Picking Low-Risk Winners


By Robert Barker Spotting growing companies with limited risk is a common goal, but few mutual-fund managers have demonstrated the knack. One of those is Michael Prober, manager of CRM Mid-Cap Value Fund (CRMMX), which over the past three years has posted an annual average total return of more than 27%, while the Standard & Poor's 500-stock index lost about 3% a year. The fund delivered that high return at lower-than-average risk, Morningstar notes. Through Feb. 26 of this year, the $75 million fund is off 1.1%, vs. a 3.3% loss for the S&P 500.

To find out how Prober chooses stocks, and which he has bought lately, I reached him by phone at the Manhattan office of the fund's sponsor, Cramer Rosenthal McGlynn, which manages more than $4.5 billion in assets. Edited excerpts from our discussion follow:

Q: How do you go about picking stocks?

A: We have a three-pronged approach. First, we invest in companies that are undergoing some kind of change -- an asset sale, acquisition, new management, new product. Anything that would create some type of confusion or misunderstanding about a company.

Q: I see.

A: Our next prong would be neglect or low expectations. We like to find companies that are pretty hated on Wall Street or have little coverage on the Street, although nowadays that's very difficult. So, for example, we might buy a company like Boston Scientific (BSX), which we bought six months ago. There were 26 analysts following the company. There was one buy recommendation.

Q: And the third prong?

A: Valuation. We value companies three ways: on a price-to-earnings basis, vs. its peers and vs. the broad market; on an enterprise value-to-cash-flow and free-cash-flow basis; and then on a private-market value basis.

Q: Maybe one way to help me understand that is to tell what have you been buying lately.

A: Let's see. We recently started buying Symbol Technologies (SBL).

Q: Why?

A: I'm sticking my neck out on the line here because the company had been a growth stock. The business slowed. They are the leader in bar-code equipment [and] went through this rapid growth period. [Now] everyone hates the stock. It's trading at 1.2 times sales, 20 times depressed earnings, 12 to 13 times 2003 earnings, and it's a proprietary technology company.

They spend 8% of their revenues on R&D. That's worth something because they will keep coming out with new products. I think it's probably pretty low risk.

Q: How's the balance sheet?

A: It's very good: There is only $175 million of net debt.

Q: You also had a position in the technology consulting firm Accenture (ACN) at yearend. Do you still, and if so why?

A: We still hold Accenture. I think the stock is appropriately valued here. We sold stock in the high $20s. When the stock hit $27 or $28, we trimmed. We bought stock in the low $20s, and I think at $25 it's appropriately valued. It's kind of a closet investment on technology, and on technology spending. We don't have a lot of exposure in technology. A lot of the direct technology companies are still too expensive.

Q: I see you pick among mid-caps in the $1 billion to $10 billion market-capitalization range. How many stocks is that, and do you limit yourself to U.S. companies?

A: It's almost all U.S. companies. The opportunity set is probably 1,000 to 1,200 companies. Now, when you do a first cut and you weed out companies that are not earning any money, that are free-cash-flow negative, that are permanent growth stocks which are always trading at too-high multiples, that are biotech stocks -- you weed all that out and you're probably down to 600 or 700 names.

And then, in order for a name to move from the 600 or 700 to what we call a work-in-process list [of] maybe 60 names, it would have to have a catalyst or an event happen.

Q: What's an example, please?

A: One example would be a name like AutoNation (AN), which we purchased in 2001. The catalyst there was new management, and they were spinning off their rental business. This is National and Alamo Rent-a-Car.

The neglect there was that only one analyst was following the company. And from a valuation perspective, when we bought AutoNation, it was trading at six times current earrings. So we thought it could get a retail multiple similar to low-growth retailers, 12 to 13 times [earnings]. And as we were doing our due diligence on AutoNation, we discovered another company, in a similar but different industry, CarMax (KMX).

Q: At yearend that was by far your biggest position, 5.2% of the portfolio. Is it still your largest holding?

A: It's not the largest anymore, but it's probably the second-largest. We've been trimming the position. But CarMax basically is a used-car-only superstore. When we first bought the stock there was no Wall Street coverage. People hated it because they tried to roll out these used-car superstores in 1996 to '98 and they didn't get it right.

Q: What changed?

A: Simple things. It was as simple as, well, General Motors (GM) would [discount] Chevy Luminas $1,500 per Lumina. And CarMax had all this inventory of Chevy Luminas and didn't know that this promotion was coming, and had to mark down their inventory. So CarMax went out and bought one Chevy dealer. And those guys know two months ahead of time when the dealer promotions are coming.

Q: Interesting.

A: So then they started to mark the cars down. Small things like that meant they were getting their house operationally in order. And they did such a good job and they felt very comfortable with the basic model that they announced they were going to roll out 15% square-footage growth over the next five years, each year.

Q: But you've been trimming your position?

A: Absolutely. This was a 5% position at $6 a share. And today it's probably a 3.5% position at $25.

Q: What else do you own?

A: A year-and-a-half ago we saw that Harcourt General was spinning off Neiman Marcus (NMGa) to its shareholders. So we went to Boston to visit the management team. And we find out that we are about to enter a two-year growth period for educational publishing. This is when the states adopt educational publishing textbooks, kindergarten through grade 12. So three weeks later, we went back up to Boston and visited with Houghton Mifflin, and three weeks after that we visited with McGraw-Hill (MHP)...

Q: ...Which I should mention is the owner of BusinessWeek.

A: Right. And a fourth player was Simon & Schuster, which in 1999 got purchased by Pearson (PSO) for 17 times cash flow. At one point in 2000, about 10% of the portfolio was in educational publishing stocks.

Q: Do you still own them?

A: We obviously sold Harcourt General and Houghton Mifflin. Both of those companies got purchased by foreign owners at 50% premiums [above] where we purchased them. McGraw-Hill we still own. It's probably half the weighting it once was. As the stock gets closer to $70 a share, I think it's fairly valued, and we begin to trim.

Q: What else?

A: The secret is to buy stocks with low expectations. When you have low expectations and the companies miss their earnings or have something unfortunate happen, the stocks don't go down as much. And the key is, when you have $1 and you lose 20 cents, you've got 80 cents. You've lost 20%. In order to get back to $1 you've got to make 25%.

Q: Right.

A: And it gets worse. If you lose 90%, then you have to make 1,000% to get back. So the idea that we have here is don't lose money. Therefore, we really have to buy stocks that protect our downside. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online


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