James Harvey, Deep Value Portfolio Manager, Royce Investment Partners.
James Harvey is a Principal and Portfolio Manager at Royce Investment Partners, the small and micro cap investing juggernaut. In his 3,750 word interview, exclusively in the Wall Street Transcript, James Harvey details his investing methodology and details several top picks from his current portfolio.
“First and foremost, it’s a value-oriented approach.
We look to buy statistically attractive stocks at low valuations and typically these low valuations come about as a result of temporary issues. As we’re doing our research, we look for stocks whose problems look transitory and possess some kind of catalyst that we feel can close the valuation gap.
Another tenet of the strategy is that we recognize that, especially in small caps, you can encounter a fair share of volatility.
But we understand that volatility differs from risk, so we tend to take advantage of this volatility in order to try and maximize returns.
We identify names that we feel are suitable for the strategy and we divide them into four investment themes.
Number one is unrecognized asset values.
The second category we label as turnarounds.
Third are undervalued growth companies.
The fourth are companies with some type of interrupted earnings or broken IPOs.
One example from the James Harvey small cap value portfolio:
“In terms of unrecognized asset values, we own a company called Atlas Air Worldwide (NASDAQ:AAWW).
Atlas [Air Worldwide (NASDAQ:AAWW)] has been in business for 30 years.
They own a fleet of over 100 aircraft that are mainly used to transport cargo for parcel customers such as DHL and FedEx (NYSE:FDX), but also e-commerce players like Amazon (NASDAQ:AMZN), who’s a customer.
They’re the largest operator of 747 freighters in the world and they break out their business into two segments: airline operations and dry leasing.
In airline operations, they provide services to their customers under agreements known as either ACMI or CMI. ACMI stands for Aircraft, Crew, Maintenance and Insurance.
Atlas Air Worldwide (NASDAQ:AAWW) owns the aircraft, they provide the crew, and they’re on the hook for maintenance and insurance but that’s it. The customer pays for fuel and the other costs such as landing fees and any other expenses. The costs are relatively well known and fixed.
CMI has basically the same structure, but they provide the crew, the maintenance and insurance, and not the aircraft. The contracts they have with their customers basically call for guaranteed minimum flying hours. These revenues are fairly predictable, and the company also provides charter services for sports teams and other organizations that want to charter on a monthly basis and just need access to a plane.
The dry leasing segment is where Atlas [Air Worldwide (NASDAQ:AAWW)] would provide aircraft to a customer and nothing else and then they would just get paid, say, a fixed monthly fee for providing that aircraft. Customers would be, again, people like DHL and FedEx who need extra capacity.
Amazon has become a pretty significant customer for Atlas [Air Worldwide (NASDAQ:AAWW)].
The key to understanding the business is that these arrangements with their clients provide for guaranteed minimum revenues that are all predetermined or pre-negotiated so, again, Atlas [Air Worldwide (NASDAQ:AAWW)] does not take on any fuel risk.
As you might imagine, over the last few years, this has been a bit of a booming business. Revenues have grown very nicely. Global air freight volumes are actually exceeding pre-pandemic levels, so earnings have been great and growth has been very good.
But we like to have it in the unrecognized asset category because other investors weren’t as attracted to these underlying assets.
It would be virtually impossible for someone to replicate a business like this today just in terms of the number of aircraft they have and their ability to serve their customers the way they do. They have a world-class fleet of planes. They keep adding planes. They have a network of customers that I would say are top notch in the business. They have unrivaled global operating capabilities, and these are all really valuable assets.
The shares trade at 80% of book value and today you could argue that the assets that they have might be more valuable than ever. It’s tough to get planes, the capacity is tight, and the services they offer are in very high demand.”
Craig Inman, Managing Director, Artisan Partners
Daniel L. Kane, CFA, is a managing director of Artisan Partners and a portfolio manager on the U.S. Value team. In this role, he is a portfolio manager for the Artisan Value Equity, U.S. Mid-Cap Value and Value Income Strategies. Prior to joining Artisan Partners in March 2008, Mr. Kane was a senior small-cap investment analyst at BB&T Asset Management, Inc. from August 2005 to March 2008. Mr. Kane began his investment career as a domestic equities securities analyst at the State of Wisconsin Investment Board in 1998.
Craig Inman, CFA, is a managing director of Artisan Partners and a portfolio manager on the U.S. Value team. In this role, he is a portfolio manager for the Artisan Value Equity, U.S. Mid-Cap Value and Value Income Strategies.
These two portfolio managers detail their contrarian deep value investing philosophy and top picks in their 4,615 word interview, exclusively in the Wall Street Transcript.
“…We approach investing with a risk-aware mentality, or a risk-aware mindset.
First, we find companies with superior business economics, looking for strong returns on equity and ROIC.
These are companies we’d like to own for long periods of time.
Second, we look for undemanding valuations, which typically occurs when other investors are avoiding a stock because of some setback in the business.
Lastly, we want to see strength in the balance sheet, which buys us time allowing a company to weather any unforeseen near-term storms as their longer-term business economics are eventually understood better by the market.
Stocks with stronger characteristics on all three of these measures typically have a narrow range of possible outcomes and so they merit a higher weight in our portfolio.
Less ideally balanced stocks will not receive the same allocation of capital.
Stocks with a binary outcome are areas we typically don’t invest in.
So while we are primarily focused on the business, valuation helps inform our view of the pessimism baked into the stock price. Typically, when we’re looking at a company, valuation is under pressure because there’s some sort of fear and uncertainty impacting the price. And rather than run away from it, it attracts our attention and interest.
We use an undemanding valuation that’s based upon a normalization of the earnings power of the company. And that’s the core tenant of what we’re looking for — something is pressuring the business today; something is causing margins or sales to be weakening or soft in the near term.
And we use the longer-term time horizon and different snapshots of valuation in order to get a feel for what the value of the company could be in a recovery or a normalization type scenario.”
One example from their portfolio is Royal Philips (NYSE:PHG).
“This is a 130-year-old company that you might recall as Philips Electronics.
The company was founded back in the early 1890s. Over the last decade-plus, the company has gone through a remake, moving from a conglomerate structure to one that’s dedicated and focused 100% on health care.
They spun off a semiconductor business in 2006, spun off their lighting and light bulb business in 2016 and more recently sold their domestic appliances business.
What you’re left with is a diverse medical business with a large installed base of diagnostic imaging devices — X-ray, CT, MRI, PET, etc. — a number of product offerings in image guided therapy, patient monitoring, breathing and respiratory care and personal health. So there’s a large installed base of imaging devices and a footprint that’s really global in hospitals and clinics across the world, which allows them to compete very effectively, versus a lot of their peers.
We got involved with this stock late last year.
Their Connected Care division, which is their second largest, operates in the sleep business. They manufacture and sell CPAP machines for patients who need treatment for sleep apnea, a serious disorder in which breathing repeatedly stops and starts.
Philips is the number-two player in the industry, along with competitor Resmed (NYSE:RMD).
Treating sleep apnea provides a tremendous health benefit for patients who show immediate quality of life improvements. Treatment is also very helpful in reducing the risk of ancillary complications like heart attack, hypertension, stroke and diabetes.
The sleep business ran into a problem in June of 2021, when the company had a recall of their DreamStation CPAP product because they noticed some of the foam that’s used to provide sound abatement for the product was degrading when patients were cleaning it with an ozone cleaning agent, which incidentally the company does not recommend doing.
There are two important aspects to this recall.
First, there is risk to a potential long-term impairment of the sleep business, which is right now only around 7% of total revenue.
In a very concentrated market with only one other significant player, Resmed, it is highly likely that Philips’ business will recover and regain traction.
Recalls are a recurring feature of the sleep business, with Resmed having their own recall in 2007.
Secondly, there is risk from U.S. personal injury lawsuits. Investors are capitalizing billions of dollars of settlements due to ongoing and forthcoming consumer injury lawsuits and multidistrict product liability lawsuits.
That remains to be seen as litigation is in its very early stages.
However, the company’s market value has declined by over $15 billion since they announced the recall. That’s a significant destruction of value when you compare that versus not only the existing pretax profit and cash flow the rest of the business generates, but also the levels of litigation payouts that have occurred in the medical device industry in the past.
Hernia mesh and hip implant settlements were significant but collectively well below $15 billion in total.
For example, Bayer AG (OTCMKTS:BAYRY), a European life sciences company recently settled a portion of litigation that stemmed from the Roundup businesses they bought from Monsanto in 2018.
News reports have detailed where consumers have been exposed to Roundup over longer periods of time and in some cases developed a form of cancer.
Bayer settled that litigation for around $11 billion or roughly $110,000 across 100,000 lawsuits. If you did similar math for Philips’ potentially affected patients, which is a much smaller number than the existing customers using their machines, you’re looking at a number for Philips which is a significantly smaller number than $15 billion of market value that has been erased.
So, we think the market has overplayed their hand in terms of penalizing the company for this litigation risk.
However, we’re eyes wide open with the expectation that the cases will play out over the next couple of years and the company will most likely settle some of these to reduce future litigation risk.
In the meantime, it’s trading for a mid-teens multiple of our estimate of normalized earnings which are obviously currently depressed because the sleep business has faced this setback and they’re not selling new sleep machines.
They’re focused on repairing or replacing machines for the existing patient base. The stock is trading at a level well below the peer set and where it’s lived historically.
The balance sheet is in great condition, with only 1.3x turns of net leverage, but certainly strong enough to be able to handle any litigation outcome, with a payout structure that would most likely take place over many years.
The stock has fallen over 40% over the last 12 months.
It’s one of the best health care businesses out there, especially given the sticky installed base, importance to clinics and hospitals in terms of how this equipment is used for their daily workflow needs to diagnose and treat patients, and strong margin and cash flow profile.
We like Philips; it’s a name we bought and added on the recent downturn.”
Get all the picks from James Harvey, Daniel Kane and Craig Inman by reading both the 3,750 word interview and the 4,615 word interview, exclusively in the Wall Street Transcript.
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