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How to Chase Value During a Bull Market

Richard Satran

Value investors like it when markets are dull and stocks are a bit out of favor. But during a bull market, it's a tough way to make a living: Even the master of value, Warren Buffett's Berkshire Hathaway, has been trailing the market over the past three years.

Still, some value investors like James Roumell, lead manager of Roumell Opportunistic Value Fund and president of Roumell Asset Management, have held their own by updating their strategies to reflect the undoubtedly upbeat market.

That involves some unusual moves, including taking relatively short-term positions in well-known stocks, most notably Apple, as well as smaller, long-term buys of virtual unknowns like mining name Sandstorm Metals & Energy. The results reported so far this year have been promising. In the most recent shareholder disclosure for the 52 weeks ended March 31, Roumell's flagship Opportunistic Value Fund reported a total return of 21.05 percent. During the same time period, Standard & Poor's 500 index gained 13.96 percent.

[See: Mutual Fund Scorecard: How 6 Famous Fund Managers Stack Up.]

Not that Roumell's preferred investments in stocks whose value has been overlooked are easy to come by. Overall stock valuations, he says, remain relatively high, leaving fewer underpriced assets. "It's why we are holding 35 percent [of the fund's assets] in cash," he says. To gauge the market's value, he uses a rule of thumb that Buffett often cites, comparing the value of the Russell Total Market Index, which includes 98 percent of the market capitalization of U.S. traded equities, to gross domestic product.

By that measure, stocks look pricey. The average total stock market value to GDP since 1970 has been 65 percent of GDP. It's about 100 percent now. Still, that's far below the nearly 200 percent in 2000 when Roumell took a timely exit from many of his holdings, and the fund showed positive returns in that downturn signalled by frothy stock prices.

Where is "value" now? Roumell's strategy has shifted to include a series of shorter-term, event-driven moves, as opposed to the deep-value plays he might pursue at other times. "There are instances where the herd goes so fiercely negative it builds on itself, and those situations are exploitable," he says, but "only for a 25 percent to 30 percent upside."

There, success has been mixed. He began buying Apple around the time it dropped from $700 to $500 in late December and early January. But so far, Apple shares he bought at an average price of $506 have been losers. Apple is near $450 now, and in an April statement, Roumell's fund reported a loss of 16 percent on the investment so far. He still considers Apple a value because minus its large cash holdings, its stock price is extremely low in relation to earnings.

That investment and others by less-common Apple investors caught the attention of Wall Street investors, who thought it might be another signal that the stock had hit bottom if value investors were buying. Hedge fund manager David Einhorn made a much-noticed acquisition of more than a million shares. Whether such bets will pay off remains to be seen.

Roumell, who draws outsized attention for his relatively small $300 million in funds because of its large returns in the value sector, has managed a 10.67 percent annualized return since the firm's 1999 inception, versus 3.62 percent for the S&P 500. His firm has also outperformed the Russell Value index by an average of about 2 percentage points per year over that span. The firm's cumulative 324.22 percent return compares with 238.09 percent for the Russell Value index and 65 percent for the S&P 500.

[Read: Are the Industry's Top Fund Managers Beating the Market?]

Another of Roumell's event-driven ideas has been a large position in the debt of struggling retailer J.C. Penney, a company long targeted by hedge funds as a turnaround play. Instead of buying the shares, Roumell bought its debt, which pays 8.85 percent yield.

That's a slightly different bet than the one made by Pershing Square Capital Management's William Ackman, who purchased the stock at $25 a share three years ago and has watched it drop to half that level amidst steepening losses and the firing of a once-promising CEO. More recently, the stock recovered to over $18 as investing guru George Soros took a large stake.

Since he holds debt, Roumell says his position in J.C. Penney is "not as dependent on a highly successful turnaround" as it is for stock buyers. The bonds, in theory, are backed up by the value of the company's large real estate holdings and protected by lending covenants that put bond holders ahead of others in any restructuring and also require the debt to be paid off in full if there is a change of control.

Roumell's fund also holds a less-known but similar investment in a large legacy technology name, Compuware, that sells enterprise software and services. Roumell bought it when it slipped below $7, calling it, at one point, the "one stock to buy if you only own one." Compuware has continued to generate cash as it tries to convert to a cloud-based software company. The stock surged when private equity investors took aim at the company. It was a smaller version of this year's Dell deal, Roumell says. "Cheap money is moving things along right now," making even large, corporate prey affordable, he says.

Value still means digging deep. Roumell hasn't stopped drilling deep for unloved and undervalued companies that are overlooked by the market. Historically, he says he considers every investment based on the kind of criteria private equity investors use, looking for cash flow and asset value that justifies an investment. "We really try to just look at every company we invest in and ask whether this is a business we would take private," he says. "In that sense, you could say this is a public mutual fund with a bit of private-equity orientation." He says his firm's long-term strategy of finding hidden value will continue to uncover returns that can double or triple.

[See: Meet the White Hat Stock Market Activists: Not Just Corporate Raiders Anymore.]

Those values can still be found because "everyone is investing in the same stories and the same stocks," he says. "The Internet has led to a commoditization of that information. You absolutely have to get out of your office and do direct work to find value."

Roumell cites "digs" that have led him to companies like Nashville-based American Safety Insurance. "When I went out and saw the chief financial officer, he said he not had an analyst visit in three years," Roumell says. The stock trades at 65 percent of book value, and managers are big owners of shares, which he considers a positive. Two of his other favorite investments have virtually no analyst coverage.

He likes Denver-based Sandstorm Metals & Energy, which finances mining and energy companies in exchange for agreements to buy their output at favorable costs. Sandstorm's shale oil deals potentially give it the upside of oil exploration without all the risks, Roumell says. Tecumseh Products is in the midst of a turnaround in which Roumell has played a role has an activist investor. He has visited plants in Brazil and India to monitor is progress.

It's not as easy as looking up a stock on the Internet, Roumell says. But there are value plays out there. "You have to dig hard to find them now. But you can find them," he says.

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