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Seeking Bigger Returns in Smaller Stocks

Jim Schier takes a broad approach to value investing. As manager of the $219 million Security Mid-Cap Value Fund/A (SEVAX), he uses both qualitative and quantitative criteria to uncover companies whose profits, he believes, will be significantly higher in five years than what is currently reflected in their stock prices.

Along with mid-cap stocks, Schier also invests in small caps. The fund currently has a median market capitalization of $2 billion and has outperformed its mid-cap value peers since its inception in May, 1997. For the five years through last month, it gained 15% on average, vs. 9.8% for the average mid-cap value fund. However, the portfolio has been more volatile than its peers. Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund its second-highest rank of 4 Stars.

Security Mid-Cap Value's expenses currently run higher than its peers -- 1.65% vs. 1.43% for the average mid-cap value fund. That's because the average account size has fallen due to market declines, notes Jana Selley, director of investor relations at Security Benefit. The fund's expenses should fall as the market improves.

Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Schier about the fund's investing strategy and top holdings. Edited excerpts of their conversation follow:

Q: What types of stocks do you look for?

A: We try to identify companies that will be significantly more profitable in three to five years, buying them at prices that reflect much lower profit levels. We keep the fund's

turnover low to capture as much of the stock appreciation as possible. We'll wait until opportunities develop so that we can buy stocks when people want to sell.

Q: Why do your favor small- and mid-cap stocks?

A: They provide a wider range in which to roam. The fund's median market cap is currently about $2 billion. By prospectus, we're required to have about 80% of our assets in stocks with markets caps of $336 million to $12.8 billion. Our current analysis of value stocks says large- and mid-cap stocks are basically fully valued, and small-cap stocks are probably at a 5% discount to mid-cap stocks.

Q: How do you select stocks?

A: We evaluate companies by comparing their pretax returns on capital with their stocks' debt-adjusted price-to-book. We try to decide an appropriate price to pay for a given level of profitability. Our process is about 50% quantitative and 50% qualitative. The quantitative side tells us how stocks are priced and how profits compare historically. The qualitative side helps to assess what the future is like.

Q: Do the stocks that are undergoing difficulties generally offer the best opportunities?

A: They can. Some companies may be facing difficulties, and you have to decide whether the issue is terminal or transitory. Sometimes, companies are in industries or sectors with significant upside potential that would give them better-than-normal revenue growth. We compare companies in the same industries against each other to find those whose profits may be lagging their peers or their historical levels.

Q: Is your process more

top-down or


A: Our process is very much bottom-up, but we consider sector weightings. Currently, we're underweighted in consumer discretionary, financials, and utilities. Consumer discretionary and financial companies have cost pressures and difficulties in expanding their profit margins. Utilities stocks generally aren't cheap.

Q: What sectors currently look attractive?

A: We have decent oveweightings in technology, materials, and industrials. In technology, we've been focusing on companies that are benefiting from higher telecom-equipment spending. The materials sector has been underinvested in for decades and faces increasing demand as emerging market economies continue to grow. Industrials are likely to benefit from greater capital expenditures.

Q: Have you made any recent changes to the fund?

A: In the last 45 days, we've been adding to our financial-services holdings a little. We've moved from about a quarter weighting of the S&P MidCap 400 Stock index to about a 40% weighting of the index.

Q: What are the fund's largest holdings?

A: Inco Ltd. (N), Computer Sciences (CSC), Shaw Group (SGR), KFX Inc. (KFX), and Murphy Oil (MUR).

Q: What has added value and helped the fund outperform?

A: It's not one single thing. We seem to emphasize small- and mid-cap stocks when that's appropriate. Every so often, we've added an equity-like security, such as a convertible bond, that has provided equity-like returns with very low risk. Also, most of the sectors in the fund have added value.

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