Descending deep into a coal mine in the name of investment research gives new meaning to the notion of dirtying your hands on company balance sheets and financial statements. Michael Prober dons his hard hat when evaluating each candidate for CRM Mid Cap Value, a little-known $120 million stock portfolio from respected New York-based institutional value manager Cramer Rosenthal McGlynn that in four short years has mined far more gold than coal.
Looking beneath the surface is typical for Prober, whose straightforward due diligence, insightful intuition, and simple but strict investment methodology has produced such powerful results that shareholders might otherwise suspect he has X-ray vision. CRM Mid Cap Value’s Institutional Class shares–which carry a $1 million minimum investment–returned 30% annually for the three years ending March 31, 2002, a period when rival funds posted average yearly gains of 12.5%. CRM Mid Cap’s net asset value has nearly doubled since inception in January 1998, soaring on the back of a 56% return in 2000, while its beta and other risk measures are in line with its peers. The fund’s retail share class launched in October 2000 with a $10,000 minimum; its performance has mirrored its older sibling.
CRM Mid Cap Value shareholders owe their success to Prober’s diverse mix of 50-plus companies, each sharing three common qualities: a change or catalyst that could boost the stock, a dearth of Wall Street coverage, and a discounted price to its peers.
Recent hopefuls include Consol Energy, whose coal mine Prober visited, insurance and tobacco conglomerate Loews Corp., car dealer AutoNation, health service provider Wellpoint Health Networks, and beauty supply manufacturer Avon Products. Prober’s steadfast aversion to technology and Internet stocks (less than 10% of the fund is technology-related, even after the sector’s ugly collapse) has been an astute defense that has kept the fund on sound footing. Indeed, other fund managers would do well to venture underground like Prober did. There’s probably nothing like a dank, dark mine shaft to reinforce an aversion to making any false moves.
Fund managers seem to have a personal view on defining what “mid-cap” really means. How do you frame the mid-cap arena? About 85% of our stocks at the time of purchase are between $1 billion and $10 billion in market capitalization. Currently we’re about 75% in that cap and stocks [with caps] between $1 billion and $20 billion are 97% of our portfolio.
We will let stocks appreciate in the portfolio beyond $10 billion. The overriding constraint is that the weighted average cap of the portfolio has to be close to the Russell Mid Cap Value average cap. So we can’t let too many stocks appreciate above $10 billion or we have to buy smaller cap–$1 billion to $2 billion–to keep the weighted average down.
Your fund doesn’t hold many stocks. What gives you confidence in such a concentrated portfolio? We own between 50 and 55 positions. The top 10 positions are usually between 30% and 35% of the portfolio. The top 20 positions are usually 50% of the portfolio. We spend a tremendous amount of time trying to understand companies. Because we do a lot of due diligence, we tend to take larger positions.
Yet since you sell winners when they push the mid-cap limit, portfolio turnover is well above average. My belief is that value managers should have higher turnover than growth managers.
How’s that? You want higher turnover in your fund? The more turnover, the better. That means stocks are hitting price targets. We start with a universe of 1,200 companies with market caps of between $1 billion and $10 billion. We’re trying to arbitrage what we think is fair value to the current share price. We take out all companies that are not earning any money and expensive companies selling at 40 to 50 times earnings. So we’re down to a universe of about 700 stocks to consider for our work-in-progress list. When a stock gets on the work-in-progress list, we process the idea. We think like business owners. We visit with management and then speak to competitors, suppliers, and customers to make sure management is telling the truth. This is a judgment business; there’s no black box here, just hard due diligence. Only then would we put a stock into the portfolio.
Frequent turnover must play havoc with tax efficiency. Is this fund kind to taxable investors? We pay attention to taxes, and tax efficiency has been very good. We had zero taxes in 1998 and 1999, 3% taxes in 2000 when we were up 55%, and 5% taxes in 2001 when we were up 20%. We’re taking losses to offset gains as much as we can. We came out of the taxable account management business. If you look at the mid-cap value product that I manage, about 65% to 70% is taxable money. We’re always trying to take losses to offset gains and to wait for stocks to go long-term. If a stock is in its 11th month and has hit its target price, but in our opinion there’s no risk that the stock will go down in the next month, then we’ll hold and later register the long-term gain in taxable accounts.
You mentioned that two investment themes are influencing the portfolio nowadays. What’s the second? The other theme is VARP stocks. Not GARP stocks, but value-at-a-reasonable-price. GARP stocks could be growing at 30% and trading at 20 times earnings. VARP stocks are growing earnings 12% to 18% but are trading at 15 to 18 times earnings. But the key is that they are growing consistently throughout the business cycle, so they don’t have a lot of volatility. Many of these companies are in consumer and health care areas, like Avon Products, Beckman Coulter, and Wellpoint Health Networks. VARP companies are very clean. Their earnings are equal to cash flow, so it’s easy for an investor in this time of troubling accounting assumptions to say these earnings are real, they’re growing through a downturn, and therefore deserve a premium multiple.
Thematic investing is distinctive, but not your usual style. What is the more typical strategy to set this fund apart from other mid-cap offerings? Our three mantras are the presence of a catalyst or change, neglect, and attractive valuation. Take Avon, for example. We purchased the stock at 20 times expected 2002 earnings and a four-multiple discount to its peers. The catalyst was that Avon has embarked on a program to increase operating margins 250 basis points over three years. This company has never focused on the back end of how you distribute product. If Avon can crash down its supply chain, it could save a lot of money.
The neglect is that while there are about 20 analysts who follow the company, the three lead analysts on the Street have been either negative or neutral. There is still some negative sentiment on the company. That’s why I bought the stock at $45 a share and we still hold the position. We think Avon will be worth $67 a share in a year, though just now we think it’s fairly valued.
Must each of these investment criteria–catalyst, neglect, and valuation–be evident before you buy a stock? Almost always. Within this three-pronged approach to investing are four buckets of ideas, three qualitative and one quantitative. First, we’re very good at leveraging our knowledge base in one company into other companies in an industry. For instance, we liked Harcourt General a couple of years ago because management was spinning off retailer Neiman Marcus. That’s the catalyst. The company also had only a couple of analysts covering it, so it was neglected. And it was trading at eight times cash flow.