S&P Rank: 2 Stars
July 31, 2003
Down But Not Out
Quick Take: In picking stocks, John McDermott, says he and Timothy Evnin, who have run the Excelsior Mid-Cap Value Fund (UMVEX) for nearly three years, favor the same sort of financial characteristics as other value-oriented managers. That includes attractive valuations and solid returns on equity.
The portfolio managers also aren’t afraid of moving into a company that other investors have been moving out of, provided they think the malady that has weakened its stock is transient.
Buying economically-sensitive companies, like retailers last year, may have weighed on the fund’s performance then, but it has helped since as the economy has perked up, McDermott says.
The fund gained 16.8% this year through June, compared to a 12.8% return by its mid-cap value fund peers. For the five year period ended in June, Excelsior Mid-Cap Value rose an average annualized 9.1%, versus 4.7% for its peers.
The Full Interview:
The Excelsior Mid-Cap Value fund began buying Cendant Corp (CD) a year ago, when the travel and real estate company was unfairly tarred with the same brush as businesses in the midst of accounting scandals, says John McDermott, who helps manage the portfolio.
At the same time, Cendant, the parent of Avis Rent a Car and Days Inn hotels, was being hurt by the weak economy, says McDermott.
Cendant, however, was four years removed from its bookkeeping problems, the executives associated with them were no longer around, and, on balance, McDermott says he and Timothy Evnin, the fund’s co-manager, “thought it looked like a pretty good value.”
Cendant, one of the funds’s major holdings, is the kind of stock that Excelsior Mid-Cap Value invests in. McDermott explains that he an Evnin are willing to own shares that have been beaten down if they think the condition is only temporary.
“We look for companies that are in the midst of some sort of change. Typically, they’ve underperformed in recent periods,” McDermott says. But if you can buy them at a good price, and if something is at work to right operations, then “we’ll go ahead and buy,” he says. These catalysts can be a management change or a restructuring, he says.
When it comes to numbers, the fund managers look for stocks priced low relative to their earnings and cash flow, and they want companies whose bottom line growth and returns on equity and capital top those of the fund’s bogey, the Russell Midcap index. The fund’s holdings tend to have slightly less debt than those in that gauge, McDermott adds.
McDermott and Evnin hunt for companies with market caps of $1 billion to $10 billion. The fund typically owns about 40 stocks, a number McDermott feels provides adequate diversity while facilitating research and enabling winners to make meaningful contributions to the fund’s performance.
“If you wind up with 100 or 150 names in a portfolio, it’s difficult to distinguish yourself from everyone else out there or from the passive benchmarks,” McDermott maintains.
A favorite stock of McDermott’s is Health Management Assoc (HMA), a hospital operator he says has been benefitting from consolidation in its industry. In addition, Health Management’s profits have been increasing at a “fairly healthy” rate, but its stock was selling at only 12 times earnings when the fund began buying shares last month, he says.
McDermott also likes ACE Limited (ACE), an insurance holding company. Bermuda-based Ace has been able to raise prices for its products, and its stock featured an attractive P/E multiple when the fund initially invested in it last year, McDermott says. The portfolio managers have added to the position “fairly steadily” since then, he says.
The No. 1 stock in the portfolio is United Rentals (URI), a construction equipment renter that McDermott describes as “the biggest player by far” in the field. Despite the downturn in the economy, United’s management has been able to sustain its cash flow, and the company is poised to pick up if economic conditions improve, as McDermott expects them to.
The fund’s second-biggest holding is Best Buy (BBY), a retailer of consumer electronics products and home office equipment whose shares fell to a point last fall where McDermott thought they looked good. Best Buy’s profits then were expanding by about 15%, but its stock was selling for only about 10 times earnings, he says.
Companies like Best Buy that offer products or services for consumers make up about 25% of the assets of the $109-million fund, McDermott says. It’s holdings in that area include paint maker Sherwin-Williams (SHW), store chains TJX Companies (TJX) and Zale Corp (ZLC), and appliance manufacturer Black & Decker Corp (BDK).
The fund managers might have acted prematurely when they bought these companies, whose fortunes are tied to the strength of the economy, last year, McDermott concedes. Owning them may have chipped away at the fund’s returns in 2002, but “it’s certainly helping us this year,” he says. Best Buy, for example, has doubled in 2003, he notes.
Outside the consumer sector, McDermott cited Symbol Technologies (SBL), a maker of bar code scanners, as a big winner for the fund. The company’s shares started the year priced at $8.45; they closed today at $12.81.
If a stock appreciates to a level that the managers consider pricey, they will trim the position or eliminate it from the portfolio. They’ll also sell if a company’s financial fundamentals seem to be deteriorating. But their inclination is to own stocks for the long haul, in part because they want the fund to be tax efficient. The fund’s turnover rate is usually about 25% or less, McDermott says.
“I think you can end up chasing your tail if you turn the portfolio over too much,” McDermott says.