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Deep Dive: Small-cap fund produces big profits, even if some of its holdings don’t

The spectacular rise in small-cap shares since the election of Donald Trump shows that investors sometimes care more about sales and market-share growth than they do earnings.

Albert Grosman and Brian Lund, portfolio managers of the ClearBridge Small Cap Fund, shared with us three of their favorite stock holdings, and only one of them has been consistently profitable.

Still, the $716 million ClearBridge Small Cap Fund LMASX, +0.22% has performed well this year, up 27.2%, easily outpacing the small-cap Russell 2000 Index’s RUT, -0.16%  22% increase.

ClearBridge Investments is a subsidiary of Legg Mason Inc. LM, -2.96% which has about $110 billion in assets under management. Grosman and Lund are based in Baltimore and run close to $1 billion in their small-cap value strategy.  

In an interview Dec. 16, Grosman and Lund described their approach to selecting stocks as a “bottom-up, valuation-focused” process through which they decide whether a company’s expected free-cash-flow growth justifies a valuation considerably higher than the current share price. A company that’s quickly increasing sales and potential cash flow might have plenty of significant potential on its way to becoming profitable.

Here are three favorite holdings of the fund, as described by Grosman and Lund:

2U

2U Inc. TWOU, +0.13%  works with major universities to create graduate degree programs, providing systems and logistical support. We recently interviewed CEO Chip Paucek, who described the programs in detail. Please see that article for detailed information about how the fully accredited programs work and how rapidly the company’s sales have been growing.

“Because they have been so successful in winning new programs, they continue to lose money,” Grosman said, when discussing 2U’s financial performance. The company makes a major up-front investment when starting a new program, and has to keep making these investments because of demand.

“This is an example of a money-losing company that, to us, is building a lot of value over time. They are winning these contracts that are value-accretive,“ Grosman said, because the up-front costs are recovered over time, and when the contracts are renewed, those initial investments don’t need to be made again.

2U is a long-term cash-flow play. Lund said: “If they win 10 new contracts next year [which the company already said it expects], and lose more money, we think they would be worth more and not less.”

Gray Television

Gray Television Inc. GTN, -0.47%  operates 51 TV stations, mainly in small markets around the U.S. “What is unique is that they are No. 1 or No. 2 in 50 of the markets they serve,” Grosman said. He added that investors have been “discounting that Gray’s free cash flow will shrink over time.” The company posted a small third-quarter loss, after being profitable on a GAAP basis, for 14 straight quarters.

Sales and cash flow can be expected to decline in 2017, because that will be an off-year for elections. In 2018, when all 435 House of Representatives seats and 33 Senate seats will be up for grabs, local broadcasters will reap the usual harvest of political-advertising spending.

Grosman believes that despite the broad concern for local TV, as viewers have ever more online choices, Gray’s free cash flow will rise because of its local focus, and that it will continue to improve its efficiency. Local stations are also being paid more in retransmission fees by cable and satellite TV carriers. “Over the next two and half years, the vast majority of [Gray’s] viewers will be repriced,” with fees expected to continue to rise, Grosman said.

Ironwood Pharmaceuticals

Lund discussed Ironwood Pharmaceuticals Inc. IRWD, +1.75% whose main product is Linzess, a treatment for constipation and Irritable Bowel Syndrome. During the third quarter, sales of Linzess were up 40% from a year earlier. Ironwood’s partner for Linzess is Allergan PLC AGN, +0.10% and Ironwood’s share of the net third-quarter profit from sales of Linzess was $50.1 million, rising 92% from a year earlier. The drug is patented through 2031, and Lund believes the patent protection might be extended until 2036.

Ironwood is still not profitable on a GAAP basis, but “they are not reaching a point where profit is inflecting, where they are covering costs and every new prescription is hitting the bottom line,” Lund said. The company also has two other versions of Linzess in development, “including a smaller dose one and one with a different release function, to benefit a larger population,” Lund said, which he believes has “the potential for the company to be worth much more than it is now.”

Ironwood has three new medications in the pipeline, one of which is a treatment for refractory gastroesophageal reflux disease. This medication is in Phase 2 testing now, “and if it does not go well, they will shut it down immediately, making [the company] instantly profitable,” Lund said.

Here’s a quick look at how all three companies have increased sales per share over the past 12 reported months:

Company Ticker Sales per share – past 12 months Sales per share – year earlier Growth of sales per share
2U Inc. TWOU, +0.13% $4.09 $3.35 24%
Gray Television Inc. GTN, -0.47% $10.36 $9.39 10%
Ironwood Pharmaceuticals Inc. IRWD, +1.75% $1.65 $$0.95 75%
Source: FactSet
The ClearBridge Small Cap Fund

The fund had 81 equity holdings as of Sept. 30, according to Morningstar, and its average annual turnover is 29%, showing an emphasis on long-term investments.

Here are the fund’s top 10 holdings as of Sept. 30:

Company Ticker Inustry Share of portfolio Total return – 2016 through Dec. 15
HealthEquity Inc. HQY, -3.53% Finance/ Rental/ Leasing 2.5% 69%
Service Corp. International SCI, +2.51% Consumer Services 2.0% 6%
Gentex Corp. GNTX, -0.35% Auto Parts: OEM 2.0% 29%
OneMain Holdings Inc. OMF, -0.49% Finance/ Rental/ Leasing 1.9% -46%
LegacyTexas Financial Group Inc. LTXB, -1.27% Regional Banks 1.8% 73%
2u Inc. TWOU, +0.13% Software 1.8% 14%
First Interstate BancSystem Inc. Class A FIBK, -1.30% Regional Banks 1.8% 50%
Treehouse Foods Inc. THS, +0.11% Food 1.8% -7%
Washington Federal Inc. WAFD, -1.13% Savings Banks 1.7% 52%
Gray Television Inc. GTN, -0.47%   Broadcasting 1.7% -35%
Sources: Morningstar, FactSet

Here’s how the fund has performed against its benchmark, the Russell 2000 Index:

Total return – 2016 through Dec. 15 Avg. return – 3 years Avg. return – 5 years Avg. return – 10 years Avg. return – 15 years
ClearBridge Small Cap Fund, Class C 27.2% 10.6% 16.3% 4.6% 7.7%
Russell 2000 Index 22.0% 8.8% 15.4% 7.1% 8.8%
Sources: Morningstar, FactSet
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Deep Dive: Small-cap fund produces big profits, even if some of its holdings don’t Reviewed by on . The spectacular rise in small-cap shares since the election of Donald Trump shows that investors sometimes care more about sales and market-share growth than th The spectacular rise in small-cap shares since the election of Donald Trump shows that investors sometimes care more about sales and market-share growth than th Rating:
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