A fund manager who’s beaten 95% of his competitors this year shares how he finds big winners in small-caps — and reveals 3 of his favorite stock picks right now

• Small-cap investing has never been tougher, but Luiz Sauerbronn has managed to succeed in 2023.
• His Brandes Small Cap Value Fund has outperformed 95% of competitors this year.
• Here’s what he looks for in stocks, and three of his favorite picks on the market today.

Small-cap investing is difficult in a market dominated by large cap stocks such as the “Magnificent 7.” In fact, small caps are trading at a significant discount to the rest of the market due to their sensitivity to economic headwinds such as higher inflation and restrictive monetary policy, which limit their growth prospects.

But Luiz Sauerbronn has managed to make it work. Sauerbronn, a director at Brandes Investment Partners, has spent the last five years co-managing the Brandes Small Cap Value Fund. According to Morningstar, the fund has outperformed 93% of competing funds over the last half-decade and 95% of peers year to date under Sauerbronn and his colleagues.

The fund’s 15% return in 2023 helps it stand out in a market that appears to be turning away from small caps. So, what is the key to Sauerbronn’s success this year?

“There’s nothing special about anything we did in 2023,” Sauerbronn recently told Insider. “I wish I could tell you about some magic we did in 2023,” he continued. It’s simply a very methodical, repeatable process that will be completed in 2023.”

Here’s what Sauerbronn and his team are looking for in high-quality, small-cap stocks to invest in, as well as three of his current favorites.

How to find strong small-cap stocks

Sauerbronn approaches stock selection from the bottom up, focusing on a tried-and-true investing strategy: finding companies with a high margin of safety.

“Basically, we want to invest in a company that is trading at a discount to what we believe is the intrinsic value of the business,” he said. “And the reasons for that can vary so much; sometimes it’s because they’re misunderstood or under-covered, but other times it’s because there’s a time arbitrage, and you have to be patient.” As a result, things can take time to play out, and the market isn’t always patient.”

Patience for Sauerbronn means holding a stock for three to five years on average. Sauerbronn did state that ideally, he would hold stocks for a longer period of time, and some stocks in the fund have been there for 10 years or more. But predicting what will happen in markets beyond the next five years is a fool’s errand.

Finding undervalued stocks and patiently waiting for the market to understand your investment thesis may appear to be simple — but if it were, everyone would do it.

“It’s not rocket science.” “It’s not,” Sauerbronn said. “But it’s difficult because, as a value investor, you’re frequently investing in things that are unpopular or psychologically difficult.” Going against the grain is difficult.”

3 favorite stocks right now

Industrials are head and shoulders above the rest of Sauerbronn’s fund’s holdings. The industrials sector accounts for 37% of the fund’s investments, with healthcare accounting for only 16%.

Given how cyclical the sector can be, especially with interest rate hikes and an economy in flux, it’s surprising that Sauerbronn and his team would place so much emphasis on industrials.

However, Sauerbronn has focused on defensively positioning the fund, focusing on stocks with strong balance sheets in an industry that has grown accustomed to easy money.

“If you look at the universe, there are a lot of small caps that leveraged up a lot when interest rates were near zero, and now the reckoning is coming.” And because we are concerned about this, we have taken a defensive stance,” Sauerbronn explained.

“Industrials are not typically seen as defensive,” he continued. They are usually cyclical. However, we believe that the ones we do hold are very defensive because they are mostly aerospace and defense companies with very strong balance sheets. As a result, many of them are net cash or have low leverage.”

Sauerbronn has three favorites among his holdings.

The first is Graham Corp. (GHM), which is his fund’s largest holding. Graham Corp manufactures critical equipment for aerospace and defense applications, and it expanded its operations in 2021 when it acquired Barber Nichols. The company hired Barber Nichols’ management team to run things, which Sauerbronn fully supports.

He also agrees to the company spending heavily in 2020 and 2021 to ramp up production in order to meet delivery deadlines for US Navy equipment. The costs of increased production took a toll on the company’s bottom line, earning the wrath of the market and causing shares to plummet in mid-2022. However, the stock made a spectacular comeback in 2023, rising 94% year to date, as its contract with the Navy began to pay off, proving Sauerbronn’s patience was well rewarded.

Park Aerospace (PKE) is another of Sauerbronn’s current favorites. As the name implies, the company produces composite materials for companies in the aerospace industry ranging from drones to jet engines.

Sauerbronn noted that the company has a strong balance sheet, good management, insider ownership, and a high return on capital — but none of that mattered in 2020, when no one was flying and aerospace orders dried up due to the pandemic.

Park Aerospace stock took a hit at the time, but it has since recovered, and Sauerbronn believes it could soar even higher.

“And so you saw a big cycle and you’re coming out of that and you have a big runway here,” Sauerbronn went on to say. “They also have a significant relationship with Airbus, which is one of their most important relationships.” And, as a result of the Max issues, Airbus is gaining market share against Boeing.”

Finally, Sauerbronn mentioned Moog Inc. (MOG) as one of his fund’s top ten holdings. Moog manufactures critical commercial and defense aviation components, which Sauerbronn appreciates.

“A lot of it is commercial aviation, but a decent chunk is defense as well, defense that should be very resilient and stable,” he said. “Free cash flow, very good, very high return on capital, management has done a fantastic job over a long, long time.”