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Online Extra: "We Know What We Own"


Thyra Zerhusen understands the 35 or 40 stocks she has in her ABN AMRO Mid Cap Fund at any given time from every possible angle. Her attention to the tiniest details has resulted in a 15.3% five-year annualized return for the $487 million fund, putting it near the top of the mid-cap blend category. Even more impressive, during much of those five years, the fund had hefty double-digit weightings in the tech sector, which was broadly pummeled during the bear market.

Her performance has earned her an A category rating on BusinessWeek's Mutual Fund Scoreboard. Lewis Braham recently spoke to her at her Chicago office. Edited excerpts of their conversation follow:

Q: Tell me about your fund's investment strategy.

A: We contact companies directly, visit them, and have an ongoing dialogue with them. We have a long-term perspective, so if you look at our holdings, some of them were already in the fund in early 1999 and are still in the fund now.

It's a relatively concentrated portfolio. Really, we know what we own. And over time if you deal with the same management, you know whether you can trust them. You can tell whether what they told you three years ago was correct or not.

Q: What do you look for in a stock?

A: We look for companies that have the ability to grow market share and distinguish themselves from their competition. We like to find companies that are focused on one business. Ideally, we like it if they have products or services that make their clients more productive, that their clients can't do without. You can own these companies for three, four, or five years.

A good example would be BorgWarner (BWA), a manufacturer of automobile parts. They make turbochargers for diesel engines. Diesel is a big thing in Europe right now because you get much better mileage. They also make transmission systems. One that's exciting is called DualTronic. It's a system that allows manual transmissions to behave like an automatic, and it's more energy-efficient than either stick or automatic. It's used by Volkswagen already and Bugatti.

The company's market cap is about $2.7 billion, and the backlog of orders for its products over the next few years is $1.4 billion. Earnings were up 22% in the last quarter over the previous year.

We also have a good valuation discipline I've been using for the past 20 years. I look at price-to-revenue growth. I look at the p-e of a company relative to the S&P 500. I also look at price-cash flow. And for certain industries that don't have straight growth and may have temporary disappointments, I look at price-revenue. In the publishing business, for instance, price-revenue is a very good to find out the bottom for a stock, how attractively it's priced.

Q: Managers often talk about diversification as a way of controlling risk. You seem to be more interested in picking good stocks.

A: You can diversify so much your fund becomes a closet indexer. That's not what we do. We don't want to lose sight of what we own. So we like to have a relatively concentrated portfolio.

Q: Is there anything you do besides good stock-picking that helps you control risk?

A: We look for good or improving balance sheets. So we don't take undue financial risk. We don't own more than 5% to 6% in one stock. We try not to have more than two-times segment exposure. So if we're investing in the technology sector, we don't like to have more than twice the weighting of the S&P MidCap 400.

Q: Where are you investing now?

A: We bought Engelhard (EC) a quarter ago. It's a specialty chemicals company benefiting from changes in environmental regulations regarding exhaust emissions at factories. Engelhard manufactures a catalyst used in the process for cleaning up the exhaust. It also make additives used by oil companies to increase the yields of their refineries. With higher oil prices, getting an extra 2% yield using their additive pays off. So I expect their revenues to increase significantly over previous years.

We also continue to like Reader's Digest (RDA), a good example of a mid-cap stock that's significantly undervalued. A case in point is the recent announcement by the company of a significant $200 million reduction in debt, which resulted in a 10% rise in the stock over a few days. This company not only has an improving cash-flow outlook but has significant top-line growth potential from developing exposure to China.

Q: Do you still have a large technology weighting?

A: We're always overweighted in technology stocks because of their better growth rates, although most of the tech stocks we have are relatively mundane industrial companies. Currently our weighting in the sector is 22%. That's on the lower side. The fund has always had between about 20% and 35%.

My favorite in the sector, based on its current valuation, is Unisys (UIS). The company provides long-term IT services in five different markets. For instance, in financial services -- large banks and insurers -- it handles back-office processes. More recently, the company won a big contract for homeland security involving bio cards and identity screening at airports as well as radio-frequency tagging for containers during shipping. Yet the company's shares are trading right now at 0.56 times trailing one-year revenues -- very low.

In comparison, IBM (IBM) sells at 1.8 times revenues, and Hewlett-Packard (HPQ) sells below 1. That's interesting because Hewlett and IBM also want to be in the IT service business. So at these levels I wouldn't be surprised if one of them made a bid to acquire Unisys.


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