2004 Mid-Cap Stock Focus - January 26th, 2004

Every January, we take time to figure out which type of stock will do well over the following 12 months.  Last year was easy, just focus on oversold large caps, particularly the techs.  In previous years, when the large caps seem fully valued, we've used our various screens to find mid-cap companies (companies with market capitalizations of $1-30 billion) that have attractive characteristics and a reasonable chance of doubling in value over a 5 year horizon.  Although half the stocks in our portfolios are large caps, many, for example Dell computer, originally entered our buy list as mid-caps and grew into large-caps.

The reason why we keep coming back to mid-cap stocks for new ideas is very pragmatic.  A company like GE (market cap $343 billion,) Microsoft (market cap $305 billion) or Pfizer (market cap $276 billion), has to double sales in order to double the stock price (assuming that the Price/Sales ratio stays constant.)  Microsoft has to come up with an additional $33 billion in sales, PFE an additional $38 billion, GE an incredible $133 billion.  In the current economic climate, it's hard to see where mature companies like these are going to come up with such dramatic sales gains.  It's a lot easier for a company with a market cap of $4 billion and revenues of a billion or two to double revenues if the company has a secure niche in a growing market.

Attached is a spreadsheet summarizing our recent research - 25 companies in all.  Of several thousand mid-cap stocks, we used our quantitative screens to identify a couple hundred companies with several key characteristics:

1. Positive cash flow - companies with positive cash flow don't need to go to Wall Street or banks to fund growth
2. Decent operating margins – we’re willing to make exceptions for companies like CDW (formerly Computer Discount Warehouse) which take a small slice of high turnover and therefore have thin margins, but generally speaking, companies with fat operating margins have room to maneuver (can spend money on promotions, discounting, distribution) in a way that companies with razor thin margins (e.g. grocery stores) cannot.  These companies average 22.7% versus 19.2% in the S&P 500.
3. Expectations of decent forward growth.  As we were reminded in recent years, Wall Street analysts are not very reliable.  Still, we have found that aggregate 5 year forward earnings estimates (i.e. the average of the reporting analysts) are reasonably predictive in identifying companies with growth prospects better than the overall S&P 500.  These companies have an average forward growth rate of 15% vs. 11% in the S&P 500.  we usually screen out companies with forward growth rates greater than 30%, because these growth rates are rarely sustainable (think of the Internet stocks, or another bubble, the Y2K stocks.)
4. Trailing and Forward P/E ratios that make sense.  The average trailing P/E of these companies is 26.2, slightly higher than the S&P 500 at 25.5.  The forward P/E averages 24.0, which is 25% higher than the forward P/E on the S&P 500 of 20.0.  Only 4 companies on our list have P/E's greater than 30, and they're on the list because we think that the company will grow earnings so fast that the P/E will drop down to a more reasonable number soon.  However, we’re willing to have higher P/E companies if their growth prospects are also higher than the average S&P 500 company (See PE/G discussion.)
5. PE/G (PE ratio/forward growth rate) ratio that makes sense.  The rule of thumb is that a company with a PE/G ratio of 1.0 is an extremely good value (e.g. forward PE=20, forward growth rate=20%.  In the current environment, it's tough to find companies with PE/G ratios of 1.0, but there are plenty of companies with PE/G ratios at or lower than the overall S&P 500, which has a PE/G ratio of 1.9 (the average of these companies is 1.6, and the highest PE/G is 2.5)
6. Beta, a proxy for risk, that is reasonable.  One way to juice a portfolio is to load it up with high Beta stocks (a stock with a Beta of 2 historically has moved up or down at twice the rate of the overall market - great on the upside, brutal on the downside.)  We like companies with Beta's less than 1 (a Beta of 0 implies that the stock moves completely independently of the market) because these companies tend to stabilize a portfolio the next time the market turns down.  The S&P 500 is defined as a Beta of 1.0, these stocks average 0.67.

Once we get the base list (about 200 companies passed the quantitative screens,) we then perform additional research to find out which of these companies have what we call a "strategic niche."  A strategic niche is something special about a company which protects it from competition, which can include:

1. Market share, companies that are #1 or #2
2. Deep customer relationships based on superior quality of the product or service, or high switching costs
3. A patented product where the company is the sole provider
4. The ability to provide a product or service that's "Better, Faster or Cheaper" than the competition.
5. "In a gold rush, sell shovels."  Investing in bio-tech research companies is pretty risky - investing in companies that sell chemicals, instruments etc. to bio-tech companies is a lot less risky.

This process gets us from 200 to 25 companies, which we will be adding to our accounts over the next 4 weeks as we do our annual account balancing.