Finding Sweet Spots in Mid-Caps

Thyra Zerhusen of the ABN Amro MidCap Fund, one of BW's 2005 award winners, shares some of her time-proven investing strategies

For both growth and value, mid-cap stocks are a good place to be, says Thyra Zerhusen, portfolio manager of the ABN Amro MidCap Fund (CHTTX ) and a winner of BusinessWeek's 2005 Best Fund Managers of the Year award. "They are often attractively priced, with smaller companies that can grow faster than the bigger, mature companies in large-cap," she explains. And the mid-caps have lower price-earnings ratios and more experienced management than the small-caps, she adds.

In the first quarter of 2005, Zerhusen's fund has done slightly better than the S&P 500-stock index. The fund is down 1.55%, compared with a 2.15% drop for the S&P. For the five years she has run the fund, its annual average return has been 11.48%. Zerhusen says she likes to keep the fund focused by holding 35 to 40 stocks.

In the current market, "it's important to really be a bottom-up stock picker and keep good communications with management in companies that you own," Zerhusen adds. She reports recently adding to positions, based on valuation, in BorgWarner (BWA ), Magna International (MGA ), and Unisys (UIS ).

These were a few of the points Zerhusen made in an investing chat presented May 26 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chat

Q: Thyra, what do you see ahead for this do-nothing market? Up, down, up, down!

A:

Early in the year we had a pessimistic outlook, so I think the first quarter, more or less, was in line with this outlook. There's a lot of uncertainty -- oil prices are high, the economy appears to be slowing, not to mention inflationary pressures, declining profit margins, etc. So it's important to really be a bottom-up stock-picker and keep good communications with management in companies that you own. You have to really understand what you're owning and why you own it, and pay attention to valuations.

Q: What's your strategy for the fund at this point? Are you adding to any of your positions?A: Yes, we have added to a few positions based on valuation. We have, for instance, added to Magna International and BorgWarner. Based on valuation, we've sold Monsanto (MON ). We established a new position in Molex (MOLX ).

Another of our holdings, USF (USFC ), was bought by Yellow Roadway (YELL ). We just received the cash and shares today, so that worked out pretty well. But we have also added to Unisys. They had a big disappointment and oversold, but we believe they're attractive now. Everything we do is fundamental bottom-up, valuation-based.

Q: Can you tell us more about why you like Unisys?

A:

It has incredible, attractive valuation. The market cap is about $2.5 billion, yet it's selling at 0.4 times revenues. You don't see that with companies that have good contracts. If you look at the contracts they have between 6 months and 12 years, they have $6.5 billion signed in contracts.

In addition to those, they have $2.5 billion in government pacts that they've signed but not been funded yet. The reason they're down is that they had two or three underpriced contracts that have been taking a little too long.

They are fixing the pricing, though, so when this happens (which could take a couple of quarters) the stock should rebound. It's incredibly cheap, and even if it may take a while, at these valuation levels somebody else may pick them up and take them over.

Q: Are mid-cap stocks still a good place to be? And how has your fund been doing?

A:

Mid-cap appears to still be a good space, because you have similar p-e valuations, but you have much higher growth rates than large caps. They are often attractively priced, with smaller companies that can grow faster than the bigger, mature companies in large-cap. Mid-cap has more experienced management and lower p-e's than small-caps.

Our fund, in the first quarter, was down 1.55%, compared with 2.15% for the S&P 500. The S&P MidCap 400, our benchmark, was down 0.4%. So we did underperform our benchmark but beat the S&P 500.

Q: How has the fund done longer-term?

A:

Longer-term, in the five years or so, we've done quite well. We're in the top 10%, according to Morningstar. I started managing the fund in early '99, and it has more than doubled in that period. As of yesterday, for the five years, annualized, it's 11.48%, which is in the top 11%. We're also relatively tax-efficient. We try to avoid short-term capital gains, and tax-adjusted we're in the top 8%, and tax-adjusted our gains are around 11.08% annualized.

Q: What are your fund's parameters for midcap?

A:

We're looking from $1 billion to $10 billion. I'd say we have probably 75% in that space. Nothing in the present time bigger than $10 billion -- only one that's close. We have a few names less than $1 billion.

Q: How many stocks are in your fund?

A:

We have a concentrated portfolio, 35 to 40 stocks. So we can have some volatility there, but if things go well, it does help our performance. Although it's easy to find more stocks and add more stocks, it pays to keep our portfolio smaller. If we're at 40, our discipline will make us push out the weakest stock to make room. We don't ever lose track of what we own.

Q: Do you think the value strategy will be the right course to follow for the rest of this year?

A:

We look at both growth and value -- what growth and at what price. It's a p-e/growth ratio. But I think value is very important -- we like to find great companies, but what are we willing to pay for it? Ideally, we like to pick stocks where growth meets value -- a good growing stock that can be classified as value. If a stock does get oversold, that's when we become interested. We don't like deeply discounted value stocks -- they do have to have attractive growth, but we still do tend to search for these oversold stocks that have bottomed.

Q: Considering all the troubles at Ford (F ) and General Motors (GM ), why do you like parts supplier BorgWarner?

A:

That's a good question. There is a cloud over them, but in our opinion it's not justified. BorgWarner does have a very attractive growth rate -- they're specializing in turbochargers for diesel engines, and given the high gas prices in Europe, 40% of cars use diesel engines. You do get 30% better mileage with diesel.

They also make timing chains, which are replacing belts and last longer. These help manufacturers give longer warranties, so they're gaining market share there. They make those dualtronic stick shift/automatic transmissions. There will be excellent growth as this transmission gains market share.

Q: Anything you like in energy?

A:

We have two names that are energy-related. One is FMC Technologies (FTI ). It has systems that provide technology for deep-sea drilling. It has $2.1 billion market cap, and it's pretty attractively priced. It's around 0.7 times revenues. We'd buy it here -- it's a long-term holding. They still have businesses in food technology and airport systems, but these will fold over time when they focus on energy production systems.

We have another, Veritas DGC (VTS ). It's around $900 million in market cap. They are involved in seismic mapping, 2D or 3D images used to find oil locations, reservoir size, etc. They can determine the size and structure of these gas and oil fields -- so again another indirect play, but it has done quite well, and I'd buy it on any pullback.

Q: You also own Reader's Digest (RDA ). What's the attraction there?

A:

The stock has done well -- it's up quite a bit year-to-date. The attraction is that they've done reasonably well in advertising sales -- it's selling at less than 1 times revenues, and with cases of takeovers in publishing companies, this is attractive.

There's a possibility that they may get the magazine into China. They've been talking to China for over a year, they've done some joint deals with Chinese publishing companies, and the idea is that they would get the approval to get the magazine into that massive market. This would be a big coup, and with this prospect on the horizon, it could be very undervalued.

Given that only two or three analysts on Wall Street follow it, it's safe to say it has largely been ignored. It was as low as $10 or less at one point, but it has turned around to $17. Our target for the stock in the next 10 to 12 months is $22 to $23, and possibly better.

Q: What portion of a long-term portfolio would you advise for mid-caps, vs. small- and large-cap?

A:

I would probably say 50% to 60%, because you have good growing companies in there, large-caps being more mature. There are sometimes good opportunities in large-cap names, of course. Small-cap is, in my opinion, more difficult to really negotiate in. I think based on the growth rates and valuations, I would put most of the money in mid-cap and the remainder placed opportunistically in large-caps that have had recent disappointments, but have potential.

My average market cap is just under $3 billion. So it's on the low end of our $1 billion to $10 billion range. I wouldn't go below $500 million to $600 million, unless I understood the company extremely well.

Q: Do you like any biotechs?

A:

I like Shire Pharmaceuticals (SHPGY ) and Edwards Lifesciences (EW ). Shire's valuation is very attractive, price-to-cash flow is 13 times, p-e is 15, the revenues and earnings growth are pretty decent. Market cap is $5.1 billion, and they have no debt. On top of that, they have a small dividend.

Q: What's your take on tech currently? Any holdings there? You mentioned Unisys.

A:

We always have between 20% and 30% in technology. Unisys is our largest holding in the space. Related, we have Diebold (DBD ) -- they make ATM machines, granted not high tech. We own Harris (HRS ), which makes communications equipment for the government as well as broadcasting companies. They've done really well three years in a row -- very good performance, big contracts with the government.

We own Symbol Technologies (SBL ) as well. And Zebra Technologies (ZBRA ), the equipment maker. They make UPC labels and printers for labels. Another we own that's software-related, Progress Software (PRGS ). They're really a baby Oracle (ORCL ) -- they make applications software for midsize companies, and they're doing very well in Europe. We always have some technology, never less than 20%. The most attractively undervalued in that whole category, though, is still Unisys.

Q: What keeps you ahead of your peers?

A:

Well, running a very focused portfolio, and understanding what I own. Having valuation being my guidance is the foundation. Having a strong buy discipline and a strong sell discipline are also important.

Q: Speaking of sell discipline, you cited at least one recent sale -- any others to note? And is the discipline sort of the reverse of your buy philosophy?

A:

Yes, it's the reverse. The third quarter last year, we sold Apple Computer (AAPL ), which we had had for three years or so. We sold a little too early, I'll admit. We made a lot of money on Yahoo! (YHOO ) -- we bought it around the third quarter of 2001, and after two years sold it based on valuation.

Q: Beyond YHOO, any Net stocks you like now?

A:

No, not right now. We aren't focused on the Internet -- we're more in traditional advertising and publishing.

Q: So besides Reader's Digest, what do you like in ads and publishing?

A:

We like Pearson (PSO ) -- that would be the Financial Times. Also their Penguin books, their 50% share of The Economist, and textbooks.

Two years ago, it was at a substantially more attractive valuation than its peers. In the meantime, the others have come down, so the spread has narrowed (though not as I expected). Still, earnings have been good, so I still like them. We also have a position in Belo (BLC ), which is more television-based.

Edited by Jack Dierdorff

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