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Focus on small-cap stocks in 'bargain bin,' but low debt

Brad Evans, manager of the $404 million Heartland Value Plus fund, has outperformed all rival funds this year by betting good money on bad stocks.

Brad Evans, manager of the $404 million Heartland Value Plus fund, has outperformed all rival funds this year by betting good money on bad stocks.

"We're looking for companies that have stumbled and the market has put them in the bargain bin," Evans said during an interview last week in Boston.

Value Plus' 12.4 percent return in 2008 is highest in its category, according to Morningstar Inc., in Chicago. The fund, which ranks second for the last 12 months and three years, targets small companies with market capitalization of $300 million to $3 billion that Evans considers undervalued based on earnings or other financial measures.

Evans' biggest holdings include Cimarex Energy Co., a Denver-based oil and gas company that's up 66 percent this year.

Asset Acceptance Capital Corp., a Warren, Mich., company that buys bad debts at a discount from credit-card firms, has gained 34 percent.

The fund has a three-year Sharpe ratio of 0.77, compared with 0.22 for competing funds, according to Morningstar, with a higher value meaning better risk-adjusted returns. The firm gives Value Plus four out of five stars.

Cimarex lagged behind peers in increasing production in recent years. Evans began buying the stock in February 2007 at less than $40 a share, which was cheap compared with other oil and gas producers, especially with the company's low debt and exploration prospects. The stock closed Friday at $69.16 on the New York Stock Exchange.

The company has profited more from the rising price of energy than other producers, whose comparatively higher debt forces them to lock in prices on the futures market to avoid shocks to revenue already under pressure from interest payments.

Cimarex's low debt allowed it to avoid locking in its selling price on the futures market and so benefited from rising spot prices.

Asset Acceptance saw its profit and stock decline when the price of receivables rose from 2005 to 2007 amid a decline in supply. The company kept debt low and has positioned itself well for what Evans, 36, calls a "tsunami" of deeply discounted receivables due to a rise in consumer-debt delinquencies.

Low debt is a recurring theme for Evans, who is based at Heartland Advisors Inc., in Milwaukee. "If you make a mistake on a company that isn't highly [leveraged], it won't kill you," he said. "Make a mistake on a highly [leveraged] company, and you'll lose fingers."

He bought Asset Acceptance in December at $10 to $12. It closed regular trading Friday at $13.13.

Value Plus, as well as its sister funds, the micro-cap Heartland Value Fund and mixed-cap Select Value Fund, follow a 10-point formula that stresses strong financing and low ratios of price to earnings, cash flow and book value. Another key is finding factors that will help the company recover from its particular misfire.

"This is not just buying cheap stocks," Evans said.

"We're trying to understand why the company will be recognized in the marketplace."

Other big performers this year for Evans have been surgical-device-maker Datascope Corp., Montvale, N.J., up 30 percent, and another Denver-based oil and gas company, St. Mary Land & Exploration Co. It has risen 32 percent.

"They have a very systematic approach," Michael Breen, an analyst with Morningstar, said in an interview. "A lot of fund companies say they have that, but Heartland is religious about it."

Unusual for a small-cap investor, Evans also seeks out companies that issue dividends. Because other investors look to small companies as an asset-appreciation class, he said, they don't price dividends into their valuations. Yet the average spread between total returns from dividend payers and nonpayers in the Russell 2000 Value Index is 2 percentage points.

"You essentially get the dividends for free, and 200 basis points compounded over time is very significant," Evans said.

A 1995 graduate of the University of Wisconsin-Madison, where he studied international relations and Russian, Evans said most investors were missing a big opportunity in small-cap investing. Small-caps, he said, have returned an average 24 percent in the 12 months following the last 18 recessions. Large-caps have returned 15 percent.

Morningstar ranked small-cap value fourth among 18 domestic stock categories this year, with the average fund falling 0.3 percent. Large-cap value ranks 14th, with an average decline of 6 percent. Funds focused on natural resources form the top category with a 12 percent return.

Despite the strong performance, investors have pulled $11 billion from small-cap value funds this year, according to data compiled by Leuthold Weeden Capital Management in Minneapolis.

Evans said Value Plus had significant net outflows in 2007 and modest inflows so far this year.

"I'm trying to ring the bell here for small-cap," he said, "because nobody's paying attention."

Heartland Value Plus


Brad Evans.


$404 million.


12.4 percent in 2008.

Key holdings:

Cimarex Energy Co., Conmed Corp., Datascope Corp.