Markets & Finance

Cheap Stocks, Big Returns


By Richard Diennor How much of his own money does Charles Rinaldi keep in the $500 million Strong Small Cap Value Fund (SSMVX) that he manages?

"Let me put it this way," he said. "My house used to be my largest asset, and now I have significantly more in the fund than my house is worth."

Rinaldi's fellow investors in the fund should have no complaints. Strong Small Cap Value is up 18% for the year as of May 8. For the quarter and year ended in March, the fund returned 9.3% and 13.3%, respectively, while the average small-cap value fund lost 0.7% and gained 10.6%. The fund carries an S&P three-year overall ranking of 5 stars, meaning it exhibits the best combination of risk and return versus its peers.

NET BETS. So what companies has Rinaldi been buying with his and other peoples' money? In early January, he began investing in two Internet stocks, EarthLink Inc. (ELNK) and Net2Phone (NTOP).

EarthLink, which currently ranks as the fund's fourth largest holding, provides access to the Internet and related services to businesses and consumers. The stock, which closed May 8 at $12.01, was selling for about $5 when Rinaldi started buying it. It has risen more than 100% so far this year.

Net2Phone, which uses the Internet to deliver messages sent by computers, telephones and fax machines, was selling for $9-$10 when Rinaldi initially staked out his position; lately it has traded for $8-$8.45.

"They're not dot-coms that are going to go away," Rinaldi said of both holdings. "These are companies that offer utility-type services. They have very strong balance sheets. They're raising prices and cutting costs."

Among other recent investments, Rinaldi named Coherent, Inc. (COHR), which makes lasers, optics and related products for medical, scientific and telecommunications markets.

Rinaldi previously owned shares of the company two or three years ago and started buying them again late in the fourth quarter last year, when they were trading between $25 and the high $30s. Coherent closed at $34.71 on May 8.

"We're not really making any money on it yet," Rinaldi conceded. "But this is a company that has quite a bit of cash ($9 per share) and very little debt."

On the surface, Coherent may seem to have an expensive price-to-earnings multiple, but if you factor in its cash flow and the value of its component parts, the stock is cheap, Rinaldi said.

ON THE CHEAP. When picking stocks, Rinaldi typically looks for shares selling for less than what the company would be worth if it were broken up. He also scans for stocks that are cheap relative to earnings, sales or cash flow. Then he looks for a catalyst, like an new product or restructuring, that can boost a stock's price.

He also likes to see healthy balance sheets, increasing revenues, decreasing costs, high ownership by management, and low institutional ownership and debt.

In addition, Rinaldi screens for stocks that have fallen for reasons unrelated to a company's financial health, such as investor selling in the fourth quarter for tax losses. The 80-110 companies the fund usually holds have market caps of $200 million-$2 billion.

"Our process is designed to uncover value," he said. "And if it works, we're buying cheap stocks all the time with some dynamic for change."

OIL FINDS. Energy companies currently account for about 22% of the fund's assets, including Forest Oil (FST), the top holding in the portfolio. Rinaldi bought a stake in the oil and gas company in the third quarter last year when it was selling at $14.38; it closed at $31 today.

Rinaldi expects Forest to generate about $12 in cash this year and likes the fact that its price-to-cash flow multiple is low. He also thinks the company has some assets off the coast of Africa that could be worth $11-$12 per share. As with many of the stocks he owns, Forest is also a potential takeover target, he said.

Rinaldi sees energy and related stocks benefitting from strong demand and increasing prices for oil and natural gas. Elsewhere in the sector, he owns Key Energy Services (KEG), which services land-based oil rigs, and Range Resources (RRC), which has been trading for in the $5-$6 range of late, but which he thinks could top $10 in a year or so. Rinaldi has owned Range Resources since May 1998, and the average cost of his shares is $4.23.

IRON AND GOLD. The fund's top holdings also include Mercury General (MCY), an automobile insurer, and Chicago Bridge & Iron N.V. (CBI), an engineering and construction company whose specialty is designing and building tanks and facilities for storing liquids.

Mercury General does the bulk of its business in California and should gain if auto insurance rates rise, Rinaldi reasoned.

Chicago Bridge is attractive because although it is in a cyclical industry that probably hit bottom a year ago, it maintained a high return on equity, increased earnings, bought back stock, and paid off debt when the industry was suffering, Rinaldi said. When the industry picks up, "they ought to do really well," he said.

Rinaldi has owned Chicago Bridge since March 1998 and the average cost of his shares is $16.50. The stock hit its 52-week high of $31.15 on May 4, but Rinaldi thinks it could rise to $50-$60 over the next couple of years.

Approximately 5%-6% of the portfolio is made up of companies that mine for precious metals, an industry Rinaldi describes as "depressed." At the same time, it's a sector that "nobody's really paying a lot of attention to," he said.

The fund owns Apex Silver Mines (SIL), Glamis Gold (GLG) and Meridian Gold (MDG), all of which have "pristine" balance sheets and generate lots of free cash, according to Rinaldi.

Another point Rinaldi makes about the fund is that it hasn't made a capital gains distribution in the last three years, making it, he noted, "100% tax efficient." Diennor writes about mutual funds for Standard & Poor's FundAdvisor


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