4 Midcaps with Competitive Advantages
12/23/2011 7:00 am EST
Sustainable advantages are what fund manager Sam Dedio looks for when he invests in a company. He talks about four of his holdings in detail, explains why they are leaders in their respective market spaces, and gives investors some clues for spotting these standouts.
Kate Stalter: Today, I am talking with Sam Dedio, Portfolio Manager at the Artio US Mid-cap Fund.
Sam, the name pretty much gives us the investing philosophy, but tell us a little bit more about that and about some of the fund’s objectives.
Sam Dedio: Sure. First, the fund is really a capital appreciation strategy, so we’re out there trying to get sizable outsized returns of capital to our investors, and not really out scouting for total-return stocks or dividend-paying stocks as a primary objective. So we really are trying to get significant returns of capital for our investors’ money when they decide to invest in our fund.
We’re core in our approach, and that means we have growth and value securities. We try not to be pigeonholed to any one portion of the market.
We want to be diversified, so being diversified is easier when you’re a core manager, because you can have a little bit more balance in your sector allocations. You’re not necessarily like a growth manager would be: Have a lot more of a weighting in, say, consumer discretionary, technology, and health care, which could be almost about 80% of the average growth manager’s portfolio allocation.
For us, it’s more like 50% to 60%. So in turn, we have a little bit more of a weighting in financial services; a little bit more in consumer staples, industrials—it’s a little bit more balanced.
The other way we try to diversify the fund is to also have securities of companies that have debt on their balance sheet, as well as companies without debt. So when we try to beat our benchmark—and we know investors have a choice between investing in our strategy, which is an active strategy versus, say, a passive strategy, which might be an index fund—we know when we compete against the index fund, that the composition of that fund includes companies with and without debt.
I like to say that the benchmark or the index has no conscience. And a lot of investors, when the market goes into a period when it’s unhappy with companies, say, that have a lot of leverage or have some leverage and active managers start to sell companies with debt, well then all of a sudden, those stocks underperform and then, when people get more comfortable, then they bounce back. And then, if you don’t have a weighting there, you could underperform.
So, we try to make sure we’re diversified across economic sectors, the capital structure of a company, owning companies with and without debt.
Lastly, we want to make sure we have companies of all sizes in the portfolio. We’re not going to have a situation where we have too many companies that are, say, on the larger-cap spectrum of mid-cap, or at the same time, we’re not going to have too many companies that are really concentrated at the lower end of capitalization of the mid-cap range.
We want to maintain diversification, so if the market goes through periods of time when, say, larger caps within mid-cap outperform, we have some exposure. And conversely, when the smaller cap stocks are running, we want to make sure we have some smaller-cap mid-caps in the portfolio, as well. So we try to maintain that balance.
Kate Stalter: That sounds like a very interesting mix. Can you tell us about a few of these specific holdings in the fund, Sam?
Sam Dedio: Sure. In our consumer portfolio, we own several specialty retailers including Tiffany (TIF) and Coach (COH), but one of the smaller ones that we like a lot is a company called Teavana (TEA).
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Actually, the market cap now is below $1 billion, so it’s at the very, very low end of the mid-cap range. It’s a stock that we own in several of our funds that we manage at Artio in the US side of the business.
It’s a specialty retailer that really is the only pure-play publicly traded purveyor of tea. They source tea from the Far East, China, Asia, and they mix the teas and they sell them to customers in really, any mall locations in the United States. They have about 195 or so stores now.
They recently went public, and it’s a rapidly growing company. The growth rate is in excess of 30% on the top line and also in earnings.
It’s a recent IPO, so with the market’s volatility in the last few months, the stock has not performed well, so we really like the long-term prospects. We think that over the next three years, the company could have north of 400 locations, and within five years, have over 500 locations, starting off at a pretty low base at 200.
The customers really like the product. In addition to selling tea, they sell what I call the hardware for tea, which includes the kettle, the saucers, and the utensils that you would use to prepare freshly brewed tea. Customers really like the experience.
The one thing they don’t have, which I think will really improve their growth comparisons year-over-year, will be a loyalty program, which we expect that they’ll implement over the next year. That will be a way to generate additional sales in their existing customer base to get them back into the stores to purchase more often; so that’s one we like a lot in consumer discretionary.
When you look down into other sectors of the portfolio, there’s a technology company we like a lot. The name of the company is Akamai (AKAM), and this company’s market cap is close to $5 billion, and really, they’re a cloud computing company.
They’ve been a cloud computing play for many years—in fact, they created their own cloud some ten years ago. They sell to other companies the ability to allow traffic to traverse their private network. What they do is ensure that companies that need to have real-time uptime for their Web sites, that the content will be delivered.
For example, when you look at the Internet retailing space, like 29 out of the top 30 Internet retailers use Akamai’s solution to ensure that when you go to a Web site and want to engage in e-commerce, that transaction happens in a timely fashion, so you’re not disappointed and leave the site. They’re really important in terms of fulfillment.
What’s happening in the Internet is pretty interesting: More and more users are going to a mobile phone or smartphone to conduct Internet searches, and going to different various sites. Therefore, the amount of mobile traffic is growing much faster than even Internet traffic in your home.
The other thing that’s happening is people are streaming more often. So streaming is very taxing on the network and causes a lot of congestion at more points in the network. So the quality of service is very important, and this company maintains a very high quality of service in the network to allow providers media solutions and content.
For example, home entertainment. If you wanted to download a movie, say, from Netflix (NFLX), that would be a great example of how a customer uses Akamai’s site to ensure you have a good experience.
They’re very important to what’s happening in the network and the changing habits of users and how they interact with the Internet, and they’re basically paid to make sure that transactions go through in a timely basis, and also content that people pay for on a subscription basis. Most of them go through on a timely basis. So this is a great example of a company that I think is even more important today than it was years ago.
The stock has been clobbered over the last year, because they didn’t meet their growth expectations, and I feel like the company’s outlook has been reset, and they’re really poised to have a decent year in 2012. I wouldn’t be surprised to see if the company is even taken over, because the assets are so important to so many companies. What a great customer list they have.
- Also read: 2 Mid-Caps for Long-Term Growth
Kate Stalter: You’ve mentioned a couple of names here that perhaps many of our listeners may not be familiar with, either at all or maybe not very familiar with. If people listening to this are interested in doing some research into the mid-cap space themselves, what are some metrics they should be looking at, Sam?
Sam Dedio: Sure. Well, when my team—we have a great team of analysts—we consider new companies to evaluate or to consider, the most important thing I think about is: Does the company have a product or service that changed the behavior of the spender?
We look at whether it’s a consumer product, whether it’s a business expense, or a capital expenditure. Now, for the viewership you have, it may be more difficult to ascertain whether or not a product, a capital good item, might be purchased more often in the next two years, because the expense is probably approved by someone that’s a specialist in an area for a certain portion of a company—part of the infrastructure of a plan, so it may not be as well known. So that is a little more challenging.
But when you start to look at the consumer—start thinking about our economy here in the United States and also the world—it is becoming more of a consumer-based economy as China develops, South America, middle classes emerge.
When you start thinking about that and you start thinking about the US and you have 65%, 70% of the economy being consumer—you know, really being a consumer-driven economy—then it gets a little easier.
Then you start to ask yourself: Are these companies’ products becoming more popular? Are the services becoming more popular, or this technology or this application or this item that they sell or the service they sell becoming more important to the mainstream?
And then you start to look at that and you ask yourself: Does it make sense that it could be more long-lasting than a quarter or two? Is it really a rapid and long-lasting change in behavior? That’s what we try to handicap.
So when you look at our companies…you look at an Akamai, and they’ve been doing this a long time. Another company we own in industrials, Parker Hannifin (PH). They’ve been around a long time. They have No. 1 or No. 2 positions. That’s another thing to look for in the end markets that they serve, and many of their end markets in filtration and motion control have No. 1 or No. 2 positions.
The other thing about a company like Parker Hannifin: they’re only one of five companies that have raised their dividends in the S&P 500 for over 50 years in a row. So that’s an example of a characteristic that is a pretty unique thing for a company, and that’s a flag that this company probably requires some more research. So that’s an example.
Oligopolies…companies that don’t have much competition. I can give you one more company that I think is a great example of that, is Airgas (ARG), which is in our mid-cap fund. That’s an industrial gas company, and it is a great example that of that oligopoly point I made.
In the United States, there are only three publicly traded industrial gas companies: Praxair (PX), which we own in our multi-cap strategy; Airgas, which we own in our mid-cap strategy as well as in our small-cap strategy; and Air Products (APD), which is another mid-cap company. That’s it. Those are the only ways to play industrial gases, which are so important to consumer products, food preparation, hospitals, the industrial base, manufacturing, and energy, to name a few of the end markets.
And when you have the oligopoly, you should think about pricing power. A lot of these companies can increase prices and take the price up, and their customers really don’t have much of a choice, because there is not really an alternative to secure the necessary industrial gases that they produce.
They also have take-or-pay contracts for some of the big installations that they sell into, so that tells you how powerful their business models can be and are.
That’s another thing your viewership base may want to think about: Now what is the competitive environment like for this company and this industry?
And you start to see, there is scarcity value. It’s only two or three companies that do what they do. That’s pretty important.
One clue to really understand that is the gross margin line. As a rule of thumb, if the company that you’re looking at, or that your subscriber base or viewership is looking at, has high gross margins, that’s really a leading indicator of what the competitive environment is like for that industry or sub-industry. And the higher, the better.
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