Fund Focus: Investing in Troubled Manufacturers Pays Off
J. Dennis Delafield and Vincent Sellecchia, the fund's veteran portfolio managers, have a knack for buying troubled companies that recover with a vengeance. Working with just three analysts who spend their time visiting these companies, it delivered a stunning total return of 120.3% during the 12 months through Mar. 10. That was nearly double the return for the Standard & Poor's 500 Index as the whole stock market bounces back from the brink. The Delafield Fund also beat 91% of the other value-oriented mutual funds that invest in small- or mid-cap companies, according to Morningstar Inc., a mutual fund rating agency in Chicago.
Yet investment flows into this fund have been almost flat over the past year, meaning that investors have deposited only marginally more money than they have withdrawn. So why would such a great-looking fund be so rudely neglected? It can't be the fund's size, which is a respectable $715 million in assets. It's not the track record of the 17-year-old fund, which outperformed more than 90% of similar small- and mid-cap value funds during the last three, five and 10-year periods, according to Morningstar. And it's priced at street level with a minimum deposit of only $1,000 and a fee that works out to 1.26% of your investment.
Troubled Manufacturers Is Its Sweet Spot
The fact is that it takes more guts than money to invest in this fund. Its sweet spot is in troubled manufacturers that are being sold down by shareholders who won't take the time to understand that their problems are temporary. Maybe they're passing through a low point in a business cycle, working through an awkward merger or undergoing a painful debt restructuring. If the portfolio managers are satisfied that a company's balance sheet shows it stands a decent chance of survival, they pounce on the stock even while it's still falling.
That alone would be enough to scare off most investors. But these portfolio managers wait patiently for the stock to bottom out and bounce back when investors see that the company has recovered. Fundholders were sorely tested through a knuckle-whitening year in 2008, when the fund fell 37.6% -- 60 basis points worse than the S&P 500 in the market's worst year in living memory.
But many of the stocks that dragged the fund down in 2008 turned out to be the same ones that drove it straight back up through the roof during the past 12 months. This is where Delafield and Sellecchia have proved themselves to be better stock-pickers than their peers. Before they buy a company, they take a close look at its free cash flow, which they define as funds from operations minus capital spending and dividends. That tells them how much cash the company has left over to pay down their debt, make acquisitions or buy stock.
Free Cash Flow Drives The 'Investment Process'
"We are willing to buy companies that are very troubled," says Sellecchia. "We buy them based on their balance sheets. Free cash flow drives our investment process. And that came home in spades in the last 18 months. We had several investments that went up several-fold from the bottom."
Their methodology led Delafield and Sellecchia to buy Sonoco Products (SON), which manufactures metal and cardboard tubing, as well as Maxwell House coffee cans and Pringles potato chip containers. They bought it in March 2009 for about $15 to $20 a share, where it had fallen from $35 in September 2008 on fears that its clients would get slaughtered by the recession and demand for Sonoco's products would fall.
"It was a nice company with good cash flows," says Sellecchia. Then Sonoco slashed costs -- consolidating 19 separately run businesses into six and closing a plant in Orrville, Ohio -- and the operating profit from its consumer packaging business for 2009 increased by 30%. The stock went back up, trading at about $30 on Mar. 9 this year.
Funds Are Concentrated On 'Middle America'
They also bought Albany International (AIN), a leading maker of fabric that is used in paper mills, when it was shutting down plants in the U.S. and Europe and expanding in Asia -- a process that consumed capital and ramped up leverage. "We were willing to accept this leverage because we understood how they were going to get out of it," says Sellecchia. The fund bought Albany as it tumbled down from about $34 in August 2008 to about $5 in March 2009, as investors instinctively sold all highly leveraged companies at the height of the financial crisis. But then the stock rose more than four-fold, to about $23 in March this year.
As a result, the fund's assets are concentrated in what Sellecchia calls Middle America -- manufacturers of everything from industrial chemicals to factory equipment to consumer electronics. Such companies are prone to corporate restructuring exercises that scare off squeamish investors, creating an opportunity for Delafield and Sellecchia.
The fund has 46.3% of its assets in industrials, which is about triple the amount held by similar funds in the value universe, says Michael Breen, an analyst at Morningstar, a mutual fund rating agency in Chicago. "They seem to understand that to outperform the pack, you have to break from the pack, and then they deliver their results," says Breen.
Some 20% Of Assets Are In Cash
To make sure it can invest in new opportunities, the fund keeps about 20% of its assets in cash. But not all of Delafield's and Sellecchia's ideas turn out to be good. For example, they bought Axcelis Technologies (ACLS), which makes equipment that is used to manufacture semiconductors, for nearly $6 a share in June 2008. Then the stock fell into a steep slide after the company missed a product cycle and lost market share. The fund sold the stock for about $4, just before it plummeted to 21 cents a year ago. (It was trading at 52 cents on Mar. 9).
Apart from the risks involved, this fund has other characteristics that would be considered blemishes by the brokers, financial advisors and other intermediaries who pick mutual funds for the vast majority of America's individual investors. Delafield Asset Management Inc., which employs the portfolio managers and analysts, came under new ownership last September when Natixis Global Asset Management sold it to Tocqueville Asset Management.
Such a transaction can raise a red flag that the new owners could somehow meddle in the portfolio managers' investment process, which could cause them to lose their touch. But, according to Morningstar's Breen, the new owners have left Delafield and Sellecchia alone, and their investment process continues as always.