(FORTUNE Magazine) – It's no secret that small stocks are hot. What's not widely known is that the very best hand at small-stock picking these days is Milwaukee's Heartland Value fund. Portfolio manager Bill Nasgovitz, who has run the fund since its inception in 1985, roves America's back roads in search of small, undiscovered companies. He finds plenty. Since 1985 the fund has averaged a 16% annual return, compared with 12.7% for Standard & Poor's 500-stock index. Over the past year that margin of outperformance has widened (see chart above), and Heartland now boasts the best year-to-date returns of any small-stock fund followed by Lipper Analytical Services. Nasgovitz discusses his favorite stocks with William Sheeline of FORTUNE.

After such a good year for small stocks, are there any bargains left? Absolutely. We invest in companies with market capitalizations of $300 million or less, and there are bargains there today. These small stocks trade at 1.35 times book value per share, vs. about 2.5 times for stocks in the Standard & Poor's 500 index. Plus, this is a terrific time of year to hunt for value. I'm referring to the January effect, where small stocks tend to outperform the market at the beginning of the year.

Where are you finding the best values now? The stocks of regional brokerage companies are amazingly cheap. When I got into the business in 1968, the average individual investor had 36% of his financial assets in equities. Last year that figure was 19%. We're in an era of low growth, low inflation, and low interest rates. In that environment CDs, Treasury bills, and money market funds just aren't going to hack it. Investors are going to have to take a look at equities. Regional brokerage firms will benefit. One of our favorites is Inter-Regional Financial Group, which owns Rauscher Pierce Refsnes in Dallas and Dain Bosworth in Minneapolis. The stock sells for $17, only a buck over its book value of $16 a share and only 4.5 times trailing-12-months earnings of $3.77 a share. Compare that with the industry leader, A.G. Edwards, whose stock is selling at nine times earnings. Even if the market has a correction and the company's earnings drop to, say, $3 a share, the stock is still a bargain. At $24 per share, the stock would sell at only eight times earnings. If there's no big correction, the company could easily earn $4 a share in 1993.

Your largest holding is an auto parts company. What's the appeal there? Trak Auto is one of the top five publicly held auto parts retailers in the U.S., but it sells well below the valuations of the other four. The stock goes for $16, about 11 times expected 1992 earnings of $1.50 per share. By contrast, AutoZone, the industry leader, sells for about 40 times earnings. Trak Auto has revenues of over $300 million from about 320 stores in Washington, D.C., Chicago, and Los Angeles. The company has also opened eight SuperTrak stores geared to the do-it-yourself market. In these stores the customer is allowed to use the company's computers to find out what's wrong $ with his or her car and to order parts at a discount. Trak Auto is 69% owned by the Dart Group, which is controlled by Herbert and Robert Haft. This is the father and son duo who were involved in takeovers in the Eighties. But this is a company that they started from scratch, and lately they have taken steps to improve the bottom line. In 1990 they hired a new president, who has closed unprofitable stores and started opening the larger, more profitable outlets. Trak Auto has no long-term debt and $4 a share in cash. It should earn $2 per share in 1993.

I see you own a restaurant company stock. Is that a good area in which to invest now? There's a feeding frenzy on Wall Street right now for restaurant stocks. Some of them -- Outback Steakhouse -- sell for as much as 60 times earnings. But one company still offers great value: JB's Restaurants, which has 109 outlets in 11 states, many in Arizona. These are family places with casual dining. The company recently opened four buffet-style restaurants, which are doing extremely well, and it plans to add ten more in 1993. Each addition should add 3 cents per share to earnings. JB's stock sells for $6.63 a share, less than its $7.40 book value, and at 13 times expected 1993 earnings of around 50 cents. The company should earn 80 cents in 1994 and $1 in two years.

Any good buys in your own backyard? Milwaukee Insurance is an old-line property and casualty company, which specializes in things like home and auto insurance. It has offices in small towns throughout the upper Midwest. The company has a new president who has lopped off unprofitable business and more or less cleaned house. The stock sells for around $12, about seven times expected 1992 earnings. The book value is $17, and the company has no debt. I think it can earn $1.70 in 1992 and $2 in 1993.

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CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: A REVVED-UP PERFORMER Money manager Bill Nasgovitz believes that the rise in Trak Auto stock has just begun.