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Mutual Fund Q&A: 
Contrarian Relative Value
Snow Capital Small Cap Value Fund
Management: Joshua R. Schachter

Author: Manish Shah
Last Update: 12:57 AM ET January 24 2012

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When unfavorable developments of temporary character are coupled with lack of analyst coverage of a small company, the markets are likely to respond with a mispriced evaluation of the stock’s true merit. The portfolio management team of the Snow Capital Small Cap Value Fund blends proprietary screening methodologies with modern behavioral finance research to benefit from companies trading at a discount to their intrinsic value.

Q:  What is the history of Snow Capital Management?

A : Snow Capital Management L.P. is an employee-owned investment management firm located in Sewickley, Pennsylvania and founded in 2001. Our roots trace back to the early 1980s to a family office led by Richard Snow. We are a boutique value equity manager with $2.8 billion in assets (as of December 31, 2011), managing money for financial advisors, high-net-worth and institutional investors with a distinctive investment process.

Our flagship All Cap Value strategy, which I co-manage with Richard, invests in companies regardless of market capitalization. It currently has approximately $1.75 billion in assets (as of December 31, 2011) and a 20-year audited track record employing our process. We launched our Small Cap Value strategy as a natural extension of our investment process, by slicing the equity universe into that specific area of market capitalization.

Q:  What are the main principles of your investment philosophy?

A :
We employ a contrarian, fundamental, relative value investment philosophy. In general, we attempt to uncover securities going through short-term difficulties while having superior fundamentals; most notably a strong balance sheet. Such names may be experiencing below normal business conditions, but have the financial strength to weather the downturn in their business and ultimately prosper after the turnaround. A distinguishing factor of our process is that we attempt to identify the catalysts that will lead to a change in investor psychology which results in price-to-earnings ratio expansion.

Just as business conditions are cyclical in most situations, so are valuations. In determining the normalized valuation of our stocks, we analyze how price-to-earnings ratios have traded in the past relative to the market and to their industry peers to give us a gauge of how investors would value that company once business conditions normalize, adjusted for any potential discounts for that particular industry going forward. Once we identify the relative P/E ratio, we attempt to calculate normalized earnings after the turnaround is complete. The product of our normalized earnings and P/E determine our target price. When skillfully executed, this contrarian philosophy results in an asymmetrical payoff pattern.

Q:  What is your investment strategy?

A :
We select stocks based primarily on the upside potential reflected in our target prices, with the specific risk profile as a determining factor. At the time of purchase a stock’s target price is typically at least 50% above the market price. There are no numerical sector or industry limits.

We believe our competitive advantage lies in focusing on longer-term earnings prospects for companies that are expecting transitory earnings problems. Such companies are often disliked or abandoned by Wall Street analysts and investors. Our "normalized", mid-cycle earnings projections provide a much more stable basis of valuation than do the quarter to quarter surprise metrics that are the focus of most investors.

Our philosophy has not changed but our investment process has adapted to evolving market conditions. We will not change our philosophy or discipline in the face of short term underperformance. We believe that periods of extreme market volatility create opportunities to increase portfolio exposure to our most attractively valued stocks.

Snow Capital's process is pure bottom-up stock selection, with sector and industry weights and other overall portfolio characteristics determined as a residual of the stock selection decisions. Since groups of stocks often move out of favor together, our portfolios sometimes feature themes, such as sector over- or under-weights, or relative tilts to style or market cap segments. These themes result solely from our stock selection process, not from any top down macro views. We do however attempt to balance our bottom up selections with the need for a well-diversified portfolio. 

Q:  How does your idea generation process start?

A :
Approximately 70% of our idea generation starts with a proprietary quantitative screening, where we scrutinize many valuation metrics - price-to-earnings, price-to-book, price-to-sales, free cash flow, and relative debt levels. We try to identify out-of-favor situations in which companies are experiencing short-term difficulties and investors have low expectations of potential earnings, with the opportunity for multiple expansion.

The other 30% of our idea generation comes from daily news flow – watching out for companies that miss analyst expectations or earnings and looking for stocks that are downgraded by analysts.

The lack of analyst coverage and media attention that most small cap names fail to generate is a wrinkle that large cap investors do not contend with. This is a huge advantage because it creates mispricing and opportunities in the market, allowing a fundamental, proven investment approach to discover great value in neglected stocks. We conduct thorough fundamental research on the names we consider- reading SEC filings including 10Ks and 10Qs, participating on company sponsored conference calls and presentations, modeling earnings estimates, doing industry research, and when appropriate, talking with management.

Q:  Could you illustrate your research process with some examples?

A :
Silicon Graphics International Corp. (SGI) is a technical computing company that we found through our screening process when it was named Rackable Systems. Silicon Graphics was formed in April 2009 when Rackable Systems announced an agreement to acquire Silicon Graphics, Inc. when the company was in bankruptcy.

Initially, we were buying Silicon Graphics for under $5 a share, below its tangible book value of $6 a share. The company was cash flow positive, but had negative earnings. We were looking at this consolidated enterprise as an attractive way to invest in the high-performance computing market with minimal risk given the balance sheet strength of the company.

Since Rackable Systems was having some difficulty before they acquired Silicon Graphics, this was a transformational deal for them and one that we felt would not only give them a much stronger position in the industry from an earnings standpoint but also a higher price-to-earnings ratio as sentiment caught up with its new growth profile. We bought the stock at $5 and about two years later the stock was trading over $20 as the complimentary attributes from the acquisition started to bear fruit and ultimately showed up in revenue, operating margins and earnings. Investors were excited about SGI and the growth in their high performance computing platforms and were willing to assign a higher multiple on forward earnings. That was a sharp contrast to two years earlier when the investing community thought the business was worth less than the cash on the balance sheet.

To illustrate the process, the price-to-earnings ratio went from a low number to be more in line with what we felt it should be trading based off of normalized earnings. We felt normalized earnings were $0.70 and a P/E of 7x with an opportunity for the multiple to be 15x, more in line with their peers, when we were purchasing the stock at $5 with a target price of $10 - 100% upside. Over the next 2 years the market’s psychology on SGI changed dramatically. At that point, SGI was trading at a price-to-earnings ratio of 28x and we exited the stock completely. P/E expansion via the excitement and psychological factors affecting the valuation contributed to the rally in the stock. The ability to identify the catalyst in the transformational deal, while maintaining a great margin for error is the perfect example of an asymmetrical risk and return profile.

Another great example would be RehabCare Group, Inc. (RHB), a provider of rehabilitation health care services, which is a company we have owned a several times over the past eight years. We were presented with a great entry point into the stock in the low teens because of the uncertainty created from the Medicare reimbursement cuts in the summer of 2010.

We bought the stock at close to $16 a share, close to five times earnings. Certainly the earnings multiple was compressed and future expectations were quite low. Before the Medicare reimbursement cut announcement, the stock was trading at ten times earnings.

The fear from the street was that the reimbursement cuts would impair future profitability. RehabCare, as most players in the healthcare sector, are fairly accustomed to managing these types of reimbursement challenges. In this situation, they did a good job for a few quarters at mitigating some reimbursement cuts. Investors realized five times earnings was too low for the companies’ valuation, investors starting warming up to the story and increased the P/E to 8 times- roughly a 25 dollar stock in early 2011. The stock was acquired in the upper $30s by Kindred Healthcare at 12 times earnings in February 2011.

This is an example of a company we were buying at a time when the market threw it out because of the uncertainty around reimbursement cuts. As we hypothesized, they were able to mitigate some of those revenue declines and were not affected in the worst case scenario in which some investors seemed to be fearful. The market hated the uncertainty. We viewed their services as an integral piece to the cost containment battle in the heath care debate.

Kindred found them very valuable, and they acquired the stock coincidentally at our normalized earnings price target. It is certainly a good story for us and one that illustrates our process.
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Sources: Data collected by and from company press releases, filings and corporate websites.
Market data: BATS Exchange. Inc.

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