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[Enterprising Investor]

For Large Stock Gains, Think Small (12/17/16)

Among our top 5 picks for 2017: a REIT, a movie-theater chain, a TV station operator.

By David Englander

A year ago, when Barron’s weighed in with our favorite small-caps for 2016, cyclical companies and small-cap stocks were in the doghouse. But that wasn’t a key concern. As always in this column, we stay focused on finding out-of-favor stocks that look undervalued.

Our results hit the bull’s-eye. Barron’s 10-stock portfolio beat its benchmarks in a year when the small- and mid-cap indexes came roaring back. Including dividends, our stocks returned 25.8%, compared with a total return of 23.5% for the Russell 2000 small-cap index. The S&P MidCap 400 came in a notch below that, at 22.3%. Meanwhile, the Standard & Poor’s 500 index returned 14.6%.
For 2017, we’ve zeroed in on five small and midsize stocks in widely diversified industries. They are Equity Commonwealth (EQC), AMC Entertainment Holdings (AMC), E.W. Scripps (SSP), Houghton Mifflin Harcourt (HMHC), and Real Industry (RELY). We’ve written positive stories on all five companies over the past year, and still see value in all of them.

EQUITY COMMONWEALTH is the sole holdover from last year’s list. The shares of the office-property real estate investment trust are up 10% since our Dec. 12, 2015, story was published (“ Barron’s 10 Favorite Small- and Mid-Cap Stocks for 2016”). Commonwealth has been reorganizing since Sam Zell became its chairman in 2014, selling properties into a strong commercial real estate market. Over the past two years, the company has parted ways with over $4 billion in properties.

Further sales are likely, which could help push the stock up from its recent $29.50. JMP Securities ’ Mitch Germain puts the net asset value at $33 to $34 a share. In the next year, the stock is apt to close that gap or come close.

Commonwealth has $2.5 billion in cash, or about $19 a share, on its balance sheet. That gives it options, should the property market turn down. Zell has a track record of making shareholder-friendly moves, and the outcome here could turn out positively, as well.

AMC ENTERTAINMENT has had a busy year. Led by its new CEO, Adam Aron, the cinema operator has pursued two acquisitions of smaller chains that could grow its theater count from 385 to roughly 900. The purchases of United Kingdom–based Odeon and UCI closed last month, and a deal for Carmike Cinemas (CKEC) awaits regulatory approval.

Carmike, one of our top picks from last year, is up 54% to a recent $33.10, on the AMC deal. Last month, Carmike shareholders approved a sweetened offer from AMC after the initial bid faced opposition.

AMC will realize synergies and benefit from updating Carmike’s theaters with the renovations it has been making in its own theaters, such as installing reclining seats and expanding its concession offerings. The 2017 film slate is also expected to be strong, which could help drive good results.

In a recent report, B. Riley analyst Eric Wold noted that the addition of Carmike could increase his 2018 estimate for earnings before interest, taxes, depreciation, and amortization by 25%, to nearly $1 billion. From a recent $32, AMC’s stock could reach $40 in a year.

E.W. SCRIPPS shares were flat in 2016, having suffered, like all local broadcasters, from weaker-than-expected political advertising throughout the year. At a recent $18.60, the stock looks undervalued, trading at 15 times the average free-cash-flow estimates for 2016 and 2017.

Political advertising could rebound in 2018. Scripps, too, could see an uplift in retransmission fees, which are expected to rise 20% in 2017. Management has been renegotiating below-market contracts.

A strong balance sheet and valuable spectrum holdings are other things to like. Scripps, which owns 33 TV stations, could buy more. Since 2008, when it spun off its cable operations, the company has done a number of transactions, including purchasing TV stations and merging with Journal Communications. On his 2017-18 estimates, Gabelli analyst Barry Lucas puts Scripps’ private-market value at $26 a share.

HOUGHTON MIFFLIN HARCOURT has seen its shares cut in half in 2016, to $10.80. The textbook publisher relies on state adoptions of its books, which are cyclical in nature and have been weaker than expected this year. In September, CEO Linda Zecher resigned, and the board has yet to name her replacement.

Houghton is on track to turn in negative free cash flow in 2016, a sharp drop from just a few years ago, when it was generating about $300 million. Still, Houghton is the market leader, and a rebound in state textbook adoptions should improve its fortunes. In the next two years, several large adoption programs are expected in California, Florida, and Texas.

Wells Fargo analyst William Warmington looks for $187 million in free cash flow in 2017, rising to $260 million in 2018. He values the shares at $16 to $18.

REAL INDUSTRY is off 32% this year. The acquisition-oriented company also is backed by deal-maker Sam Zell, and has almost $1 billion in federal net operating losses. Investors have been waiting for Real Industry to make a deal so it can start to monetize those tax assets to offset future earnings, only that hasn’t happened.

In August, CEO Craig Bouchard resigned, a major blow for the stock. Bouchard was seen as the man who could do deals and build up the company.

We still like the potential here. The management team is experienced, and its operating business, an aluminum recycler, has some defensive characteristics; 50% of its sales volume is tied to tolling agreements with aluminum mills and auto companies. Under tolling, Real converts customers’ scrap aluminum to finished aluminum for a fee and takes no commodity risk.

The shares trade for an inexpensive enterprise value of 7.2 times estimated 2017 Ebitda. B. Riley analyst Josh Nichols assumes that Real can monetize its NOLs by 2025 through future acquisitions, realizing value of nearly $200 million. He values the shares at $12.

While it is said often in investing, patience could well be rewarded in Real’s case.

Returns for our 2016 picks were driven by our top five returning stocks, all up over 25%. Energizer Holdings (ENR) bagged a quick return. Last December, investors were down on the prospects for the stand-alone battery business, after it split from its personal-care operation, Edgewell Personal Care (EPC), in July 2015. The stock was trading for a deep discount to other consumer-staples companies.

While battery usage has been declining, it hasn’t been rapid. Energizer, too, generates healthy free cash flow. In the first half of the year, investors began to recognize that. In May, Energizer announced that it was using some of its cash flow to buy a car air- freshener business, a move to diversify. Not long after, we recommended taking profits when the shares were at $52. Since then, the stock has moved back down to the low $40s.

ONE THEME that we harped on last year was the opportunity to benefit from the commodity downturn in the agricultural and oil-and-gas sectors, by betting on the beaten-down shares of high-quality industrials. Two stocks that fit the bill were FMC (FMC) and Actuant (ATU).

FMC, a maker of pesticides, had been hurt by weak crop prices and farmers’ reduced incomes. Actuant, an industrial outfit that, among other things, makes hydraulic tools used for heavy lifting on construction sites, was depressed, due to its exposure to the oil-and-gas industry. Oil prices have since rebounded, and the agriculture industry has shown signs of turning the corner.

As the fortunes of their respective markets improved, both companies’ shares have made a recovery. At a recent $58, FMC has returned 56% since our story appeared. And Actuant has returned 27%, to $28.

New Jersey–based Kearny Financial (KRNY) has returned 28% since last December, when the bank was fresh off its conversion to full stock ownership and flush with excess capital. Its shares were cheap, trading just above tangible book value.

Kearny has since been borne upward with the rest of the banking sector, on the prospects of higher interest rates and fewer regulations under President-elect Donald J. Trump. At a recent $15.40, the shares trade for 1.35 times tangible book. They probably don’t have much upside in the year ahead.

The only loser in the batch was Oaktree Capital Group (OAK). The shares of the distressed-debt specialist have dropped 16% since our story ran. Healthy dividends have helped soften that blow, but even on a total-return basis, the stock is down 11%.

Oaktree has nearly $23 billion to deploy for investment. The main problem has been that the firm hasn’t had much opportunity to put the capital to work. Market valuations remain high, and competition among distressed-debt investors has been intense.

Oaktree’s 20% stake in asset manager DoubleLine has become more valuable in the past year. But for the stock to work, the market will need to provide investing opportunities.

http://www.barrons.com/articles/for-large-stock-gains-think-small-1481955679