An Interview With Patrick J. English, Portfolio Manager, FMI Common Stock Fund

    by Maria Crawford Scott


    CATEGORY: Mid-Cap Stock

    PERFORMANCE* (as of 3/31/03):

      Fund Category
    1 Year -15.8 -21.8
    3 Years 5.7 -9.6
    5Years 3.6 -0.6

    RISK: Below Average

    TOTAL ASSETS: (as of 3/31/03) $120 million

    CONTACT: FMI Funds 800/811-5311

    The spotlight has been focused on large-cap stocks over the past decade, first as the stars of the great market run-up during the late 1990s, and more recently as the scoundrels of the new millennium bear market.

    With much less fanfare, the mid caps have quietly managed to outperform their large-cap counterparts over the last decade.

    Combine that with the less volatile value-based strategies, and you have an approach that has been far more “bearable” over the past three years.

    One fund that has fared very well using just that combination is the FMI Common Stock Fund, managed by Milwaukee-based Fiduciary Management Inc. The fund was among the top 25% of all mid-cap funds for the last year, three years and five years through March 31, 2003. Although the fund was down –5.7% in the last calendar year, it returned 19.0% in 2000 and 18.6% in 2001, and over the last 10 years, it returned 11.4% compared to 7.1% for the Russell 2000 and 9.3% for the S&P 500.

    Currently, the fund has about $120 million in total assets.

    In early April, portfolio manager Patrick English discussed the management of the fund with Maria Crawford Scott.

    What is the investment philosophy of the fund?

      Basically we’re looking for sound business franchises. And we’re trying to marry the identification of a sound business franchise with a cheap valuation. We execute that through a very detailed, diligent research effort.
    What is the universe of stocks that you focus on?
      Our focus is on the small- to mid-cap range of the market. About 75% of the stocks are under $2 billion in market capitalization and 25% are between $2 billion and $4 billion.
    Why do you focus on mid- and small-cap companies?
      We find the smaller-cap market to be a little less efficient—usually there are bigger discrepancies between intrinsic value and the stock price.

      The Russell 2000 is the benchmark we have historically used for the fund. And we are quite aware of where the benchmark is with respect to each industry. The fund is well diversified—our 41 stocks represent a very broad industry grouping.

    What do you look for in a prospective stock?
      We look for particular characteristics in the business.

      For instance, we look for an above-average return on invested capital. And we look for companies that generally sell modestly priced goods and services—we’re not involved in companies that sell big-ticket items, because those kinds of companies tend to have a very volatile revenue and earnings picture. That’s not to say that we don’t buy cyclical companies—occasionally, we do. But more typically we buy the more stalwart-type companies.

      A good example is Aptar Group (NYSE: ATR). Aptar is the world’s leading producer of dispensing systems for a whole range of medicine cabinet-type products. For instance, they make squeeze bottles that dispense soap with a valve that is always open but doesn’t leak; they make the nasal sprays that dispense pharmaceuticals—that sort of thing. You probably have eight or 10 of their products in your bathroom right now. These are very simple ideas—the product is consumed and then thrown away.

    They’re selling their packaging systems to other companies?
      Yes, they’ll sell to the Proctor & Gambles, the Loreals, the Pfizers.
    I’ve never heard of it.
      Right! That’s the kind of company we like to own—it’s a company with a billion dollar market cap, but nobody’s ever heard of it. They earn a good return and it’s a very understandable business.

      That’s another one of our tenets—we have to be able to understand it. We avoid situations that require an advanced degree in physics to understand.

      Aptar has a solid market niche, it’s well financed and it trades at a reason multiple—14½ times earnings this year, 13 times next year’s.

      Those are companies that we let time work for us. Over time, the company grows at about 12% compounded. We’d call it a fair value here, not a screamer but a fair value. In this marketplace, we like companies that are fairly predictable in their earnings streams.

    How do you put a value on a stock?
      We look at a number of factors. We look at transaction prices—mergers, acquisitions, spin offs. And we also spend a lot of time looking at historical valuations—we identify the low end and high end of a trading range of a stock relative to its peer group and the market. We’re generally buyers at the low end of those ranges and sellers at the high end of those ranges.
    Why would a company be selling at the lower end of its valuation range?
      Typically buying a superior business at a cheap price requires us to enter the story when there’s something wrong, there’s a cloud over it.

      Some value managers simply look at break-up value or straight asset value, on the expectation that an outside agent will come in to cause a change and realize that value. We’re more interested in the underlying business, and we’re banking that the underlying business will regain its footing and begin growing again. We’re not looking for an outside agent to have an impact on the stock. Now, it’s always a plus when somebody comes in and takes over one of your stocks at a big premium. But we want the underlying business to work. When the problems are solved and the company begins growing again, that’s typically when our investments flourish.

    What is typically causing the problem in the companies you buy?
      It runs the gamut. Sometimes, it is simply related to the market. For example, one company we own is Idex Corp. (NYSE: IEX), which we feel has four or five very solid niches in manufacturing. They’re currently depressed because virtually everything in U.S. manufacturing has been decimated. But we feel that these niches have a better-than-average chance of recovering. We think the stock is attractive on a three- or four-year time horizon.
    Do you make any decisions in terms of the types of stocks you invest in based on your macro outlook—your outlook for the economy in general?
      We use primarily a bottom-up approach, which focuses on the fundamentals of individual companies. However, we are influenced by what we can see in the marketplace that’s macro-related. For example, we’re highly attuned to what’s going on in China and India.
    Because of the competition?
      Yes. We’ve analyzed both the Chinese and the Indian labor market in great detail, and we think that competition from them is an issue that has multiple years to play out, possibly even a decade or more. We think that the market has generally underappreciated what’s going on there and what their labor is capable of doing in those particular countries.

      So, we put all of our prospective stocks, as well as our existing stocks, through a filter, so to speak: Are they addressing the threat of Chinese and Indian labor competition? Are they positioning themselves for the opportunities in those markets? For example, we’ve gone through all of our manufacturing companies to determine how much of their cost of goods is truly related to labor. A lot of manufacturing companies talk about “direct” labor, but there is really much more of a company’s cost structure that’s tied to other types of labor—production engineers, supervisors and so on. So, we analyze every one of our companies and their labor cost structures to determine which of their products are vulnerable to foreign competition.

      There aren’t any easy answers, but we know some companies are sticking their heads in the sand and hoping for the best, while others are addressing the issue.

    Does your approach tend to skew you toward certain industries?
      Yes. Because we’re very valuation sensitive, when there are industries that are really out-of-favor we have to be careful not to go hog wild. We’re very conscious of that.

      If the business models don’t meet our criteria we won’t go into the stocks no matter how cheap they are. For example, you’ll never see a large weighting in technology in our portfolio or fund. Most technology stocks just don’t fit us—they don’t have recurring revenue, they have an unpredictable revenue and earnings stream, there’s obsolescence. Even if tech stocks were cheap, which they’re not, we probably wouldn’t have a large weighting there.

    You have roughly 3% in REITs (real estate investment trusts)—is that a relatively new investment?
      No, and in fact that’s gone now. It was one stock, ProLogis, and it did very, very well for us in a very tough stock market. But the market cap got very large and we didn’t feel as good about the relative value, so we sold it earlier this year.
    When did you buy it?
      About three years ago, in the late 1990s. At that time, there was a tremendous interest in technology and growth stocks, and there was absolutely no interest at all in dividend-paying money-making enterprises. So it was very, very cheap. We felt that the indexes were being driven by growth and technology stocks, and we felt this was a tremendous relative value. For us, it was a way to own stocks that did not have a high correlation with the stock market, which we felt was very vulnerable to a hit. So we took a position, and it served its purpose well.

      Now, we’re finding more traditional stocks that are in niche, special situation stories.

    When would you sell a stock?
      One, when we feel it’s trading above its intrinsic value. Two, if the position size is too large. And three, if it becomes evident we’ve got the story wrong.

      But we have a very low turnover ratio, and actually that ratio really overstates the actual amount of turnover because we do some trading around positions depending upon valuation. In terms of name turnover, last year we only sold six stocks out of the portfolio. The year before, only eight.

    How quickly does it become evident that you’ve made a mistake?
      It’s all over the map. Sometimes it’s very quickly, within a couple of quarters. But we do such a great amount of work on the front end that we’re usually not surprised right away. So more typically it’s over the course of a year or two—we recognize the business isn’t what we thought. For instance, it may be more volatile or subject to more competitive pressure than we thought. At that point, we’ll begin eliminating the stock.

      But we will not sell just because a company is having a bad quarter. For example, we have a company called Paxar (NYSE: PXR), which just announced they’re going to miss the March quarter pretty badly. They are moving production to China and Vietnam, and they haven’t been able to ramp down their U.S. costs as fast as they are incurring costs to ramp up overseas. They’re doing exactly what we want them to do, but the transition is painful. Now, I would certainly not sell that stock for that reason. In fact, we’re buying more because the stock has gotten battered.

      Other times, we’ll sell a stock if, for example, they make a big acquisition that we think is stupid. Managements sometimes do that. They feel bigger is better. And our basic belief is that nine out of 10 acquisitions fail.

    Mid-sized companies have tended to outperform both the small caps and large caps even over longer periods of time within the last few decades. Do you feel that that has contributed more toward your performance than your value-oriented strategy?
      My fundamental belief is that of all the different strategies out there—big cap, small cap, growth and value, however you want to slice up the market—value tends to win out over the long haul. That to us is more important than the absolute market value of the company.
    What is your market outlook?
      I would say that we’re mostly through the bear market, but with this caveat: It stuns me that investors continue to chase growth technology stocks. When you look at the top 20 tech stocks and you look at the valuations, it blows my mind. These stocks in the bottom of the 1990s were trading at a third of where they are now. So to think that we’re coming out of a bear market at those kinds of valuations for some major companies—I just don’t believe it. I think there’s another major leg down for big-cap tech.

      For me to be more comfortable with the stock market, I’d like to see that whole sector just get pounded again. And then I’d like to see time pass where you don’t get these gigantic rallies.

    Would that bring the whole market down?
      I don’t think so. I used to think so, before the last three years came along. But our stocks have performed great over the last three years. If big-cap tech gets clocked, I don’t think it’s a foregone conclusion that these stalwart, smaller companies have to get clocked. The valuation spread is so enormous. First of all, none of these big-cap stocks are growing to any great degree at all—it’s not even a question of chasing the growth, it’s just chasing what people think is going to move.

      Second of all, even though we’re going through this bear market, many of the traditional, stalwart companies that we like are still relatively attractive.

      We are not market timers—we are always fully invested. And, to anybody who listens, we say you ought to stay in the stock market. If you’ve lost money you ought to put more money into it. It’s never fun to go through these periods, but we’re confident that our types of companies will survive and prosper, and ultimately the stock prices follow that.

→ Maria Crawford Scott