(08/29/12) 3 Picks from a Small-Cap Fund Manager

Mutual-fund manager Tom Laming tells MoneyShow about three companies from various industries where he sees potential. These are companies capitalizing on current demographic and industrial trends.

Kate Stalter: Today, my guest is Tom Laming. He is the lead portfolio manager for the Scout Small Cap Fund (UMBHX).

Tom, one of the things that everybody who watches the market—and in particular, small-cap investors—they get pretty concerned about volatility. People have almost come to expect these big market swings that we've seen over the past few years. What are you seeing in that regard right now?

Tom Laming: Volatility is definitely on the downtrend. We're a long ways from record lows, but we are way off the highs that we were at last fall. And the concern that most people have is that historically, when you've seen really high volatility, you often have a good market after that. And when you see really low volatility, you sometimes can run into some poor performance.

I think in the long run, the fact that we are at low levels really means nothing. My concern is that, a little glitch out of the Middle East or a spike in oil prices...some exogenous factor could cause a little downward pressure on the market.

With that being said, if you go back and look at the history of volatility, we are at low levels, but we've been much lower. And it can stay at low levels for a long, long time. So I don't know if it's ushering in a new period of low volatility, but it certainly is at the low end, and I think that sets us up for a little bit of risk. But long-term, I wouldn't worry about it.

Kate Stalter: You talked about risk. Obviously, one of the big things that's in the news: Everybody is looking ahead to see what happens with the fiscal cliff. Certainly there's political risk out there. What are you seeing politically in a macro sense, under the general heading of risk? What are we facing?

Tom Laming: Well, the term that gets used so much, the fiscal cliff that's out there, it's really two factors. Its one a big cut in government spending that's automatically mandated that will hit January 1.

That being said, I noticed today defense stocks like Lockheed (LMT) and Northrop (NOC) are all hitting 52-week highs. That may be a signal that there may be some kind of compromise.

I think that's much less important—I think that's good for the market, it's good for the deficit, longer term. The more important factor, I think, to investors is that taxes are going to increase. Not just on income, but on capital gains and dividends. And I think that is a further risk, and that is a very measurable one. After-tax value of equities is going to be lower, if the tax rate on things that equities pay—capital gains and dividends—goes up.

The other factor that I think is kind of an interesting one, at least in the way it's covered typically in the press, is the crisis in Europe And I think to a large extent, what's happening in Europe—in terms of their budget issues and risks—are probably understated with respect to European investors, European citizens, and so forth. But I think that crisis is actually overstated on US companies and the negative impact.

And my example would be Boeing (BA). Boeing certainly sells aircraft into Europe, but nowhere near as much. You know, it's largely Latin American and Asian from a growth standpoint for Boeing, yet Airbus is by far their biggest competitor. And Airbus is wounded during this. They are having to start to finance some of their own jet sales and so forth.

So I think, to some extent, Europe—actually the crisis there—I think is more of an impact positively from a competitive standpoint for US corporations. Europe just isn't that big of customer. It's about 2% of our GDP, so I think it's overstated in respect to our stocks.

Kate Stalter: Let's talk about what's going on in the general market. The indices have been in rally mode in the past few weeks, and a lot of the analysts are out there saying, There's still all this bad news; it can't last. What is your take on that?

Tom Laming: Well, you know, we've been positive for quite some time actually, and that's started to pay off this year, being fully invested and actually expected the market to do better.

I think we started this year at valuations that were just too attractive, despite the fact that this is the worst recovery from a recession that we've had since the Great Depression. But stocks just got too cheap and they're still cheap. They're not as cheap as they were.

The market's up nicely this year. The S&P is up about 14%. But the other thing that's layered on top of this—and it continues to this day—is sentiment.

Merrill Lynch tracks a very interesting sell-side indicator. It's really based on the average recommended equity allocations by Wall Street's strategist. Now, this isn't retail investors, this is institutional investors and what they are recommending to clients, and it's never been more bearish. They're recommending record levels of cash and exposure to bonds, and I think that's one of the reasons why the market has done better.

There's so much cash on corporate balance sheets and in investors' pockets, P/E multiples are actually relatively attractive, and bonds are selling at record low yields. And I think buying bonds at record low yields is probably like buying stocks at record high P/Es in the late 90s, and that probably doesn't end well.

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Kate Stalter: Let's talk then about some of the investments that you have right now, a couple of holdings that you like at this moment.

Tom Laming: Sure. We've been very focused on what many of your listeners do, and I do in both my work and spare time: Being connected to the Internet continuously through wireless networks, through phones, through tablets.

Companies are accumulating tremendous amounts of data on their customers, and they have to analyze that data. So we see kind of a two-pronged effect of both a huge growth in data network traffic, and also the need to store that data.

A good example, and it's almost mindboggling, is that 250 million photos are uploaded to Facebook (FB) every day. That's about 3,000 photos per second. YouTube now accounts for about 10% of traffic. All of that is putting a lot of pressure on companies to solve those problems, the bandwidth and storage.

So one of the companies that we own is LSI (LSI), and the company is a semiconductor company with a software component as well. And they sell semiconductor products that help solve that storage problem. So much, in fact, one of the highest growth areas for that company is the move from magnetic storage of information—like on a disk drive, a magnetic disk drive, which would typically be in your PC at home—to storage on semiconductors.

In fact, we own a derivative company on that, Fusion-io (FIO), that actually is focused on that, and semiconductor solid-state storage for corporate data. And they're really problem solvers. What we see is something that's going to be growing at a very high rate for quite a long time.

Kate Stalter: I understand you have a different investment from another sector of tech that you can talk about today.

Tom Laming: Yes, um, kind of an unusual company...at least its name is unusual. It's called Two-Six (IIVI), and it comes from the Roman numerals for 2 and 6, of the columns on the periodic chart of the elements.

The company, historically, has been very much an expert at combining elements from those two columns. And those types of products get used in a lot of industrial and communication reasons.

Some of the things they might be familiar with—even within your own automobile, for example, if you have electrically heated or cooled seats. Those make use of what's called the thermoelectric effect, and that requires what Two-Six is very good at, in terms of compound material production.

And then many of the other applications are tied into industrial purposes, like the transition from traditional methods of welding to laser-based welding and cutting. So Two-Six makes a lot of optoelectronic components that go into those systems.

Kate Stalter: We've got about a minute left here. I know you have one more stock, a company with kind of an unusual business that you could talk about today.

Tom Laming: One of the things we're focused on is some demographic trends that we can take advantage of. And as the baby boomers age and have more leisure time, the cruise industry has been good. It's economically sensitive, but in general has a demographic tailwind to it.

Especially in the small-cap area, it's hard for us to own a cruise line, but Steiner Leisure (STNR) actually runs spas that are on the cruise ships, so they are on all the ones you would typically know of, like Carnival (CCL), which also owns Holland America, Princess, and Cunard. And then Royal Caribbean (RCL), which owns Celebrity. And then some other lines like Norwegian and Disney (DIS).

So when you go into a spa or you get a massage on those cruise ships, you're typically dealing with an outsourced service, where those cruise lines have actually hired Steiner Leisure to deliver that product.

It's been a very well-run company with very large returns on invested capital, which is something we look for. We want to make sure the company is earning more than its own cost of capital, and Steiner has done a very good job of that.