Patience Pays Off for Ben Graham Disciples

DURING THE EARLY 1970s bear market, Bill Nasgovitz, founder of investment firm Heartland Advisors, developed a stock-picking strategy inspired by his re-reading of Benjamin Graham's tome on value investing, "The Intelligent Investor."

Today, the managers at Heartland's small-cap value fund credit that same strategy for their success so far this year. With echoes of the 1970s haunting investors amid today's sluggish growth and rising inflation, the Dow Jones Industrial Average strayed into bear-market territory when it hit a fresh intraday low on Monday. The small-cap Russell 2000 benchmark, while holding up a bit better, is 19% off its peak. The Dow closed Tuesday down 13% year to date, and the Russell down 8%.

But Heartland Value Plus (HRVIX) is in the black — by 9.5% — making it among the best-performing U.S. stock mutual funds, according to Morningstar. The fund also had a solid showing last year and its five-year annualized return of 15% ranks it in the top 1% of peers. Still, investors pulled money out of the fund last year and earlier this year amid the wider exodus from small stocks. More recently, some of this scared money has returned.

"The next few months are very difficult to predict," says Adam Peck, one of the fund's three managers. "I can't say we're at a bottom, but as we get through earnings season and the election, we could start to see a better market."

Peck says stock picking during these tough times "comes down to the process" Nasgovitz developed all those years ago. There are 10 criteria in all; a prospective investment will ideally meet at least seven of these. A key one for bargain hunters to keep in mind right now? A "catalyst," Peck says. In other words, a trigger for the anticipated gains. Stocks that have one are less likely to prove value traps — cheap shares that get even cheaper.

For instance, the fund likes Asset Acceptance Capital (AACC), which buys bad debts from lenders and then tries to collect enough to recoup its costs — and hopefully more. With delinquencies rising, the supply of bad debt is increasing, which should drive down the prices Asset Acceptance pays for portfolios, possibly improving margins, as Peck hopes. And, in fact, Asset Acceptance noted after its first quarter that "the pricing environment continued to improve" and that "given macro concerns... certain issuers may be inclined to sell more portfolios at lower prices in coming quarters." Peck also notes that company insiders started buying Asset stock toward the end of 2007.

Overall, the fund's managers are wary of financial companies and the consumer discretionary sector. They like energy and materials, with oil and gas company St. Mary Land & Exploration (SM) their recent largest holding. If you're worried about oil prices falling, Peck says they've based their analysis of St. Mary on crude at $80 a barrel, rather than the $140-range it currently roams.

The fund offsets some of its energy exposure with other holdings, such as Cooper Tire & Rubber (CTB), one of the portfolio's few consumer stocks. Cooper's shares are trading at about $7 while its book value is parked in the low teens per share. The stock boasts a 5% annual dividend yield. As the economy slowed, consumers put off getting new car tires, but Peck says such skimping can't go on forever. Since Cooper's tires are at the industry's lower end, they'd presumably outsell pricier brands.

Down the road, Peck sees the U.S. economy recovering as other countries slow down. Likewise, small caps that were the first to get hit by the downturn should be the quickest to rebound, he says. Investors who pulled their money out of small caps and moved it into international stocks will likely reverse that move, he predicts. "I think small caps would be a good place to be."

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