March 1, 2000

Middle Man

Andrew Stephens hails from the Midwest and loves m

Photography By Blair Jensen

Andrew Stephens draws his investment style from his rural Wisconsin roots: The portfolio manager of the Artisan Mid Cap Fund thinks of his stocks as plantings to be cultivated. In addition to his main "field," he has a "garden" where he takes his risks and tests new stocks, normally in a 1% position. If they show signs of flourishing, he'll plow more money into them and move them into the main crop.

But farmers are conservative, and Stephens isn't about to let those stocks grow like kudzu. He trims them back when they reach a 5% position, when they reach 80% of his valuation target, or when profit cycles begins to decelerate. And he'll pull a stock up by the roots when the company shows deteriorating fundamentals or when more attractive valuations exist elsewhere.

Stephens also has his eye on the sky, watching if the visions of the companies he invests in are taking flight. "You have to get out of the normal business model and open your mind to capture all of the dream," says Stephens. "But then discount it back like mad. Buy the dream cheap, and you've got a great purchase."

And buying cheap is what Stephens likes. Although, as a growth fund manager, he looks for companies with accelerating earnings and expanding profit margins, he takes a value approach to buying companies that are out of favor and selling at a discount.

To Stephens, mid-cap stocks are fertile ground because they have more dramatic growth than large-caps, but less risk than small-caps. And the market agrees. Mid-cap growth funds had a spectacular 1999, with an average total return of 64.8% - the best return of any non-sector fund category, according to Morningstar. This year, mid-cap growth funds are returning 6.0%, trailing only small-cap growth funds by 0.5% for the lead.

Artisan Mid-cap Fund's 57.9% total return in 1999 underperformed the growth category, but beat the S&P 500 by 36.9% and the 400 MidCap Index by 43.2%. Morningstar ranked the fund in the 43rd percentile of all mid-cap growth funds in 1999.

Not being the best of show doesn't perturb Stephens, however. He saw too much risk in chasing aggressive returns by increasing technology weightings. He's more content cultivating consistent returns and points out that the fund was ranked 7th of 143 core mid-cap funds by Lipper for the two years ending December 1999.

Before joining the four-fund Artisan Partners, Stephens worked with Milwaukee-based Strong Capital Management for 12 years where he co-ran the Strong Asset Allocation Fund for three years. Artisan is also headquartered in Milwaukee, although Stephens makes his home in Chicago.

The boyish-looking Stephens speaks earnestly and sincerely about his fund and about investing. "Everything I see and hear is fascinating to me," he says. "I'm consumed with finding perfection, whether it's the perfect place to invest or the perfect person to have on my team."

You've said that mid-cap stocks are the Goldilocks asset category. What do you mean? I stumbled on mid-caps when I was trying to find the best risk-adjusted performance in the market. The key determinant in getting into our database is whether the stock is a franchise. In other words, does the company have two of these four characteristics: dominant market share, low-cost producer, proprietary asset, or defensible brand. With mid-caps, I can buy a franchise that is better than Coke or Gillette. Mettler-Toledo, one of our stocks, has a 40% share worldwide. American Power Conversion has a 50% share worldwide. Coke and Gillette don't have that kind of market share. Nor do they trade at a discount the way mid-caps do. And with mid-caps, we get the small-cap effect - 50% or more annual cash-flow growth - but with better trading liquidity and more seasoned management teams than small-cap companies. So as a category, we think they're just right, like Goldilocks' porridge.

How big is the universe of mid-cap stocks? We define mid-cap as a market capitalization between $600 million and $6 billion, and there are probably 2,000 companies in that category. We have 185 names in our database, of which we generally own between 55 and 65.

Given the market's longtime obsession with large-cap stocks, what's behind the astonishing performance of mid-caps last year? Coming out of the recession of 1991 and 1992, big-cap companies were growing their earnings almost as fast as small-caps. But big-caps had a lot less business risk and better liquidity, so investors bid then up. Since the market has become so momentum-oriented, that feeds on itself and you get the S&P 500 effect.

Now, large-cap companies' growth rates have pretty much peaked, so people are looking at mid-cap companies, which are showing accelerating growth rates. Plus, when last year's third-quarter earnings came out and people realized the Fed's policy on interest rates, the market began to broaden, and we'll see it continue to broaden this year.

Now that mid-caps are in the spotlight, can you still find bargains? We have more ideas now then we've ever had. I think that's a function of our team and our database. We don't really care what the market is doing. Rather, we evaluate all these mid-cap franchises, and our list grows. Are they always timely? No. But the market tends to be manic-depressive, and you'll get your opportunity a couple times a year.

In spite of your growth categorization, you have a strong value orientation. That's right. We think our job is to expose people to the benefits of the capital markets without undue risk. We do this by selecting franchise companies that will maintain their high cash flow in the future. The other factor we consider is the value of the vision that management is trying to create. How hard will it be for them to overcome the hurdles they face, and what amount of cash will be generated? Then you discount that value back at the cost of capital to determine the worth of the stock. If you don't know its worth, then you don't know what to believe when the market is down, and you can't seize opportunities.

Artisan Mid Cap
Artisan Partners Limited Partnership

1000 North Water Street, Suite 1770

Milwaukee, Wisconsin 53202

800-344-1770

www.artisanfunds.com

Portfolio manager: Andrew C. Stephens

Manager's tenure: 3 years

Fund started: June 1997

Minimum initial investment: $1,000

Load (front-end): 0%

12(b)-1 fee: 0%

Net assets: $97.9 million

Dist. yield (trailing 12 months): 0.00%

P/E ratio: 37.5

P/B ratio: 10.0

Median market cap: $2.46 billion

Expense ratio: 2.00%

Turnover: 203%

3-year alpha: -

3-year beta: -

3-year r-squared: -

3-year standard deviation: -

Returns
1998: 57.89%
1997: 33.37%
1996: NA
1995: NA
1994: NA
12-month (annualized): 60.64%
3-year (annualized): NA
5-year (annualized): NA
Top Five Holdings
Kinder Morgan, Inc.: 4.6%
Dynegy, Inc.: 3.7%
Mettler-Toledo International: 3.1%
Adelphia Communications: 3.0%
National Semiconductor: 2.7%
Equity Allocation
As reported in the February issue of Morningstar's Principia Pro.

Annualized returns are through January 31, 2000.

Projecting future cash flows is pretty difficult, isn't it? That's why we use a discount rate as high as 25%. Then, we wait until we can buy the stock at 55% to 65% of its worth. It's a discount on top of a discount. If we can get it at that price, we're fairly comfortable we've taken most of the risk out of our assumptions.

Last year, you were in the 43rd percentile of mid-cap growth funds, yet the stated goal of the fund is to rank in the top quartile of mid-caps. Our goal is to be in the top quartile of all mid-cap funds, not just growth funds. We're not willing to take the risk that it took to be in the top quartile of mid-cap growth funds last year. Those funds have 40% to 60% weightings in technology. A concentrated portfolio feels good for a while, but when things change, you're forced to reposition, and you don't know what you believe any more. We want to be a consistent top-quartile performer through all markets with a well-balanced portfolio. Our weighting in technology is 31%, which is higher than it's ever been, but it's driven by fundamentals.

Are you really finding opportunities in technology these days? We look at things from a top-down perspective, based on themes. The theme driving technology now is the move from analog to digital. There are a lot of sub-segments of that. As we move to digital technology, networks are being built to handle higher speeds and more precise data. Broadband will be everywhere, and we'll need high-speed rotors, high-speed switches, and software that can manage these different networks. We're finding opportunities in this new infrastructure. Semiconductors and the software used to design semiconductors are the foundation of the new technology.

If you never let individual stocks exceed 5% of your portfolio, doesn't that force you to sell your winners? It's not a diversified fund if you hold more than 5% of assets in a single stock. So we're trimming our winners, absolutely. But it's also a problem if you hold a stock too long and the momentum guys start to sell it because they've misunderstood a quarter. Then you've delivered to your shareholders volatility that is unacceptable. That to us is more of a crime. At 5% we think we're maximizing the opportunity without being excessively greedy.

Doesn't buying a new stock have its own inherent risk? Not at all. We have a database of 185 names that we know very well. Where we find a franchise, good value, and accelerating earnings, we take a 1% position and put it in our "garden." We use the garden, which is about 25% of our portfolio, as a place to get to know our investments before we make the big bet. That's where all the turnover is and where we take risk. If we've valued the stock correctly and there's an improving profit cycle, we'll see that early and we'll commit more capital to it, and put the stock into our "crop" with a 3% to 5% position. That's the portion of the portfolio that makes money. Eighty percent of our gains come from 20% of our names, so we allocate capital to the names we think will be the most successful.

When do you take profits, then? We harvest the portfolio when one of two things happens. If the stock price reaches 80% of its private market value, we'll cut back its position to 1.5% That's another risk-control technique. It's been in our crop, it's working great, but it's reached the highest number we can accept.

So your relatively high turnover of 203% comes from 25% of your portfolio? Seventy percent comes from turning over names. The balance occurs when a stock moves from a 1% position to a 5% position and the trimming back process. If a stock gets into our crop and it stays within our valuation band, we'll own it for as long as the profit cycle increases. Two to three years is our target period. For our top 10, I would say the average is 18 months.

We think there are two ways to add value to a portfolio. One is through security selection. And the second is by actively managing capital by putting money into the names that have the highest probability of success. I can't say we're going to run at 200% forever. We'd like to see it come down a little, but we're never going to be a low-turnover fund. We can add too much value managing it the way we do.

Do you automatically sell a stock if it gets too big? No. We limit our buys to companies between $600 million and $6 billion, but we have a 5% tail of companies over $8 billion and a 5% tail of companies below $1 billion. We think we can do a much better job buying within our sweet spot than trying to own all strata of the market, but we won't sell a company that's still within our valuation band just because it grows.

You've increased your energy holdings. That's a pretty contrarian position, isn't it? Energy is a terrific example of our strategy to be early when the profit cycle is just beginning and the market sentiment is still a little bit pessimistic. Then we can ride it through to the sweet spot and sell when the market is euphoric. Deregulation and consolidation are occurring in energy markets, and these companies are experiencing the restructuring that drives profit cycles. The gas people have figured out how to survive in a deregulated environment, and now they are acquiring electric utilities. They're going to become one-stop providers of power nationwide, and the potential growth of their earnings and cash flow is enormous. Kinder Morgan is now our largest position and Dynegy is second.

What have you bought recently? Adelphia Communications is a cable company that controls Los Angeles. You can't have a nationwide cable network without Adelphia. The company is going through a big upgrade cycle as it rolls out digital technology. This will give it the 'fat pipe' for high-speed access to the edge of the network. It's relatively undervalued compared to its peers.

The Internet is driving change in America's distribution infrastructure, requiring better intelligence about inventory. We want to be exposed to this growth, so we bought Zebra Technologies, which is the dominant worldwide manufacture of high-speed bar-code printers. We also bought Symbol Technologies, the dominant provider of scanning devices.

What's your prognosis for mid-caps? In the next five years, mid-cap stocks will be the best risk-adjusted place to invest in the U.S. equity markets. Everything is set up for that to happen.

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