-term risk is manageable while any sustained rebound in oil and gas production could lead to a much higher stock price.
Infinera Corporation (INFN, Financial) is a leading manufacturer of digital optical telecommunications equipment that enables deployments and upgrades of high-speed networks. It fits into our turnaround category. Delays in product introductions and other operational issues caused the company to lose market share and face margin pressure. Going into 2020, Infinera was making meaningful progress on its multiyear turnaround plan, with its backlog improving on the strength of new product introductions that helped the company gain momentum with customers. The coronavirus pandemic then hampered its near-term business prospects, extending the timeline of the turnaround and putting significant pressure on the stock.
Infinera Corporation (Nasdaq: INFN)
Yet we continue to see an opportunity for Infinera to execute on its turnaround plan. While certain customer deployments may continue to be pushed out due to the pandemic, the optical end market in which it operates has favorable secular tailwinds around 5G deployment and the upgrade of existing fiber networks that need to meet the demands of higher network traffic. Infinera is well positioned with its new product roadmap to capitalize on these trends as evidenced by record bookings for some of their products in 2020’s first quarter. Furthermore, Infinera is making headway on outsourcing certain elements of its manufacturing process to a contract manufacturer, which should improve operational reliability and improve margins. The company also bolstered its liquidity through a convertible debt offering that should give it more than enough runway to make it through any near-term market weakness while continuing to execute on long-term growth initiatives.
America’s Car-Mart (CRMT, Financial) sells and finances used autos primarily to subprime consumers at 148 dealerships located in small to midsized towns (with an average population of less than 50,000) in 11 southern and midwestern states serving 81,000 customers. Prior to the broad, indiscriminate market decline in March, the company was not a statistically valid value-oriented stock for the portfolio. It rapidly became eligible in the downdraft, when its stock declined from a 52-week high of $129.80 per share in February 2020 to a 52-week low of $35.18 in March. We took advantage of this severe market dislocation to invest in what we see as a well-managed, long established, and competitively positioned company with low leverage at an attractive price to book ratio of 1.2x—down from 2.9x at its February 2020 high. Even in its early June share price range in the mid-eighties, the stock continues to offer significant potential upside in our undervalued growth category.
America’s Car-Mart (Nasdaq: CRMT)
We also like that the company has limited exposure to customers working in recently vulnerable sectors of the economy—particularly oil and gas, food service, and airlines—and funds its growth primarily with free cash flow instead of external funding sources, two important considerations in the current market environment. The dealership manager conducts character interviews as part of the credit application, with his or her compensation directly linked to collections at the dealership that service the installment loan. The company also has a high level of repeat customers.
Also underpinning our investment thesis is the belief that an auto purchase is increasingly becoming non-discretionary, specifically for much of Car Mart’s customer base, many of whom reside in sparsely populated areas where public transportation is inadequate or non-existent. In addition, state unemployment benefits often support the continued average monthly payment on an auto loan from the company. In previous economic downturns, the company has seen customers return after having migrated to new car dealerships, thanks to offers such as 0% down and other easy financing terms. Car-Mart’s higher-quality used cars and motivated salespeople, as well as the introduction of a digital platform, have served as additional catalysts to expand customer reach and revenue growth. Furthermore, the company’s gross margin has the potential to widen on its lower cost of inventory: The supply of used cars has been swelling due to the limited number of auctions during the period of COVID-19 restrictions while bankrupt rental car companies are selling inventory that’s been only partially offset by repos sold at auction. These catalysts should continue to drive upside in the stock in a range of economic conditions.
Mr. Hench’s, Ms. Franks’s, Mr. Kosowsky’s, and Mr. Mielnik’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
