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.
We bought the stock, but when I visited Harcourt General I realized the real catalyst is that we were entering a two-year period where states accelerated adoption of K-12 textbooks. The last time they did that was seven years ago. There are three K-12 textbook companies in the United States besides Harcourt General: Houghton Mifflin, McGraw-Hill, and Simon & Schuster. About six months before we visited Harcourt General, Simon & Schuster was bought for 17 times cash flow by Pearson. So two weeks after we purchased shares of Harcourt, we visited with Houghton Mifflin. And after that we visited with McGraw-Hill. At one point in 2000 we had 10% of the portfolio in educational publishing stocks.
The next bucket is leveraging a catalyst in one industry into a different industry. In late 2000 we identified a company named Consol Energy, primarily a coal company, which had been buying natural gas reserves that sit on top of their coal mines. Historically they would drill a natural gas well about six months before a mine went underneath. Then they started to drill reserves three to five years out, expediting reserve development and increasing the net present value of the reserves and the value to shareholders. The company was trading at 4.5 times cash flow, which is at the low end of coal company valuations. The catalyst was the acquisition of these gas reserves, one analyst covered the company, and we were buying at the low end of historic coal company valuation range.
I remember the stock was at about $18. The price of coal had been down for years. I visited the company and went underground in a coal mine. I spoke with the CEO and the manager of the gas business and found there was about $14 to $18 a share in the value of the gas. I also found that the coal industry in the U.S. has been consolidating, and no one was investing in new capital equipment or mines.
Yet among utilities, which use most of the coal in the U.S., coal inventories were down to about 10 to 15 days at their plants. The utilities were accustomed to coal prices being low and didn’t want to hold extra. But utility generation was growing at about 3% to 5% a year and coal inventory was depleting, while coal production was relatively flat. It seemed that demand was going to cross supply. At one point in 2001 we had about 12% of the portfolio in coal stocks.
The third qualitative bucket is simple: Reading periodicals and speaking to contacts within the investment management industry. It could be reading in Barron’s that Loews Corporation, which owns Lorillard tobacco, most of insurer CNA, and Diamond Offshore Drilling, is about to IPO Lorillard. The share price went to $50 from $48 when this was announced. With the stock at $50, we felt the pieces of Loews were worth $80 a share, and the catalyst was the Lorillard IPO. We felt that when you get to $80 about one-third of the value is Lorillard. And when you highlighted that value the share price would go up. Two analysts were following the company–both tobacco analysts and not insurance or oil rig analysts.
Loews’s valuation was such a big discount to fair value, you’d think everyone would realize it. But it was hard to dig out what Lorillard was worth. We benefited because we’re generalists. We could pull from Loews’s complicated financial statements what Lorillard was worth at an IPO by doing comparable valuations of RJR and Philip Morris. We set a near-term price target–six to 12 months–of $60 and a long-term price target–12 to 18 months–of $75. How close we are to that target price will determine position size. Because of the Lorillard IPO in January 2002, we made this a 4% position at time of purchase at $50. After the Lorillard IPO, Loews’s stock hit $60 and we sold half the position. Now we have a 2% position with a target price of $75.
The last bucket is the only one that involves a quantitative screen. But we don’t screen as typical value managers would on price-to-book, price-to-sales or price-to-earnings. We actually screen based on neglect. The first cut would be the number of analysts who follow the stock. Second, we rate the recommendation of the analysts from “buy” being 1 to “sell” being 5, and we’ll look at anything over 2.5.
For example, in 2001 cardiovascular products company Boston Scientific had 26 analysts following it and one strong buy recommendation. Their stent business was under pressure because a supplier was suing them. We felt they would develop their own product. And we felt the private market value was worth a lot more than the share price at the time. We set a price target of $25 with the stock at $16. It was a 3% position then; today it’s a 1.5% position and the stock is at $25. But there’s not a lot of catalyst and we’ve been selling the position as a source of cash.
It’s not only analysts’ recommendations that we look at. We’ll also focus on companies whose earnings have declined in the last three or four quarters but whose share price has stopped declining. That means there’s inherent value or franchise to the business because the earnings keep going down but the stock is flat. Then we’ll call the company and see if there’s a catalyst to get people interested.
Tell us about the fund’s top holding. The top holding is AutoNation at 3.3%. AutoNation is the largest automobile dealer in the country. Management is implementing best practices throughout this group of 375 dealers that were acquired over a four-year period. There’s tremendous opportunity for cost savings, and that’s really the catalyst. The neglect is that people view automobile dealers as cyclical as automobile manufacturers, and they’re not. Now the company trades at about 12 times expected 2003 earnings, when other retailers that don’t have a monopoly share in their franchise territories nor the opportunity to gain best practices are trading at 15 to 20 times earnings. We think that AutoNation can be a $20 stock in a year, and recently the price was $14. People are discounting the stock as cyclical, but AutoNation gets 70% of its earnings from selling everything but new cars–parts and service, financing income, and used cars.
Which market sector is the least familiar to you? One industry where I’ve spent the least amount of time is technology. I still think valuations on technology even now don’t support future earnings, so we only have 5% to 7% of the portfolio in technology.
How do you handle investment mistakes? If I wake up in the middle of the night and worry about a stock, there’s usually something wrong. If we think the catalyst is not playing out or the market’s expectations are too high (we like the stock to have low expectations), we’ll sell the position. If fundamentals deteriorate, we sell. And we try to manage the portfolio, trimming positions as the stock moves to its price target. So we’ll never have a 4% or 5% position as a stock gets to its target price. You have to be humble in this business. He who makes the least mistakes wins. But you have to take enough risk to get the performance, otherwise you should just buy Treasury bonds. But that’s not what we’re paid to do. So we have to take risk and sometimes we’re wrong. When we’re wrong, we admit it and move on.
We’re not just a deep value investor. We’re to the right of deep value and to the left of core value. In 2000, at the peak of the Internet, this portfolio had roughly 22% utilities and pipelines, 10% savings and loans, 10% property and casualty insurance, 10% educational publishing–more than 50% in these defensive areas because the market was so high. Our average P/E then was about 12. Today our average P/E is about 16, partly because mid-cap stocks in general have done well, but our stocks, some of these higher quality companies, these VARP stocks, trade at 16 to 18 times earnings. The key to being a good portfolio manager is to be flexible and not have biases against companies or management. As long as a security fits in our mid-cap box and has change, neglect, and valuation, we should be willing to buy it.