Portfolio Manager Perspectives

Jeff Benjamin

Why mid-caps deserve some love, too

Plenty of gems among these mostly under-appreciated stocks, says Scout's Dunkerley

Mar 7, 2011 @ 3:00 pm

By Jeff Benjamin

As long as investors continue to overlook mid-cap stocks, portfolio managers like Pat Dunkerley will continue to enjoy a particular advantage.

“Mid-cap stocks tend to be neglected by investors, and portfolio managers tend to sell them too quickly,” said Mr. Dunkerley, manager of the $350 million Scout Mid Cap Fund Ticker:(UMBMX).

Like a lot of mid-cap portfolio managers, Mr. Dunkerley copes with the irony of being underappreciated — while buying underappreciated stocks for a living.

“This is an institutional-grade, repeatable process,” said Mr. Dunkerley, who manages the fund for Scout Investments, a $20 billion asset management firm.

The fund, which applies a combination top-down and bottom-up research process, seeks to invest in companies with market capitalizations of between $1.5 billion and $17 billion.

The bottom-up due diligence on each company includes financial analysis in order to value the stock, but also requires a positive catalyst and keeps an eye out for ‘gotcha risks,'” he said.

A company's cash flow, for example, must be above net-income levels.

“Cash is the first proof that the accounting is reasonable and honest,” he said. “That's part of the balance sheet test.”

The portfolio of around 70 stocks also is constructed with an emphasis on low debt ratios as one measurement of risk.

“We will pay a higher price for a low-risk company and a lower price for a high-risk company,” Mr. Dunkerley said.

The top down, or overlay, part of the research includes a weekly review of more than 100 economic indicators.

The strategy considers roughly 800 potential companies that make up the Russell Mid Cap Index.

While the idea is to let the bottom-up research generally dictate portfolio weightings, Mr. Dunkerley said sector weightings are capped at 25%.

The fund is presently most exposed to energy, at 14% of the portfolio, and materials at 11%.

Investors should expect the annual turnover rate in the Scout mid-cap fund to run between 100% and 200%, according to Mr. Dunkerley.

An example of the kind of value inside the fund is Priceline.com Inc. Ticker:(PCLN).

The stock is up more than 95% over the past 12 months.

Mr. Dunkerley became bullish on the online travel company when he realized that the U.S. market was missing the fact that much of the company's growth was coming from Europe and Asia.

Another company that also happens to be well-suited for the current geopolitical environment is Concho Resources Inc. Ticker:(CXO).

The Midland, Texas-based company produces the kind of light, sweet crude oil that Libya does. Obviously, the disruption in supply in that war-torn country has boosted the profile of Concho. Indeed, the company has seen its stock price climb 125% over the past 12 months.

Then there is AutoZone Inc. Ticker:(AZO), a company that has repurchased 10% of its outstanding stock over the past year.

Mr. Dunkerley said a company such as AutoZone is poised to benefit from an uncertain job climate. In such an environment, consumers tend to keep their cars rather than buying new ones.

The stock gained 58% over the past 12 months.

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives.

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