"Promising opportunities can be found among securities that are most deeply undervalued relative to their future earnings potential." -Arnold Schneider
Arnold Schneider (Trades, Portfolio)’s Small Cap Fund came roaring back to life in 2016, with an amazing 58.5% return—that almost made up for his big losses in 2014 and 2015.
Behind his big gains—and losses—lies a deep-value investing strategy, a return to Benjamin Graham’s ideas and to what Warren Buffett (Trades, Portfolio) called "cigar-butt" investing.
Serious deep-value investors are not concerned about the quality of the stocks they are buying, they just want deeply discounted prices. James Roumell of Roumell Asset Management writes in his second quarter 2017 letter to investors, “Our investment mantra lies in pursuing value not by searching for great companies, even ones that might be reasonably priced, but rather in sourcing 'Out of favor, overlooked and misunderstood' securities”
As will be seen, Schneider is taking on some those out-of-favor stocks.
Who is Schneider?
Schneider graduated from the University of Virginia in 1983 with a Bachelor of Science degree in commerce. From 1983 to 1996, he was a senior vice president and partner at Wellington Management.
In 1996, he set off on his own, founding Schneider Capital Management. He is currently president, chief investment officer and principal of the firm. Schneider is the only member of his firm to have more than 25% of its shares, according to its Form ADV Part 2A.
Bloomberg reports Schneider also serves as “Portfolio Manager of Russell Investment Company - Russell U.S. Strategic Equity Fund and Russell Investment Company - Russell U.S. Dynamic Equity Fund.”Â
What is Schneider Capital Management?
Schneider Capital is an investment management and advisory services firm; it provides advice to institutional investors, investment companies and pension and profit sharing plans (Form ADV Part 2A).
While primarily oriented toward institutional investors, the firm does offer one publicly traded mutual fund, the Schneider Small Cap Value Fund (SCMVX). According to a Yahoo Finance description, the fund seeks long-term capital growth through investments in companies that have a market cap below the largest company in the Russell 2000 Index and are considered undervalued.
Yahoo Finance also reports the fund’s net assets at $41.67 million, making it less than 10% of the firm’s total assets of $606 million. It has a volatile portfolio with a beta of 1.53.
Schneider’s firm manages a significant amount of assets on behalf of institutional investors and other money management organizations. Its one publicly traded fund should be a volatile one given its heavy exposure to small caps.
Investment philosophy and process
On their website, Schneider and his team describe themselves as deep-value investors who believe their best opportunities will come from securities that are deeply undervalued in relation to future earnings potential. So their choices will not be just any cigar-butts, but rather those that continue to have potential value despite their share price collapses.
They sum up their investment philosophy below:
They also outline their investing process:
A broader context for Schneider’s philosophy comes from his macroeconomic and geopolitical analyses. In his second quarter 2017 letter, published Aug. 7, Schneider discusses two such issues:
- Oil and gas: He notes the price of oil dipped in the quarter because of OPEC production, U.S. inventory reductions and an uptick in Libyan production. He also says few exploration and production companies can be profitable at prices below $50 per barrel. In the long term, he expects higher prices because current spending is not enough to sustain supplies. Overall, he thinks the oil and gas stocks he holds should perform very well in the future. He wrote: "We believe energy equities, particularly those held in the Fund, offer enormous upside potential once again." Almost 35% of the Small Cap Value Fund is made up of energy stocks.
- Financials: Schneider is also optimistic about his financial holdings, which comprise more than 24% of the Small Cap Fund. He says bank stocks should get a boost from deregulation and increases in the federal funds rate. In addition, the U6 unemployment rate is at a 10-year low and the main unemployment rate is at a 16-year low; this should lead to upward pressure on wages and the rate cycle. He adds, "Banks should have earnings increases well above market averages over the next couple of years. Overcapitalized balance sheets will enable large sustainable buybacks combined with rising Net Interest Margins.”
Turning to deep-value stocks, here are GuruFocus charts of three of the top 10 holdings in his Small Value fund:
Whiting Petroleum Corp. (WLL, Financial) currently sells for less than $5, a far cry from 2014 when oil reached a peak and the stock was selling for more than $90. This five-year GuruFocus chart shows when the company became a cigar-butt.
Aviat Networks Inc. (AVNW, Financial) went from $200 territory in 2008 to less than $20 today. The 10-year chart shows lots of time to buy this communication equipment company at a deep discount, but no opportunities to get out with a profit.
American Equity Investment Life Holding Co. (AEL, Financial), a life insurance company, is finding new life as it recovers from a share price collapse in late 2015. For investors who bought this name in early 2016, there has been quick and decisive proof they invested in a cigar-butt with many puffs left in it.
Schneider added to his holdings of all three of these stocks in the second quarter of this year.
He has stuck to his deep-value core by adding to each of these top five holdings despite continuing uncertainty about two of them. Whiting will likely recover when oil prices begin rising again. Aviat, though, continues to be a real test of a value investor’s resolve.
Schneider’s small-cap holdings
As noted, the Small Cap Value Fund represents less than 10% of his total holdings, but he says they use the same style in all investing areas.
The following Morningstar table shows the fund’s sectoral profile:
The individual holdings of the Small Cap are shown in this table from Yahoo Finance:
It is not surprising this fund is volatile (with a beta of 1.53) given its major positions in small caps (as advertised in the fund’s name) and that energy and financials have such a prominent place.
Performance
Since the fund is small cap, it does not make sense to compare it with the S&P 500. Logically enough, Schneider compares his fund with the Russell 2000 Value Index, as shown in this table from the firm’s website:
For investors, though, the S&P 500 is the benchmark that matters. If an active fund manager cannot consistently stay ahead of it, they might as well be in a passive fund.
The following Morningstar chart paints a dimmer picture of the fund’s performance when compared with the category average for small value funds (and the S&P 500):
This Morningstar table shows investor returns for the fund and an insight into the ranking of the fund within its category. Note how, on the last line of the table, the fund jumped from the 70th percentile to top spot over the past year:
An investment in the Schneider Small Cap Value Fund is very much a shoot-for-the-stars move. The objective of the fund is long-term capital growth, but on a cumulative basis over at least the past 15 years, that swing for the fences has not been very rewarding.
Conclusion
Many investors have followed Buffett as his investing style evolved from buying anything that was cheap to, as he says, buying wonderful companies at fair prices.
Schneider has chosen to stay with the style of the man who largely defined value investing, Graham. He buys stocks of deeply discounted companies, but narrows that field somewhat by restricting his universe to stocks that have future earnings potential.
For investors who would emulate Schneider, or buy into his mutual fund, beware. The returns have been amazing at times, but you must pay a price for those big years to come around.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
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