Many people thought large company blue chip stocks would rotate back into favor in 2011 after lagging small company stocks in the previous two years. But mid-cap stocks, typically defined as those with a public value between $1 billion and $6 billion, have led the pack among domestic companies so far this year.
As of mid-April, the Standard & Poor's MidCap 400 Index had a total return of 8.46%, compared with 5.58% for the large-cap S&P 500 and 6.57% for the S&P SmallCap 600. Overall, S&P believes mid-cap stocks should generate 22% earnings growth in 2011, which is much higher than the projected 15% growth for large caps.
One of S&P's top picks in the mid-cap fund area is Meridian Growth Fund. Its manager, Richard Aster, was a runner-up for Morningstar's domestic stock fund manager of the year award for 2010 (along with the fund's co-manager, William Tao). Aster has earned such recognition before. In the 27 years since the fund was launched, he has seen several bear markets, a few frothy ones, and, of course, the Great Recession.
What has helped the fund through the tumult is that it has a lower standard deviation than many of its peers. The 30% drop in the fund's net asset value in 2008, for example, actually looked tame compared with the nearly 44% plunge for the average Morningstar mid-cap growth competitor. A growth-at-a-reasonable-price enthusiast, Aster used the downturn to load up on stocks such as software makers Autodesk and Adobe, which he had considered too expensive before.
While the fund sometimes lags its more aggressive competitors in strong bull markets, as it did in 2009, it usually isn't by a very wide margin. The fund was up about 36% that year, trailing its category average by about 3 percentage points. But it charged ahead in 2010, nearly doubling the return of the S&P 500 index by rising another 31%.
Aster says the most challenging time for the fund was in the late 1990s, when its attention to valuation kept it out of skyrocketing Internet-related stocks that catapulted other growth funds to the top of the charts. Shareholders voiced their displeasure by leaving Meridian and moving into more aggressive offerings. While Meridian dipped as the new century dawned, it did so less drastically than many of its competitors.
A low expense ratio of 0.84% has also helped the fund outpace many of its more aggressive, more expensive fund rivals over the long term. Over the last 15 years, its annualized return of 11% has beaten the S&P 500 by 4 percentage points and its Morningstar mid-cap growth category peer by more than 3 percentage points.
Today, with over two years of strong returns behind the fund, the 70-year-old manager believes that midsize companies with a proven ability to grow earnings are well-positioned to produce solid returns in the years ahead.
Valuations, while not as attractive as they were a couple of years ago, remain reasonable. "The average stock in the portfolio is selling at roughly 20 times estimated calendar 2011 earnings. That's pretty good for a growth fund, and it's about in line with the historical average."
Over the next few years, the challenge will be finding stocks that can grow earnings enough to give portfolio stocks room to appreciate. "If we own stocks with an average annual earnings growth of 15%, their valuation relative to the market is going to fluctuate," Aster says. "My job is to keep that earnings growth rate of the portfolio companies moving up the hill at a good clip. And that's a more realistic goal with a growing company that has a public value of $3 billion or $4 billion versus one that's valued at $40 billion."
With a solid market niche and growing overseas demand, some companies, particularly those involved in technology and software, will be able to do that. But he feels that others, particularly those related to the health-care industry, will have trouble keeping up.
"Obamacare is putting considerable pressure on health care charges, and that's got to have an impact on the companies in the sector," he says. "Let's say a hospital sees 1,000 patients and gets $10 million to do it. Then the following year, it sees 1,300 patients but only gets $9 million. That puts a lot of pressure on earnings."
He also takes a dim view of the semiconductor industry. "It's pretty much a commodity-driven type of business, and the life cycle for the products they produce have a very short life cycle," he says.
On the other hand, he has a more optimistic outlook for Royal Caribbean, the second-largest cruise ship company after Carnival and the fund's largest holding. The stock plunged several years ago as investors worried about how the recession would affect a business built on discretionary income. While both the stock and earnings rebounded in 2009 and 2010, concerns about high energy prices have held it down recently.
Interest in cruises to North Africa and the Middle East has also dropped with unrest in those regions. "It's actually 20% less expensive to go on a cruise versus a hotel vacation, so the business hasn't been hit as badly as many people think," says Aster. "The company has a strong balance sheet and is well-positioned to overcome higher energy costs and other temporary problems."
With their high volume of international sales, software makers such as Autodesk and Advent also make the grade. A leader in automated design and engineering software, Autodesk, which Aster purchased in 2008, derives 60% of its sales from overseas. Advent, a leading provider of accounting and trade-order-management software, has plans to expand its geographic reach and already gets about 20% of its revenue from overseas.
Companies like Autodesk and Advent weren't even on the drawing board when Aster began investing in small and mid-cap stocks in the late 1960s as a graduate student in economics at the University of California in Santa Barbara. "Back then, I looked at what were then small companies, like McDonald's. I was attracted to their ability to go from $500 million in annual revenue to over $5 billion in a relatively short time and the positive impact that had on the stock."
But he had also learned to focus on risk early in his career as a bank examiner for the U.S. Treasury, taking into account the problems that can arise when there is too much leverage on a balance sheet. During his 18-month stint on the job, he evaluated loans for industry, agriculture and even movies. "To me, that experience was more valuable than getting an MBA," he says.
After leaving his job at the Treasury, he went to work as an investment strategist and economist at several firms before founding Aster Investment Management in 1977. He decided to start the Meridian Growth fund seven years later to accommodate smaller investors who wanted to tap into the growth potential of companies with strong balance sheets and solid management that were on the cusp of becoming major names.
Since then, Aster has relied on word of mouth and favorable publicity to promote the fund, which has no sales, marketing or distribution fees. "The nice thing about good investment results is that you don't have to pay anyone to bring in money," he says.
While the portfolio of 50 to 60 stocks is more focused than the typical mutual fund, Aster helps maintain issuer diversification by trimming back once a stock has reached about 3% of assets. And while he won't necessarily eliminate a mid-cap stock when its public value moves into large-cap territory, he does set some limits. He recently closed out the fund's position in cell tower provider American Tower, for example, after its market cap hit about $20 billion. He replaced it with SBA Communications, a smaller company in a similar business.
The public value of portfolio companies ranges from $600 million to $15 billion, with the average clocking in at around $5 billion.
When possible, Aster will kick the tires of companies he thinks about buying. In 2008, a shopping trip influenced his decision to purchase stock in Bed Bath & Beyond. At the time, the company had been hit hard by a recession that devastated the housing market and crushed sales at most home goods stores.
But when he visited several Bed Bath stores, he found high-quality, well-organized merchandise and friendly sales people. Just as important was the company's balance sheet, which remained pristine even in a tough economic environment. At Linens 'n Things, a major competitor, he noticed that the staff were not nearly as well-trained and the stores were starting to look a little shoddy.
Since he established the position in Bed Bath & Beyond, the company has improved profits and the stock has risen substantially. At Linens 'n Things, meanwhile, hundreds of stores were shuttered in 2008 and 2009 after the company declared bankruptcy.
"Now that its major competitor has closed its doors, the firm has less competition in a more stable economic environment," observes Aster. "It's truly the leading force in home goods merchandising."