Markets & Finance

Midsize Values Reap Outsized Returns


With the U.S. economy expected to rebound later this year, many value-oriented funds are seeking to capitalize on the depressed sectors where they traditionally invest. Michael Meyer, co-manager of the C&B Mid Cap Value Portfolio (CBMDX), says he has loaded up on economically-sensitive industrials and cyclicals, as well as some beaten-down technology outfits, in the hope they will thrive as conditions improve.

Meyer's fund has weathered the three-year market downturn fairly well. For the three years ended Apr. 30, C&B Mid Cap Value fund gained an average annualized 15.1%, vs. 3% for the average midcap value fund, while taking on slightly less risk. For the five-year period, the fund has risen 9.5%, vs. 1.7% for its peers. Based on risk and return characterisitics over the last three years, Standard & Poor's gives the fund its highest rank of 5 Stars.

Both Meyer and James Norris have co-managed the $150-million fund since its inception in February, 1998. Their firm, Philadelphia-based Cooke & Bieler, manages about $2 billion in assets overall, including three mutual funds. Palash Ghosh of S&P's Fund Advisor recently spoke with Meyer about the fund's strategy. Edited excerpts from their conversation follow:

Q: What kinds of stocks do you look for?

A: We primarily invest in under-valued midcap companies with market caps between $500 million and $5 billion that have strong financial characteristics, such as high return on equity, strong balance sheets, industry leadership, competitive advantages, and the ability to generate excess free cash flow and to re-invest that cash at attractive rates of return. They also feature low debt levels, a dividend or stock repurchase policy that is beneficial to investors, and strong management.

Q: How do you go about selecting which stocks to buy?

A: Based on our valuation criteria, we often buy stocks trading at depressed prices because they are facing some short-term, but solvable, issues. We have intensive interviews with company management, as well as with their customers and suppliers. Cash-flow analysis is a prominent part of our stock-selection process. We think that all companies have an intrinsic value, which is derived from their ability to generate cash flows over the long-term. We purchase stocks at a price significantly below their intrinsic value -- generally at a discount of 40% or more.

Q: How many holdings are in the portfolio?

A: The fund presently has 38 holdings. We typically hold between 30 to 45 stocks, and keep a fairly concentrated portfolio by design, having examined and understood the underlying business risk.

Q: What benchmark do you use and how has your relative performance been?

A: Our benchmark is the Russell Mid-Cap Value index. In calendar 2002, the fund pretty much matched the index. In 2001 and 2000, however, the fund significantly outperformed the Index. We attribute that out-performance primarily to good discriminate stock-picking across a broad range of sectors.

Q: What are your top 10 holdings?

A: As of Mar. 31: Zale Corp. (ZLC), 4.3%; Big Lots (BLI), 4.2%; Aon Corp. (AOC), 4.1%; Carlisle Cos. (CSL), 4.1%; Pall Corp. (PLL), 3.8%; Tommy Hilfiger (TOM), 3.8%; Hasbro Inc. (HAS), 3.8%; Steelcase Inc. (SCS), 3.7%; CBRL Group (CBRL), 3.7%; and Snap-on Inc. (SNA), 3.6%.

Q: What percentage of assets do these top holdings account for?

A: These 10 stocks accounted for 39.9% of assets. As a risk-control measure, we won't allow any individual stock to occupy more than 5%, at cost, of the portfolio's assets.

Q: Tell me about one of your top holdings.

A: Pall Corp., a leader in the filtration industry, generates about $1.5 billion in annual sales, and serves a broad customer base. Cash flow and sales are very stable since filtration products need to be periodically replaced.

We purchased the stock late in the summer of 2002, when the price had declined to about $16. The stock was under pressure for a long time because of some negative issues related to the company's big contract with the American Red Cross. We felt they had worked through these problems, and that they were poised to boost earnings. The stock is currently trading in the low $20s, and we think it has an intrinsic value of about $29.

Q: Tommy Hilfiger's stock price has been in a steep decline since last summer. Why do you still have it in the portfolio?

A: Our investment thesis is that Tommy Hilfiger is a strong, well-recognized apparel brand, which we think has staying power. They generate $1.9 billion in annual revenues, but the company's market value is only $700 million. It's trading at a p-e of only 6.

However, we're currently re-evaluating our position here since Tommy has rejected some takeover proposals, notably from Jones Apparel Group (JNY). We are concerned by this because, they said they want to expand their brand portfolio on their own through acquisitions. We are closely monitoring them. We have a price target of about $15 for Tommy.

Q: What are your top sectors?

A: As of Mar. 31: industrials, 27.3%; technology, 15.8%; finance, 14.8%; media and services, 11.8%; retail trade, 10.3%; and consumer nondurables, 9.2%.

Q: Technology is one of your largest sectors, which could be considered odd for a value fund. Can you discuss a couple of your tech holdings?

A: Our exposure to technology is about double the index weighting. We have been moving into tech for the past 12 to 18 months. On a valuation basis, we have found an increasing number of attractive midcap tech companies with solid balance sheets and competitive advantages that are trading at depressed prices. Our large-cap portfolio has a much smaller exposure in technology.

Some of our favorite picks are Mykrolis Corp. (MYK), a maker of liquid and gas delivery systems to the semiconductor industry, and AVX Corp. (AVX), which makes passive electronic components like capacitors.

These companies have impeccable balance sheets, low debt, and good cash flow. Moreover, they dominate their niche businesses. Mykrolis is depressed because the semiconductor industry as a whole is soft. But when that business rebounds, companies like Mykrolis stand to benefit.

Q: Relative to your benchmark, in what sectors are you most under-weighted and over-weighted?

A: Finance is a slight underweight, since we've trimmed back on Countrywide Financial (CFC). We are severely underweight in energy and utilities. We have fundamental concerns about the utilities industry since they have excess supply, and because companies have made too much investment in power generation.

We are overweight in areas such as economically-sensitive industrials and cyclicals. The stocks we bought here came purely through our bottom-up selection process, but these are industries that we think will benefit greatly when the U.S. economy rebounds.

Q: What are your sell criteria?

A: We sell a stock outright when it reaches our target price. We start scaling back as it approaches that target. We also sell when the company's fundamentals have deteriorated, or if we determine our original investment thesis no longer is applicable.

Q: Can you cite some stocks you recently sold, and why?

A: Last year, we eliminated Avnet (AVT), an electronics components distributor, on our concerns over the fundamentals of the electronics distribution business and Avnet's increasingly leveraged balance sheet. Recently, we sold off Perrigo (PRGO), a private label manufacturer of over-the-counter medicines, because it reached our price target.


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