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Middle-class values

They're not as liquid as blue chips, and they don't have the growth prospects of many small caps, but midsize companies offer some attractions of their own.

They're not as liquid as blue chips, and they don't have the growth prospects of many small caps, but midsize companies offer some attractions of their own.

By Charles Keenan
September 2002
Institutional Investor Magazine

What defines value in a bear market that has seen the Standard & Poor's 500 index fall 19 percent through mid-August this year?

A growing number of portfolio managers believe that opportunities look promising -- relatively speaking -- in midcap value stocks. With market caps between $1.4 billion and $8.5 billion (as Morningstar defines the category), these stocks are more liquid than their small-cap counterparts and offer greater growth prospects than those of large caps.

"Midcap stocks offer a compromise of growth and liquidity," says Jim Norris, co-manager of the $64 million Cooke & Bieler Mid Cap Value Portfolio. "It's the best of both worlds."

Their growth prospects look more appealing given the recent drop in stock prices. For the moment, these midcap value fund managers find themselves ahead of the pack. Their ­6.3 percent return through August 16 outperforms small-cap value funds, which returned ­8.2 percent, and large-cap value funds, which returned ­9.3 percent, according to Russell index data.

"It's a really compelling opportunity out there," says Eileen Rominger, a portfolio manager of the Goldman Sachs Mid Cap Value Fund, about even as of mid-August. "It's a good time to go shopping."

Rominger and her cohorts point out that midcap companies are more numerous than the big blue chips, yet generally fall under the radar of sell-side analysts. According to Morningstar, 829 stocks fit the midcap value category, versus 359 for large caps. Says Stan Majcher, portfolio manager of the $100 million Hotchkis and Wiley Mid-Cap Value Fund, "There is a higher probability that something will be overlooked."

Smart stock pickers in this sector focus on price -- but they rarely buy something merely because it is cheap.

The average price-earnings ratio for the Russell midcap value index on July 31 was 21.5 times trailing earnings, versus 29.7 for the Russell midcap growth index. That's also cheaper than an average P/E ratio of 23.4 for the Russell 1000, the large-cap index, and 33.2 for the small-cap Russell 2000.

Especially in the current market environment, the portfolio managers look for quality companies with strong cash flow, low debt and able management. "For some value managers it really is all about price," Rominger says. "Yet having an emphasis on quality has really helped us avoid a lot of torpedoes." Many of the managers look for companies with a strong competitive advantage. "If you don't have a leg up on the competition, then your investment prospects are pretty dim," says Norris.

That philosophy has paid off well at the C&B Mid Cap Value Portfolio. Norris's fund is the top-performing midcap value fund for the three-year period ending in mid-August, as ranked by Morningstar, with a 16.5 percent annualized return. One of Norris's holdings, Perrigo, an Allegan, Michigan­based maker of over-the-counter pharmaceuticals, controls about 70 percent of the market for generic pharmaceuticals. The stock had languished in 1999 as a result of an ill-fated diversification into personal care products and an inadequate inventory control system. Norris began buying in January 2000 after management decided to abandon personal care products and overhaul its inventory system. He bought his stake, representing about 5 percent of the portfolio, at an average cost of $7. Norris took some profits between July and October 2001 at roughly $15, reducing his position to about 1 percent. The stock traded at roughly $10 in mid-August.

Norris, whose fund won't hold more than 50 stocks, keeps an eye out for beaten-down names. One example is Sunnyvale, California­based Dionex, whose products are used to analyze chemical substances in a variety of industrial and scientific applications, such as gauging the water quality of municipalities and measuring the purity of liquid ingredients used to make pharmaceuticals. The company's stock suffered amid the technology downdraft, falling from a peak of $49 in 1999 to $23 in late July, but Norris feels it's oversold. Although the firm's operating margin declined from 24 percent in 2000 to 21 percent in second quarter 2002, Norris says, "most CEOs would kill for that kind of number."

Like Norris, Goldman's Rominger looks for companies earning in excess of their cost of capital. "It is much easier to be patient as a long-term investor if you have a good balance sheet and good cash flow going for you," she says. It also helps to have a margin of safety built into the stock price: The average P/E among the 110 stocks in their portfolio is 13.5 times estimated 2003 earnings, versus 16.2 for the S&P 500.

These days Rominger and her co-manager, Chip Otness, are bullish on financial services stocks, with 27 percent of the fund's assets invested in the sector as of the end of May. They've done especially well with Everest Re Group, the Barbados-based reinsurer. The fund started buying in April 2000, paying $29 a share for what became 1.9 percent of its holdings. Investors abandoned insurers and reinsurers post­September 11, but Rominger and Otness believed that Everest Re's conservative underwriting would ultimately stand it in good stead. With a strong balance sheet and steady cash flow, Rominger says, "we had no anxiety waiting it out until times got better." The Goldman fund had cashed out all of its shares by May 2002 at an average price of $63.

Daniel Bandi, portfolio manager of both Armada's $1 billion Small Cap Value Fund and its just-launched $6.1 million Small/Mid Cap Value Fund, reports a similarly successful history with Everest Re. He bought his stake in late September 2001, with an average cost in the $45 to $47 range, then cut his position in half in October, when the stock hit the low 60s. For the new Small/Mid fund, he loaded up on Everest Re on July 2 -- the day after the fund opened -- buying a 1 percent position at $53, then increasing the stake to 1.5 percent when he bought more shares at $45 late in the month. "The stock was beat up, trading at 1.2 times book value and 4 times cash flow, which looked good to us." Recently, Everest Re traded for $51.

The Goldman fund has done particularly well with its energy stocks. Among its top ten holdings: Irving, Texas­based Pioneer Natural Resources Co., an oil and gas exploration and production company (up 20.5 percent this year), and Ocean Energy, a Houston-based oil and gas explorer (up 5.1 percent). Last year the fund bought shares of Patterson-UTI Energy, a natural gas and oil rig operator, after the company's May 2001 purchase of its second-largest competitor, UTI Energy. The buyout, which came amid a decline in prices of natural gas and oil futures, drove Patterson-UTI's stock down by as much as 60 percent, to $14, in early September 2001.

Still, the Goldman managers admired the company's low cost structure and clean balance sheet. That month they scooped up shares, buying a stake representing 0.5 percent of the fund at $14.80 a share. Investors soon came to share their optimism and bid up the stock. In January the fund took profits at an average of $19.90 a share.

Portfolio turnover rates vary among managers. Neuberger Berman Regency Fund, managed by Robert Gendelman, has an annual turnover rate of 256 percent. At the other end of the spectrum, Jonathan Simon, portfolio manager for J.P. Morgan Fleming Asset Management's Mid Cap Value Fund, posts an annual turnover rate of 40 percent. He'll ride out the ups and downs if a stock meets his criteria for good management, solid cash flow and strong earnings growth potential. "As long as the company is performing well relative to our expectations, we tend not to be fazed by stock price volatility," Simon notes.

About 3 percent of his fund's assets are now held in Clayton Homes, a Maryville, Tennessee­based prefab home maker. Simon's average cost between March and November 1999 was $10, representing 1.5 percent of fund assets. The stock rose as high as $19.60 this year, but in mid-August traded at $13.25. Yet Simon remains an enthusiast. The company has had a very low credit-loss rate owing to a conservative mortgage underwriting approach. In June Simon bought more shares at an average cost of $15.25.

Over the years Simon has often bought positions in family-controlled companies. "They tend to do a very good job of creating long-term value," he says. He now owns stock in the Washington Post Co. (up 25 percent for the year), Brown-Forman Corp. (up 16 percent) and Columbia Sportswear Co. (up 13 percent).

Most midcap value managers are happy to pick up former growth stocks that have fallen on hard times, so long as the price is right. Hotchkis and Wiley's Majcher, whose fund was second among all midcap funds with a three-year annualized return of 14.4 percent, bought shares in personal computer maker Gateway from August 2001 through the first quarter of this year at an average cost of $6. The stock recently dipped to $4, but Majcher isn't too concerned. At that price, he points out, Gateway is trading at book value, with no debt and $635 million in cash. "We're not paying much for the stock," he says. Eventually, Majcher adds, the PC market will bounce back, and so will Gateway.