Invesco Ltd.’s Robert Mikalachki invests in companies with an enduring edge on competitors, a strategy that has led him to everything from a mattress maker that he calls the “Mercedes-Benz of bedding,” to a car dealership whose small-town locations create local monopolies.
Shares such as Tempur Sealy International Inc. and Lithia Motors Inc. have helped the Invesco Select Companies Fund (ATIAX:US) produce the best risk-adjusted performance among U.S. blend funds over the past five years, according to the BLOOMBERG RISKLESS RETURN RANKING. The $1.6 billion fund combined the fourth-highest absolute returns and below-average volatility in a group of 173 funds that invest in a mix of fast-growing and cheap stocks of all sizes and have at least $1 billion in assets.
Mikalachki, who buys mainly small-capitalization stocks, will invest in any industry if he can find companies that can carve out leadership positions. Lithia Motor (LAD:US)s’s car dealerships often have no competition in the locations they operate in, while Tempur Sealy pioneered memory-foam mattresses, drawing on technology first used by the National Aeronautics and Space Administration to support astronauts in space. Mikalachki avoids natural resource firms because their products make it difficult to pick winners from losers.
“We want to see something that is going to keep our businesses ahead of the pack five years from now,” Mikalachki said in telephone interview from Toronto, where he is based. “It is tough to be distinctive when you are pulling junk out of the ground.”
Mikalachki’s emphasis on companies with a competitive edge has resulted in a concentrated fund of 25 to 30 stocks, compared with an average of 251 for a typical small-capitalization fund, according to data from Chicago-based Morningstar Inc. He also trades stocks roughly half as often as its small-cap peers.
Of late, Mikalachki has found it hard to find stocks to buy. The fund had 27 percent of its assets in cash as of July 31, according to a regulatory filing.
The inability to find cheap stocks “is one of the things out there telling me it is getting heady in the stock market,” said Mikalachki. “We find companies we like but we can’t drag them across the line because they are too expensive.”
Bloomberg’s risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk. The returns aren’t annualized.
Invesco Select Companies returned an adjusted 8.4 percent in the five years ended Oct. 21. It had lower volatility than the average blend fund, even as it bought stocks with a median market cap of $2.1 billion. Small-cap stocks, as measured by the Russell 2000 Index, have greater volatility than both mid- and large-cap stocks, according to data compiled by Bloomberg.
The fund’s stable performance may be the result of buying businesses with good fundamentals and not overpaying for them, said Mikalachki, who doesn’t aim to produce low volatility.
The fund invests in businesses selling for less than the value of their expected future cash flows. Its holdings sell for an average of 10 times cash flow (ATIAX:US) compared with 15 times for the Russell 2000 Index, according to data compiled by Bloomberg.
The $6.5 billion Fidelity Small Cap Discovery Fund (FSCRX:US), which ranked second, gained 7.7 percent over five years. It combined the second-highest absolute return with above-average volatility. The $44 billion Fidelity Low Priced Stock Fund was third in the ranking on a risk-adjusted basis, returning 7.1 percent.
Mikalachki, 42, joined Trimark Financial Corp. in Toronto in 1999. Atlanta-based Invesco Ltd (IVZ:US). acquired Trimark in 2000. Mikalachki, who has managed the Select Companies Fund since 2003, is a graduate of Wilfrid Laurier University in Waterloo, Ontario.
Mikalachki always refers to the fund’s investments as businesses, rather than stocks, because he says it keeps him focused on fundamentals, not market sentiment. In conversation, he takes a proprietary view of those holdings, often referring to the holdings as “our companies.”
Describing Alliance Data Systems Corp., which runs loyalty programs for retailers, he said, “We give our clients insights into the best shoppers.”
Lithia Motors, a Medford, Oregon-based company which sells new and used cars in the western United States, climbed more than 26-fold over the past five years, making it the single biggest contributor to the fund’s performance, according to portfolio data (ATIAX:US) compiled by Bloomberg.
“You might say: ‘They are a car dealership. How differentiated can they be?’ ” said Mikalachki.
The answer hinges on geography, according to Mikalachki. The lack of competition in the towns in which it operates means its dealerships win higher margins and more service revenue than rivals, he said.
Lithia has also benefited from the comeback of Chrysler Group LLC, whose vehicles account for about one-third of sales, according to James Albertine, an analyst for Stifel Nicolaus & Co. Inc. in St. Louis.
“Chrysler was extremely hard hit during the economic downturn and they have recovered more rapidly than anyone expected,” Albertine said in a telephone interview. He has a buy recommendation on the stock.
Shares of Lithia gained 84 percent (LAD:US) this year, compared with an increase of 32 percent for the Standard & Poor’s index that tracks auto retailers.
Mikalachki said investors overestimated the competitive threats facing Tempur Sealy (TPX:US), the Lexington, Kentucky-based mattress maker. The company’s products attracted a host of rivals who boasted their mattresses were as good as Tempur Sealy’s, said Mikalachki.
“The truth is they couldn’t make a dent, not a dent in this company’s sales,” he said. “These guys are the Mercedes-Benz of bedding.”
The fund sold the majority of its position in the bedding firm at between $45 and $60 a share because the stock became too expensive, according to Mikalachki. Tempur Sealy, whose shares traded for as little as $3.93 a share in March 2009 when stock prices reached a 12 year-low, last appeared in the portfolio April 30, 2011, according to regulatory filings.
The Invesco fund has also benefited as outside investors bought its small-cap businesses.
“Acquisitions have found us a lot over the years,” said Mikalachki.
Silver Lake Management LLC, the private-equity firm based in Menlo Park, California, bought Smart Modular Technologies WWH Inc., an Invesco holding, in August 2011. Shares of the technology company almost tripled in the three years before the buyout, according to data compiled by Bloomberg.
Mikalachki will sell a stock if its price rises above what he considers fair value. He will not sell just because one of his holdings moves beyond the boundaries of the small-cap category. Bloomberg defines small-cap stocks as those with a market value of less than $1.5 billion.
Alliance Data has a market capitalization (ADS:US) of over $11 billion. The Plano, Texas-based company was the fund’s second-largest stock position as of June 30, Invesco’s website shows.
Mikalachki will dump a stock if his original rationale for buying it proves wrong. In 2010, he sold Jackson Hewitt Tax Service Inc., a tax preparer, after realizing that the company’s newer franchises were not performing as well as he expected.
Shares of the Parsippany, New Jersey company fell 89 percent between the end of 2008 and April 30, 2010, the last time it appeared in the portfolio, according to regulatory filings.
“That one still gives me shivers,” Mikalachki said.
The fund’s cash position has hurt performance in a rising market, he said, and will continue to do if stocks move higher. “It is tough to stick your knitting in markets like these,” he said. “You can wind up looking like a dinosaur.”
Still, Mikalachki has no intention of giving in and buying shares he regards as overpriced. “Looking back these are the kind of times where we do best for our clients,” he said. “The idea is to not do something stupid.”
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