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Finding Quality in the Bargain Bin

As lead manager of the Principal MidCap Fund (PEMGX), Bill Nolin is optimistic that the market will recognize, and reward, well-run midcap companies. Nolin has run the Des Moines, Iowa-based fund since November, 1999. For his universe of stocks and his benchmark, Nolin looks to the Russell Midcap index. Of its 800 stocks, he chooses those he deems to be the best 100 to 130. As of Jan. 31, the $483.5-million fund held 115 companies, with a one-year turnover of 38.8%, vs. 64.4% for its peers.

Nolin roughly follows the Russell's sector weightings, but varies his holdings according to where he finds the best opportunities. At yearend 2004, his top five sectors were financial services (20.6% of the portfolio), consumer discretionary (20.1%), industrials (13.4%), health care (13.3%), and information technology (13.2%). The fund's top five holdings were TCF Financial (TCB

; 2.6% of the portfolio), Gentex (GNTX

; 2.2%), IMS Health (RX

; 1.9%), Republic Services (RSG

; 1.9%), and Fidelity National Financial (FNF

; 1.8%). According to its prospectus, the fund can invest up to 20% of its assets in foreign stocks.

Nolin's approach has produced a winning formula. For the three years ended in January, 2005, the fund registered an annualized return of 11.2%, vs. 8.6% for its midcap blend peers. For the five years ended in January, it rose 8.9% on average, vs. 6.6% for its peers. Based on risk-and-return characteristics over the last three years, Standard & Poor's gives the fund a rank of 4 STARS.

"The returns are a function of how well the business does, and how well the marketplace likes it," Nolin says. "We stick to what to we do -- we buy these businesses and don't overpay for them."

Carol Wood of Standard & Poor's Fund Advisor spoke recently with Nolin about the fund's investing strategy and top holdings. Here are edited excerpts of their conversation:

Q: How would you describe your investment philosophy?

A: We're fundamental, bottom-up stock investors focused on managing risk. We believe that stock selection is what generates returns. This is based on Warren Buffet's saying that if the business does well, the stock eventually follows.

Q: What is your investment strategy on the fund?

A: We buy high-quality companies that have a sustainable competitive advantage, and we pay a reasonable price. We stay within the midcap range -- companies with a market cap of $1.5 billion to $10 billion.

We look for high profitability, believing that it may be due to a competitive advantage. From there, we look at valuation and free cash flow.


return on equity (ROE) of our portfolio is around 18.8%, vs. 15% for the [Russell Midcap] index. Our return on assets is 8.3%, vs. 5.7%. Our net margin is 11.5%, vs. the index's 10%. The price-earnings ratio in our portfolio is 22.2, the index is 23.6. So we're paying less for superior companies.

Basically, we want to own a good business that will grow over three to five years. We push aside average and overvalued companies, commodity companies, and fads.

Q: What's an example of a recent fad?

A: Low-carb diets. One of our holdings, Weight Watchers (WTW), suffered last year because of it. But the number of people on low-carb diets has trailed off significantly. Our average cost for Weight Watchers was around $37, today it trades at $45-$46.

Also, in 2003, people bought volatile stocks, companies without earnings -- semiconductors, for example. One company in the index, Agere Systems (AGR.A), spun out of Lucent Technologies (LU) several years ago, has never made money. In that year, its stock went up well over 200%. In 2004, it came back to where it was before. We're just not going to participate in things like that.

A lot of people are just interested in returns, or a stock that can go up 50%, but we want to manage our downside.

Q: How do you do that?

A: It's built into our process. It starts with buying high-quality companies and pushing aside turnarounds, commodity companies, average companies. The second area is valuation -- p-e ratio, free cash flow yield.

Q: If the valuation becomes high, would you sell it?

A: Yes. That's part of the risk reduction. We'll reinvest it in a company with a better valuation. We run a diversified portfolio and monitor the companies. We call it early warning-signs analysis -- looking for problems in the business, and recognizing them before the marketplace does.

Over a year ago, we owned a company, 99 Cents Only (NDN), a dollar retailer in California, which decided to jump into the Texas market. We realized that they were not going to be as successful in Texas as in Los Angeles, and sold the stock. Later, people became aware of their problems, and the stock went down 50%.

Q: What are your buy criteria for stocks?

A: They must be midcap companies with sustainable competitive advantages, with which comes growth and good ROE, return on invested capital, and profit margins. Then, it's the valuations, free cash flow, and the growth rate of that free cash flow.

Q: What are your sell criteria?

A: The opposite of the buy criteria. We sell when the valuation is too high, when something's changed in the business, and when that sustainable competitive advantage is gone.

Q: Could you please describe one or two top holdings and how they reflect your investment style.

A: Gentex is now our second-largest holding. They make automatic dimming rearview mirrors for vehicles. They've got an 80% market share, and, essentially, one competitor with a 20% market share. Roughly one vehicle in four today has an automatic dimming mirror. With $500 million in sales, they have profits -- this is staggering for an automobile supplier -- of over $100 million.

Our largest holding is TCF Financial, a bank headquartered in Minneapolis. This company is really a great organic growth story in banking, where most growth comes through acquisitions and consolidation. They're in Jewel Grocery Stores in Chicago, and in several grocery stores in the Minneapolis area. Their focus is on being convenient to the consumer. Their

return on assets of over 2% is outstanding for a bank, and they have ROE of around 25%.

Q: A stock report from Standard & Poor's has a "sell" on TCF. It advises avoiding the shares based on valuation. Is that an issue for you?

A: No. This stock sells at around 14 times earnings. The Russell Midcap index is around 23 times earnings. It's not overvalued when the company has been growing earnings at around 12% to 15% a year, not taking a lot of risks, and doing it organically. They're building out new branches and reinvesting in their business. This is vs. an acquisition, or a hit-and-miss strategy you can't count on over a long period.

Q: Are there any areas or sectors that you avoid?

A: No. We're diversified pretty much across all sectors. The one area that's harder for us is technology, because the competitive advantages there are not as strong, the valuations have been very high, and the management teams have not been very shareholder-friendly.

Q: Are there any other recent additions to the portfolio?

A: One is Cintas Corp (CTAS), the fund's ninth-largest holding as of Dec. 31, 2004, at 1.7% of the fund's assets. It's the leading company in providing uniforms and uniform cleaning, with around a 30% market share nationwide. It's still a fragmented industry, so they're the No. 1 company. There's been a slow but steady growth in use of uniforms throughout industries. The company believes that over time they can grow their top line at around 15%.

Q: Midcap stocks have enjoyed fast growth for the last decade. Do you expect that to continue?

A: We think midcaps have a couple of advantages that will be helpful going forward. Midcap companies grow faster than a big company like General Motors (GM) or IBM (IBM), and are more likely to be bought out at a 20% to 30% premium. Midcap stocks were undervalued, but that difference has narrowed. Still, we think there's a good chance they'll outperform because of growth and takeovers.

Q: Do you have different scenarios for how your fund will perform, depending on if the economy continues to improve or slips back into recession?

A: We don't manage the portfolio based on potential results because they're unknowable to us. So we don't change our strategy.

A couple of things we think are in our favor is that high-quality companies are cheap right now. They sell for around 18 times earnings, and low quality sells for around 24 times earnings. We think at some point, the wind's going to be at the back of high quality, and that midcaps should do well.

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