An Exceptional Mid-Cap Track Record
Thyra E. Zerhusen is the principal founder of Fairpointe Capital LLC, CEO and chief investment officer of the firm. She is part of the investment team, serving as lead portfolio manager for the Mid-Cap Equity and ESG Equity Strategies, including the AMG Managers Fairpointe Mid Cap Fund, the AMG Managers Fairpointe ESG Equity Fund, the Parvest Equity USA Mid Cap Fund, and institutional separate accounts.
Prior to founding Fairpointe Capital, Thyra was the chief investment officer for Mid-Cap Equities at a predecessor firm, beginning in October of 2003. Thyra also spent four years at Talon Asset Management, as Senior Vice President and Portfolio Manager, where she began managing the Aston (now AMG) Fairpointe Mid Cap Fund. She has been a guest on Wall Street Week with Louis Rukeyser, CNNfn’s Mutual Fundamentals, Bloomberg, and CNBC.
Mary L. Pierson is a co-founder of Fairpointe Capital LLC and Co-CEO. She is part of the investment team, serving as co-portfolio manager for the Mid-Cap Equity and ESG Equity Strategies, including the AMG Managers Fairpointe Mid Cap Fund, the AMG Managers Fairpointe ESG Equity Fund, the Parvest Equity USA Mid Cap Fund, and institutional accounts.
Prior to co-founding Fairpointe Capital, Ms. Pierson served for seven years as a member of the Mid-Cap Investment Team, led by Thyra, at a predecessor firm. She co-managed the Aston (now AMG) Mid Cap Fund, the Parvest Equity USA Mid Cap Fund and separately managed institutional accounts as well as providing research and analysis of existing and potential mid-cap equity holdings.
I spoke with Thyra and Mary on December 4.
Please tell me about the history of your mid-cap core equity product and its investment mandate, as well as your backgrounds that led to the introduction of this product?
Thyra: In 1999, I was hired to manage a mutual fund. My mandate was to transition an existing all-cap fund to a mid-cap product. I had worked on mid-cap stocks for a while. The Fund had only $18 to $20 million in assets at that time. I gave up a job and took a salary cut to run this fund.
That was the origin of this mid-cap product and 20 years later we continue to use the same process.
What is your investment process? What are the key characteristics of the companies in which you invest?
Thyra: We are focused on valuation, but that doesn't mean that we are value managers. We love growth stocks as well, but we don't like to overpay for them.
For quite a few years we owned Nvidia. I was surprised to realize that the stock today is cheaper than when we sold it. The stock had moved up quite a bit and has come back down recently. In the past, we also had Apple computer and Yahoo. We’ve owned Monsanto, after its spin out.
We look for value and we like to buy stocks that are opportunistic or temporarily out of favor and where the next three years outlook is not reflected in the stock price.
Ideally, we like companies that have products or services that are must-haves and clients cannot do without. That's not the case in every situation, but quite a few of our stocks are in that category.
Why do you focus on mid-caps, rather than small- or large-caps?
Thyra: Mid-cap is a segment that is inefficiently priced, more so than large-or small-cap. Many pension sponsors pick large-cap managers and small-cap managers, and mid-caps are mostly ignored. Mid-caps have better liquidity than small-cap stocks which allows you to manage a portfolio with fewer stocks. Unlike large-caps, we have good access to management, which is very important to us.
Usually before buying a stock, we have a call with the company and, in most cases, we have meetings with top management. Because we have a pretty concentrated portfolio, we are often among the top 15 holders of a mid-cap stock. We have some clout with those companies due to our holding size and longer-term outlook. They take our calls and they come to visit us.
Mary: That's an advantage over large-cap. You can imagine an investment manager calling up and wanting to have a conversation with the CEO of a large-cap stock. It is much more difficult than with a mid-cap company.
What is your risk management process?
Thyra: We pay attention to valuation and we like to buy a stock when it's attractively valued. We like to minimize downside. We have a maximum position size for a single stock. We also have a maximum by sector weighting. We like to have reasonable balance sheets as we don't like too much financial risk. In most cases, we have a limit on how much debt-to-capitalization a company can have.
Since inception in 1999, your mid-cap product has returned 11.92% annually net of fees as of September 30, 2018. That beat the S&P 400 mid-cap index by 127 basis points and the Russell mid-cap index by 226 basis points. It outperformed the S&P 500 by 563 basis points. What has been the source of outperformance by mid-cap stocks in general (relative to the S&P 500) and specifically of your product?
Thyra: Overall, mid-caps are less mature so they still have better growth opportunities. Apple Computer was a mid-cap stock when we owned it in 2001/2002. Monsanto also qualified as mid-cap in 2002/2003. Those companies had better growth than large-cap companies on the average, which are more mature.
The other big factor is M&A activity. There are more takeovers in mid-cap than large-cap. With our selection process, we have had a higher incidence of takeovers versus the S&P 400 mid-cap index. Our incidence of takeovers was about 20% higher than the S&P 400.
This has to do with how we pick stocks. We buy companies that are fairly focused and have good valuation and good balance sheets. Often they are number one in their space.
Even if Wall Street doesn't pay attention to that and there's no corporate finance business, other companies notice. We have a long list of all the takeovers we had. Most of them were bought by a larger company in their space.
In your most recent commentary, you noted that market dynamics will favor value stocks going forward. What has been the source of underperformance for value over the last decade, and why is that changing?
Thyra: This is heavily influenced by what happened in the last two years or so. It flip flops. I have some data here that shows there are years when value outperforms, and there are other years when growth outperforms. Over longer periods, we have been able to outperform both value and growth as well as the S&P 500..
What happened in the last two years was that a lot of money moved into passive investments. You had pension funds going into a large index, like the S&P 500, and also into small-caps. Six months ago, the valuation of the S&P 500 or its top 100 names, and also the valuation of small-caps, went to very high levels. The small-cap index, at some point a few months ago, was up over 20%.
That is not the case anymore. Now you see the inverse, small-caps have declined substantially recently because of limited liquidity. On the way up, they couldn't absorb all that money without going to excess valuations. Now funds are moving out of small-caps and liquidity again becomes a problem.
You also discussed the impact of tariffs on the markets – in terms of greater uncertainty and possibly inflation – as well as on your positions. Is that playing out as you expected?
Thyra: Today we had a company announce their results. It's a great company. We have a small position in it, Donaldson, and they also indicated its raw material price has made an impact. Revenues were in line with expectations but earnings were a penny short and the stock is down 8% to 10%.
More and more, we hear from companies that margins are down because of higher raw material costs, whether it's steel or aluminum. The tariffs do make a difference to them. For a while, they were talking about passing on some of these price increases. But in a market that's slowing over time, that may not be working out.
Donaldson is a Minnesota-based company that does filtration. Anything that produces dirt or dust is good for them – trucks, heavy equipment, mining, energy. It is still pretty small in China but its opportunities are fairly bright in China.
Mary: I just want to underscore one point that Thyra made. This is in response to your question whether tariffs have had the effect that we expected. Initially companies were telling us that they were planning to pass on any effective tariffs to their clients, just like Thyra mentioned. But what has changed in the last few months is that because the impact of the tariffs is such a headwind for global growth and demand, companies are now saying that they aren't able to do that. We're hearing more and more that companies are not able and not willing to pass on through price increases from tariffs because they're more concerned about demand than in the past.
That's a change. Maybe it should have been an expected change in their attitude, but definitely it's been a change in the last few months. The tariffs have taken a bigger toll broadly in the market and that is having a secondary effect on company's decisions related to tariffs.
You have a significant overweight in communications services relative to the mid-cap index (17.7% versus 2.0%). Why is that and can you discuss some of your positions in that sector that represent that investment thesis?
Thyra: Communications services is a strange and new sector. In one definition, maybe we are overweight, but it relates mostly to how those sector definitions have changed.
For example, that category includes Tegna, a TV-station company. We have a big position. We own Meredith, which publishes a lot of women’s magazines. They bought Time Inc., but they also have local TV stations, and its stock is undervalued and selling at one-time revenues. That's what these properties go for, but it's undervaluing the TV stations that it has. We own the New York Times, which has been a great stock. It's up quite significantly. Scholastic is also a position, the publisher of a lot of educational products for children.
We own Lions Gate, which is in entertainment, TV and movie production. We also own Cars.com, which is a spinoff from Gannett dedicated to automobile-related information and advertising. It started putting ads in digital form and now in cars.com. So cars.com is a technology company based on one definition, but another vendor defines it as communications services.
Mary: The changes that are made by S&P, GICS or Russell affect us in terms of our sector weightings, but we are bottom-up investors. With the exception of limiting our exposure in any one sector to 30% to 35% of the portfolio, we may be overweight in some sectors sometimes, and underweight in those same sectors at other times. But that is not because we're making top-down decisions about the sector, but because we're looking for good stocks and companies in which to invest.
Thyra: This is a new sector. Up to very recently those companies were bunched into consumer discretionary. Consumer discretionary had many disparate stocks bunched together and now there is this newly created communication services sector.
Mary: It’s really helpful for us to have that sector separated out because it makes it clearer that it's very different from other consumer stocks that we have in the portfolio. The fact that there's only a 2% weight in the benchmark shows that it wasn't the mid-cap area that propelled the GICS to make this change. It was the fact that the FANG stocks were so huge and were such a dominant force that they wanted to put them into a separate sector.
That was really the impetus for this change; it had to do with large-cap stocks. The fact that there's only a 2% weight in the mid-cap benchmark for communications services is just a corollary, and it's unrelated to the decision. It's a reflection of the fact that the decision was made to reclassify the FANG stocks, which are large-cap stocks.
Are there other positions that you’d like to discuss that are representative of the types of companies you own?
Thyra: In this environment, you have to know what you buy and how much you pay for it. All the uncertainty might be positive for us. Our performance has improved in the last three-month period.
One stock we bought a year ago, Hormel, has done quite well. It's a stock that even when we move more into a slowing but not a recessionary economy, people will still buy its products.
We had revisited some names that we had owned in the past, like Molson. The beer company appears to be very undervalued at this point in time.
We haven't changed how we invest or what we buy, and we are cautious and looking for opportunities where the outlook for the next three years is not currently reflected in the stock price.
How do investors typically use your product? As a separately managed account, how can advisors access your product?
Mary: Our typical client is an institution with a designated allocation to mid-cap stocks. For that reason, we tend to be fully invested with a low cash position. We recognize that we are expected to be fully invested in mid cap-stocks by our clients.
We do accept direct accounts with a minimum of five million in the account. The strategy is also available on a number of wrap platforms, with lower minimum requirements.
Some of our readers may have noticed that your recent performance hasn’t been as good as your long-term record. What guidance can you offer?
Thyra: For an extended period last year, and year-to-date, we underperformed. But we have been there before. Usually, after a period like that, we come out fairly strong. In this case, the period may have lasted a little bit longer than I would have expected. The move to passive investing may have contributed to the distortion between growth and momentum, and more fundamental value investing.
Recent changes indicate that we are going back to an environment where fundamentals matter and that environment should be good for us.