An Interview With Patrick J. English, Portfolio Manager, FMI Common Stock Fund
by Maria Crawford Scott
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 were looking for sound business franchises. And were trying to marry the identification of a sound business franchise with a cheap valuation. We execute that through a very detailed, diligent research effort.
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.
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.
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—were not involved in companies that sell big-ticket items, because those kinds of companies tend to have a very volatile revenue and earnings picture. Thats not to say that we dont 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 worlds 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 doesnt 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.
Yes, theyll sell to the Proctor & Gambles, the Loreals, the Pfizers.
Right! Thats the kind of company we like to own—its a company with a billion dollar market cap, but nobodys ever heard of it. They earn a good return and its a very understandable business.
Thats 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, its well financed and it trades at a reason multiple—14½ times earnings this year, 13 times next years.
Those are companies that we let time work for us. Over time, the company grows at about 12% compounded. Wed 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.
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. Were generally buyers at the low end of those ranges and sellers at the high end of those ranges.
Typically buying a superior business at a cheap price requires us to enter the story when theres something wrong, theres 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. Were more interested in the underlying business, and were banking that the underlying business will regain its footing and begin growing again. Were not looking for an outside agent to have an impact on the stock. Now, its 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, thats typically when our investments flourish.
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. Theyre 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.
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 thats macro-related. For example, were highly attuned to whats going on in China and India.
Yes. Weve 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 whats 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, weve 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 companys cost structure thats 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 arent 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.
Yes. Because were very valuation sensitive, when there are industries that are really out-of-favor we have to be careful not to go hog wild. Were very conscious of that.
If the business models dont meet our criteria we wont go into the stocks no matter how cheap they are. For example, youll never see a large weighting in technology in our portfolio or fund. Most technology stocks just dont fit us—they dont have recurring revenue, they have an unpredictable revenue and earnings stream, theres obsolescence. Even if tech stocks were cheap, which theyre not, we probably wouldnt have a large weighting there.
No, and in fact thats 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 didnt feel as good about the relative value, so we sold it earlier this year.
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, were finding more traditional stocks that are in niche, special situation stories.
One, when we feel its trading above its intrinsic value. Two, if the position size is too large. And three, if it becomes evident weve 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.
Its all over the map. Sometimes its very quickly, within a couple of quarters. But we do such a great amount of work on the front end that were usually not surprised right away. So more typically its over the course of a year or two—we recognize the business isnt what we thought. For instance, it may be more volatile or subject to more competitive pressure than we thought. At that point, well 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 theyre going to miss the March quarter pretty badly. They are moving production to China and Vietnam, and they havent been able to ramp down their U.S. costs as fast as they are incurring costs to ramp up overseas. Theyre 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, were buying more because the stock has gotten battered.
Other times, well 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.
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.
I would say that were 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 were coming out of a bear market at those kinds of valuations for some major companies—I just dont believe it. I think theres another major leg down for big-cap tech.
For me to be more comfortable with the stock market, Id like to see that whole sector just get pounded again. And then Id like to see time pass where you dont get these gigantic rallies.
I dont 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 dont think its 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—its not even a question of chasing the growth, its just chasing what people think is going to move.
Second of all, even though were 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 youve lost money you ought to put more money into it. Its never fun to go through these periods, but were confident that our types of companies will survive and prosper, and ultimately the stock prices follow that.