Scott Hood came on board at First Wilshire Securities back in 1993 when the firm was still relatively small. Hood noted it took him a little time to make an impression on company founder Fred Astman: “I don’t think Fred noticed me for the first year until he recognized I was a kindred spirit in value nerdiness.” He clearly made a good impression as he eventually became the firm’s co-portfolio manager in 1998 and then CEO in 2001. Of note, over a 15 year time horizon, First Wilshire’s separately managed account composite has put up a net annualized 16.8% return compared to 7.4% for the Russell 2000.
Scott Hood’s value investing philosophy
When asked for a one sentence description of his investing philosophy, Scott Hood replied: “Our goal is to find ignored, undervalued companies in improving or emerging industries that have good growth potential and limited downside.”
Finding such companies requires energy and a little bit of tenacity, and owning them successfully requires patience until the
value is recognized. Our premise is that if your stocks overall have lower valuations, better growth prospects and stronger balance sheets than the index, eventually you should outperform. Or at least you’re stacking the odds in your favor. Stocks with above-average growth but lower-than-market valuations usually make up three-quarters of our portfolio, and any number of things can obscure the growth potential we see.
Maybe the industry is emerging or poorly understood. Maybe the growth is resulting from some sort of change – a new product, a new business model, a new distribution channel – that the market hasn’t bought into yet. Maybe the company missed a product cycle but is getting back on track. Maybe the whole sector has been struggling but is poised to get better.
To exemplify his value investing philosophy, Hood discusses to a few stocks he’s currently holding in his First Wiltshire portfolio, and why he feels they are good investments.
Hood notes that stocks with strong growth but lower-than-market valuations typically represent around 75% of First Wiltshire’s portfolio. He points to Jacobs Engineering (design, engineering, environmental and project-management services for construction projects) as a good example of this kind of stock.
“Because infrastructure spending has been what we consider below normal for several years, Jacobs has had to retrench and cut costs to the point where its earnings power – if not its earnings – has markedly improved. It’s a stronger company, but the market couldn’t care less because the industry it’s in is weak. But that won’t always be the case.”
Specifically Scott Hood states:
The company is based in Pasadena, California – we can actually walk to our meetings there – but it’s well diversified both geographically and across industries. Roughly 45% of its business is overseas and it has considerable expertise with complicated, high-profile projects that are not easy to execute. It’s working on a $2.3 billion terminal upgrade and replacement project for the Dallas/Ft. Worth airport. It’s involved in the design and construction of the express rail line from Guangzhou, China to Hong Kong. It’s building oil refineries in places like Estonia and Australia.
This is a relationship business built over time and Jacobs’ relationships are as good as they come and typically result in add-on future business. Even though the industry is cyclical, the company’s margins have been relatively steady and it makes
money through the cycle. Over time, gross margins are 13-16% and operating margins are around 5%.
While we’ve admired Jacobs for years and have long considered it well managed, the stock at 15-20x earnings has always
been too expensive. But during the fourth quarter the shares came down to a level that was basically where it was during the
financial crisis, even though the company now has much higher revenues and earnings and almost no net debt.
When asked about oil prices and the price of the stock, Scott Hood noted:
The stock was already weak based on the poor global capital-spending environment, but yes, falling energy and other
commodity prices appear to be the main reason it has fallen further. So one of the first things we did was gauge the exposure to energy. The impact will vary – pipeline work may suffer but projects tied to refineries may benefit – but the company has only about 7% of its business tied directly to oil and gas. It’s unreasonable to assume that all goes away, but if it did it would be a 7% hit to revenues. The stock is off 40% since last summer.
When asked about valuation, Scott Hood stated:
For the fiscal year ending in September the company’s mid-range earnings guidance is $3.60 per share, leaving the P/E at less
than 11x. Management believes over the next three to five years that EPS can grow 15% annually from organic growth, acquisitions and share buybacks, which we believe is credible. The company is long overdue to benefit from a good cycle, especially considering the neglected infrastructure needs worldwide.
If they approach those growth targets, we see no reason the valuation can’t at least get back to the low end of the 15-
20x historical P/E range. At 15x estimated 2016 earnings of $4.10 to $4.20 per share, the stock would trade in the low $60s. The company recently instituted its first buyback program in the last 15 years. Management has in the past been acquisitive, to good effect, so we consider it a good sign that they now consider buying back stock as the best use of cash.
Another profile Hood is on the lookout for is a company that “may have modest growth potential but is just incredibly cheap, sometimes trading at less than liquidation value or even net cash.” He notes that this type of opportunity is relatively rare, but “crop up once in a while when you’re constantly screening and pounding the pavement for ideas”
The stock he highlights in this category is Essex Rental, which rents cranes and other equipment to the construction industry. It’s a small company, and is suffering through a tough period in its market (low utilization rates).
Hood explains what makes Essex Rental special: “We expect utilization to pick up and cash flow to significantly improve, but what’s unique about this is that if you just liquidated all the company’s equipment at fair prices, you’d be left with four to five times the current market value. There’s a legitimate issue over whether creditors will have the patience to let things play out, but we feel pretty good about the downside protection.”