How this small-cap fund is beating the market in 2022 with eclectic value investing

Published Sun, Apr 24 20227:58 AM EDT

Fund manager James Davolos came to the gospel of Warren Buffett by way of a beautiful fishing boat in his hometown. Growing up on the Jersey Shore, Davolos was enamored by a fishing boat belonging to a family who ran a small insurance agency. Wondering how the family could own such a nice boat, Davolos' curiosity led him to discover the agency's ties to Buffett and Berkshire Hathaway and, eventually, the principles of long-term value investing. "It's interesting how people end up in value investing because it's such a quirky field," Davolos told CNBC. Davolos is now a portfolio manager at Horizon Kinetics, a position he worked his way up to after joining the firm as a trading clerk in 2005 fresh out of college. One fund Davolos manages, the Kinetics Small Cap Opportunities Fund , is beating the market this year and has a track record of outperformance. The fund is up more than 10% this year, compared with the S & P 600 Small-Cap Index's roughly 8% decline. It has beaten out 99% of its peers in the past one, five and ten years, according to Morningstar. The fund invests in companies with market capitalizations at or below the highest market cap of an S & P 600 member that the managers consider to be undervalued. "I call it 'eclectic value,'" Davolos said. "We want to own something or buy something for less than it's worth." One of the different strategies the Kinetics Small Cap Opportunities Fund employs is to focus on companies with a "hard asset emphasis." Most of the fund's portfolio companies are connected to a finite, tangible physical asset with strong and steady demand. When prices rise, the physical assets gain value and thus benefit the company. This has helped the fund to avoid some pitfalls in the sector. Indexation in the small-cap space "leaves some voids in the market" that can make some names mispriced, according to Davolos. "One of the biggest challenges of small-cap is that the indexes are over-diversified," Davolos said. "Small-cap indices suffered mightily from really buying into a lot of the more speculative tech and EV names over the past few years that you really couldn't justify on a fundamental basis." Managers also have a preference for companies that do not rely heavily on capital, and thus see profit margins expand as business grows. Take energy, for example. Rather than investing in oil-and-gas producers, the fund has embraced energy royalty companies, which own the land on which other businesses drill and earn revenue from that drilling. "That enables you to have very long-lived portfolios. If energy prices continue to rise and volumes continue to rise in the established fields, all of that goes to the bottom line. It's a really eloquent, nuanced business model to participate in energy," Davolos said. The fund's top holding is Texas Pacific Land Corp , which made up nearly half of the portfolio as of the end of 2021. Texas Pacific Land is one of Texas' largest landholders and a majority of its revenue comes from royalties paid by Chevron and Exxon Mobil . Murray Stahl, Horizon Kinetics' co-founder, chairman, CEO and CIO, also serves on the board of Texas Pacific. The company's shares are up more than 10% this year and nearly 46% from its January lows. The rally comes as energy prices have climbed this year amid fears that the war in Ukraine will limit global energy supplies. Another capital-light way the fund is playing a secular trend is through CACI International , a defense technology company that makes up the fund's third-largest holding. The defense technology stock is up 6% this year. CACI International's specialization in high-tech segments of defense "juxtaposes the capital intensity of the big, capital goods manufacturers that are commonly associated with defense" like Boeing or Lockheed Martin , Davolos said. With rising interest rates and inflation threatening stock performances, quality in terms of fundamental assets is more important than ever, according to Davolos. "We think that high-quality assets purchased properly are going to endure any cycle," Davolos said. "That's really the best risk mitigation tool that we have."

Fund manager James Davolos came to the gospel of Warren Buffett by way of a beautiful fishing boat in his hometown.