A Mid-Cap Investor is Thinking Bigger

This Perkins Mid Cap Value fund manager is finding good values in large-company stocks. He shares four stock picks and his economic outlook for 2011.

Much has been made of the past ten years being a lost decade for stock investors. Don’t tell that to shareholders of Perkins Mid Cap Value (symbol JMCVX (opens in new tab)). Over the past ten years through January 25, the fund returned an annualized 9.5%. According to Morningstar, that beat the typical fund investing in undervalued, midsize companies by an average of 2.3 percentage points per year. Perkins even managed to return 5.6% annualized over the past three years, no easy feat considering that the period includes the stock market’s miserable performance in 2008 during which the fund lost 27.3%.

Both Perkins and the overall market have recovered impressively since stock prices bottomed in March 2009. Can the party continue in 2011? We checked in with Jeff Kautz, chief investment officer of Perkins Investment Management and a co-manager of Mid Cap Value since 2002, for his take. Here’s an edited transcript of our conversation:

KIPLINGER: What is your outlook for the economy in 2011?

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

KAUTZ: Estimates for growth in gross domestic product are starting to move higher, from a range of 2% to 2.5% to 3% to 4%. After the November elections, we got a second round of stimulus by the extension of the Bush tax cuts and by another round of bond purchases by the Federal Reserve. Plus, the Obama administration now appears to be more supportive of business in general.

So with a more pro-business environment, we have a pretty good chance of seeing the recovery take hold. Corporate balance sheets are in good shape. Statistics indicate that cash is about 7.5% of total assets, which is the highest level since 1959. The question remains as to whether corporations will be more willing to invest in their businesses. For that to occur, we really need to see a transition from stimulus-related growth to a more-solid economic footing.

What does a more-solid economic footing entail? We need to see better job growth as well as wage growth. Housing needs to improve. I’m concerned about growing government debts worldwide and whether that is inflationary in the long term. I also have concerns about China raising interest rates to fight growing inflation there. That could put a damper on growth around the world. We also need to address some difficult issues at home, such as the rising national debt and growing spending on entitlements.

What’s your outlook for the stock market in 2011? The momentum has clearly swung to the upside since March of 2009. Stocks don’t look terribly expensive. At 13 to 14 times projected earnings for Standard & Poor’s 500-stock index, valuations look reasonable right now if those earnings estimates are achieved. So there is probably room for upside. Also, we’re starting to see some money move out of fixed income and into stocks. If that’s sustainable, that would give the stock market another boost.

The biggest risk we face is complacency. I worry that investors will ignore the lessons learned in 2008 and will introduce too much risk into their portfolios for fear of missing a rally. Whether it’s China putting the brakes on growth or the European debt crisis, either issue has the potential to flare up just as investors move it to the back burner.

What about earnings? Earnings growth has been a lot stronger than we would have thought. A lot of the earnings growth in the past 12 to 18 months has come from cost cutting, which can only go on for so long. The year-over-year earnings comparisons will certainly start becoming tougher. There’s probably room for a little more cost cutting to be done, but we need to start seeing more sales growth this year.

How do you find investment candidates? Too many investors ignore the risk side of the equation, and that’s where we start. I don’t mind taking on risk as long as I feel we’re being adequately compensated for taking on that risk. When we screen for ideas, we look for financially strong companies. We try to identify companies that have underperformed over the previous 12 to 18 months, that have good franchises with solid balance sheets and cash flows, and low expectations for the stock. These companies trade at a discount to what we believe is their fair value.

Sounds like what many other investors do. Where we really start to differentiate ourselves is through our valuation work. When we first look at a company we look at how much money we could potentially lose before we examine the upside potential. So, for instance, what would happen to the share price if the economy deteriorated, sales sagged or earnings contracted? We also look at different valuation measures depending on the sector and see if we can figure out where the stock has tended to bottom in past downturns and top in better times. Using this data, we come up with a very conservative price target for both the downside and the upside.

Where are you finding value now? We’re finding the best reward-to-risk opportunities in larger-capitalization stocks. Large caps may not offer tremendous upside potential relative to small or midsize stocks, but they have less downside risk.

How about some specifics? We continue to find value in health care. Health-care companies are sounding a lot more confident for the coming year. They’re getting more comfortable with health-care reform and the impact it will have on their businesses. And even with reform, there’s still decent predictability for upcoming earnings. For example, we like Laboratory Corp. of America Holdings (LH (opens in new tab)), which offers lab services. It can actually benefit from reform because it will have lower expenses for bad debts as fewer clients fail to pay their bills. Plus, more people will be able to participate in preventive testing under the health-care reform program. So although the company’s profit margins may be hurt in the short term due to greater Medicaid exposure, it will make up for that by doing more testing and get paid for its services with more regularity. LabCorp generates a tremendous amount of free cash flow [the cash profit left after deducting capital outlays needed to maintain the business].

Where else are you finding opportunities? We also like big technology companies. In 2010, we bought companies that we wouldn’t even have considered in the past, such as Cisco Systems (CSCO (opens in new tab)). In 1999-2000, when the stock was trading at 80 times earnings, it wasn’t even on our radar screen. However, at 13 times earnings and with $4 of net cash per share on the balance sheet [cash minus long-term debt divided by shares outstanding] and great free cash flow generation, Cisco is attractively priced. The same applies to Microsoft (MSFT (opens in new tab)).

Anything else? We also like certain insurance companies, such as Allstate (ALL (opens in new tab)). It has high brand value, but it’s trading below book value [assets minus liabilities] and at just eight times earnings. Allstate’s home and auto insurance businesses are among the few insurance lines with the ability to increase prices now, and the company generates strong cash flow. The problem with Allstate lies with its small life-insurance business. However, Allstate has new management in place to focus on stabilizing pricing and shrinking this business. That should improve profitability and free up capital, which may be used to buy back stock in 2011.

Follow Jennifer on Twitter (opens in new tab)

Jennifer Schonberger
Staff Writer, Kiplinger's Personal Finance