Hunting for Value With Royce

• ByTim Melvin, RealMoney.com Contributor
• On 2:55 pm EST, Friday November 13, 2009

I'm uncovering some interesting trading ideas as the 13F-HRs continue to flow in. Today I want to look through the recent filing of Charles Royce of the Royce family of funds. The firm is one of the best small-cap value firms in existence and its filings are always a treasure trove of potential investment ideas. The firm has been around since the 1970s and has achieved success during a wide range of market conditions.

The company bought some interesting stocks in the last quarter. One of my favorite stocks found its way into the Royce fold -- I bought LB Foster stock last year when it dipped below book value. After the election, the prospect of infrastructure-based spending stimulus sent the stock up almost 70%, and following my discipline I sold into the strength. I have been hoping since then the stock will come back down to a level where I can rebuy. The company is in the sweet spot of infrastructure -- its products are used to build bridges, railroads and energy plants, all areas that will see tremendous spending over the next decade. Right now the shares trade at 1.25 times book value and have an EV/EBITDA ratio of 5.3. The stock needs to come down a bit; when it does, I will be an enthusiastic buyer.

The firm also has a little more faith in retail than I do, as it added two women's apparel companies to their portfolios. I have owned Charming Shoppes before and probably will again. The company has gone through restructuring and management changes in the past two years, but it does have a strong niche in the apparel market, operating chains under the Lane Bryant and Fashion Bug brands. The company just sold its credit card portfolio in a transaction that will net $136 million to prop up the balance sheet, but I don't foresee revenues or earnings improve anytime soon, and I'd wait before taking the plunge on Charming Shoppes.

I would also hold off on Royce's other retail purchase, Dress Barn . These shares have tripled off the lows and now trade too far above book value for me to chase them here. The company is also in the process of buying Tween Brands in an all-stock deal that could pressure Dress Barn shares. I would keep an eye on the stock, because the company did grow revenues last quarter, something not many retailers can say right now. More impressively, in addition to opening new stores, the company actually posted 1% same-store sales growth year over year. In addition, the balance sheet is in good shape with more $233 million in cash on the books and just $142 million of debt. Still, I'd wait for the shares to come down a bit before considering a position.

The Royce team also took a new position in a company that intrigues me: GameStop is the leading retailer of new and used video games in the world. Just this week we saw how strong the home gaming business is when the newly released Call of Duty game sold units totaling $300 million in one day. The weak economy has not hit the company; in fact, it has given a boost to its fast-growing used game business. This development bodes well for the company, as used games have profit margins that are almost twice those of new games. Same-store sales for this company have grown at 12% the past three years while total sales have risen at a 43% annual pace. In spite of these positives, the shares trade at just 10 times trailing and 8 times expected earnings. If the EV/EBITDA ratio, currently 5.3, were to fall below my magic 5 level, I'd think the stock would be a raging buy for long-term investors.

Finally, one of the firm's largest new investments in the quarter was in troubled regional bank Fifth Third . The bank is still struggling with credit problems -- nonperforming assets stand at about 3.5% of all assets right now. Although management is trying to improve the situation with mortgage modifications and other measures, the company probably has a few more quarters of credit problems ahead. With more than 50% of its loan portfolio in the commercial space, I'd like to see the equity-to-asset ratio a lot higher than the current 6.9 before becoming a buyer of this one. Clearly someone at Royce feels differently about this one than I do.

A lot of the holdings in this family of funds fall well below the minimum market caps that would allow me to discuss them here. It is worth a visit to the SEC's Web Site to peruse the recent filing. Also keep in mind that Royce tends to be very diversified in its holdings and appears to scale into most purchases over time.

Happy hunting!

Buzz up!