A rosy small-cap outlook

Optimism characterizes management's thinking at the Natixis Vaughn Nelson Small Cap Value Fund (NEFJX). Consider the view of co-portfolio manager Chris Wallis on the Federal Reserve Board's monetary policy: "We're entering a phase of non-restrictive monetary policy, and I don't think rates will go anywhere." As for inflation, he said: "We're seeing some agricultural and energy supply-and-demand shock, but all the inflation we're seeing is coming through the weaker U.S. currency." Longer term, Mr. Wallis added, "we're not looking at runaway inflation, and we don't believe it will be anywhere near what we saw in the 1970s." He co-manages with Scott Weber the $200 million fund at Vaughn Nelson Investment Management LP in Houston. The firm manages $9 billion, and the co-managers are responsible for $2.8 billion in this particular small-cap-value strategy. This year through Thursday, the fund had gained 3.8%, which compares with an average decline of 3.1% by the Morningstar small-blend category. The Standard & Poor's 500 stock index had fallen 8.5% over the same period. Vaughn Nelson took over management of the fund on a subadvisory basis in March 2004 on behalf of Natixis Global Asset Management LP, a Boston-based firm with $910 billion under management. Previously, the fund had a slightly different investment objective as a multimanager small-cap-growth fund. Morningstar Inc. of Chicago rated the fund with four stars for both the three- and five-year periods but gave it just three stars for the fund's entire 10-year history, which includes such low points as a 31% decline in 2002. Under the current management, there is a strict adherence to bottom-up research that appears to leave -little to chance. "We're using an absolute-return strategy, and we're assuming we'll be able to beat the index," Mr. Wallis said. The basic value strategy involves identifying companies that are 50% undervalued, based largely on return on invested capital. He said managers look primarily for three specific situations: stocks with a high return on invested capital, which currently represents about 80% of the 70 positions in the fund; stocks trading at a 50% discount to an identifiable asset within the company, which is the case in about 20% of the current portfolio; and stocks with a dividend yield of 10% or more. Companies paying dividends at that level are not currently represented in the fund, but better days are coming, according to Mr. Wallis. "That has a lot to do with where we are in the credit cycle," he said. "It's a very different world today, but those [high-dividend] opportunities will come back." The research process, which generally concentrates on those companies with market capitalizations of between $300 million and $3.5 billion, begins with a ranking of the Russell 2000 Value Index. A basic valuation and profitability screen boils the larger universe down to between 500 and 700 companies, according to Mr. Wallis. As part of a search for names not already being monitored as part of a proprietary database, the list then is screened for factors such as return on equity and leverage characteristics. The nitty-gritty of uncovering new ideas touches everything from insider-buying activity to public filings to talking to management and evaluating every line item on the balance sheet. "We look at seven years' worth of history," Mr. Wallis said. "You've got to know what you're going to own." One example of where the re-search takes the portfolio is Pediatrix Medical Group Inc. (PDX), a Sunrise, Fla.-based provider of neonatal and other pediatric specialty services. At $52.42 per share as of Friday's close and down 23% since the start of the year, Pediatrix qualifies as a buying opportunity, according to Mr. Wallis. "This is a company with no debt and significant reinvestment opportunities," he said. "There are certainly election-related concerns with regard to health care, but at the end of the day, birth rates aren't changing, and health care will continue to be a meaningful part of the economy." Another health care sector company in the portfolio is LHC Group Inc. (LHCG) of Lafayette, La. The home health care provider is trying to find ways to take cost out of the health care system, which Mr. Wallis described as a positive secular trend. "The demographics for this trend don't really turn positive until 2010, but you need to be looking at this today," he said. LHC closed Friday at $22.01, down 11.9% since the start of the year. Questions? Observations? Stock tips? E-mail Jeff Benjamin at -jbenjamin@investmentnews.com.