Steve Schroll and Laton Spahr of AXP Mid-Cap Value Fund

Quick Take: In the brief time it has been around, the AXP Mid-Cap Value Fund/A (AMVAX) has stayed ahead of its competition. The $331-million fund, which began operating in February 2002, was up 9.3% this year through September, versus a gain of 5.8% for the average mid-cap value fund. In 2003, the AXP fund returned 47.7%, compared to 36.4% for its peers.

In overseeing the fund, stock pickers Steve Schroll and Laton Spahr and lead portfolio manager Warren Spitz look for medium-size companies whose stocks are deeply undervalued compared to the overall market. They also lean towards companies that pay and increase dividends, and whose returns on invested capital are improving.

The fund's management team takes a value-oriented approach in running three other funds that focus on large-cap stocks: AXP Dividend Opportunity/A (INUTX), AXP Equity Value Fund/A (IEVAX) and AXP Invest Series:Dvsfd Equity Income Fund/A (INDZX).

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That the AXP Mid Cap Value Fund has a stake in Transocean Inc (RIG) seems fitting. The company drills for oil in the depths of the ocean; the fund concentrates on stocks with rock-bottom prices.

"We really want to emphasize very low valuations," says Laton Spahr, who helps oversee the portfolio. That's because data has shown that over the long run, "the cheaper the stocks, the better the returns have been," he says.

When making investments, the fund's three managers look for shares priced low relative to the market based on a variety of measurements, like a company's earnings, book value or cash flow.

Although they'll own companies with good or bad looking balance sheets, their bias towards inexpensive stocks can lead Spahr and his colleagues to consider businesses whose accounting pictures, at first glance, appear downright ugly. In these instances, they want to see healthy cash flow that can help a company dig itself out of a financial hole.

While the team won't necessarily hunt for high returns on invested capital, they like to find returns that are improving, Spahr says. Similarly, they're willing to bet on unprofitable companies, if they think the business will start generating earnings, he says.

The fund can own small and large-cap stocks, but at least 80% of the 100-130 companies that make their way into the portfolio are medium-sized, which the fund's literature defines as those with market capitalizations of about $1.2 billion to $9.8 billion.

An advantage to owning mid-caps is that they tend not to be followed too closely by Wall Street, so they can appreciate rapidly when big brokerage houses begin tracking and recommending them, Spahr says.

"We love to look for stocks that are either not covered, or ubiquitously hated, by the Street," Spahr says. If mainstream analysts decide that something should be sold, "there's a good chance that they've mispriced the security," he adds.

Energy stocks like Transocean are among the managers' favorites, Schroll and Spahr say, because the shares' price-to-cash-flow multiples are very attractive. Beyond that, these companies are benefitting from economic growth in many parts of the world, which has spurred demand for oil, they say. The fund has about 13.5% of its assets in the sector, according to Spahr.

Transocean, a contract driller that's been in AXP Mid-Cap Value since the fund was launched, stands to gain as oil companies increase spending on deep water exploration, the managers say.

One of the fund's largest energy holdings at the end of August was Pioneer Natural Resources (PXD), which explores for and produces oil and natural gas. The stock features the best looking price among its peers, based on Pioneer's free cash flow, the managers say. In addition, the company's production, which will be helped by Pioneer's recent acquisition of Evergreen Resources, is "well above average," Spahr says.

The fund has also been finding values among insurers and reinsurance companies, especially those that provide property and casualty coverage, Schroll says.

Most of the investment community thinks these companies have lost the ability to raise prices, the fund managers say. But they don't share that view, and even if premium rates decline, insurers' costs will fall faster, which should boost their book value growth into the low double-digit range, (10%-12%) Schroll says.

The fund's No. 1 stock on Aug. 31 was property and casualty insurer XL Capital Ltd`A` (XL), a company whose management Spahr and Schroll admire.

At that time the fund's biggest major holdings also included ACE Limited (ACE), one of the insurers implicated today in a lawsuit filed by New York Attorney General Eliot Spitzer charging Marsh & McLennan (MMC) with bid rigging. Spahr declined to comment on what, if anything, he planned to do with the ACE stock in light of the litigation.

News of Spitzer's action lead investors to sell insurance stocks. Despite that, Spahr, who believes the market's reaction was "overdone," says he still likes valuations in the sector.

When it comes to selling, the managers, who hold little cash as a rule, will liquidate a position if they need money to buy something they consider a better investment. Stocks that start getting pricey and companies whose financial foundation begins to erode get trimmed or eliminated from the portfolio, too.

Just as they gradually build up positions, the managers say they back out of an investment bit by bit. "We don't try to ride any individual stock from beginning to end," Schroll says. "We will tend to buy early and wait" for shares to gain ground, he explains.

The managers' willingness to hold stocks for the long run translated into a 36% turnover rate last year. By comparison, similar funds turned their portfolios over at a 74.3% clip.

Looking at the overall stock market, Spahr says he is optimistic about its prospects in the near term, because companies' profit growth and free cash flow remain robust, while valuations are "reasonable."

"In fact, they're cheap, given where interest rates are right now," he says.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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