Meet Our Newest Fund Analyst Pick

Shareholders of  FMI Large Cap (FMIHX) could have been forgiven if they thought the fund had gone on a hiring spree in early 2009. Virtually overnight, the fund listed a half dozen or so more portfolio managers. But these weren't new hires. Rather, executives at the fund's advisor, Fiduciary Management Inc., wanted to highlight the fact that the stock selection and research is done by a team of analysts. They also wanted to recognize the analysts' contributions to the entire research process. Analysts at FMI are generalists--they are not tied to specific sectors or industries--and they are collectively involved in every buy and sell decision made in the portfolio.

This total-team approach is different than the sector-aligned structures of most firms, and it is a key driver of this fund's and sibling  FMI Common Stock's (FMIMX) success. Because they study many different industries, FMI's analysts are able to contribute to the debate of whether a stock should be included in the firm's compact portfolios. FMI doesn't compensate analysts based on the performance of their picks. Rather, it's the quality of their ideas and insights that count.

Milwaukee: Home of the Boutique
Milwaukee might not be the financial hub that is Chicago, but it is home to a handful of strong-performing boutique asset managers. One of the best is FMI, which Don Wilson and Ted Kellner founded in 1980. (They had worked together at in-town rival Nicholas Co.) The next year, in 1981, the firm launched its flagship fund, FMI Common Stock, which has delivered one of the best long-term records in the mid-blend category. In January 2002, the firm opened FMI Large Cap, which has followed in its sibling's footsteps, becoming the envy of its large-blend peers.

FMI Large Cap has pushed past its category peers with just a handful of well-researched picks. It will typically hold fewer than 30 stocks, while its average peer has more than 120. The team buys companies with strong franchises, high recurring revenues, defensible market positions, and stock prices below the FMI's fair value estimates. FMI backs up this philosophy with conviction by building a truly actively managed, long-term-oriented portfolio.

Few, if any, of the attributes the team requires of a stock change dramatically in the short term, and the portfolio's metrics back up that theory. Turnover is well below the group norm, and the compact portfolio indicates that the team's research drives stock selection, not the need to mirror a benchmark profile. That's a key distinction in the large-cap space, because consistently gaining a research edge over a wide swath of liquid, well-covered stocks is inherently difficult. A look at the company-specific metrics further validates the team's philosophy. The portfolio boasts a higher free cash-flow yield than the S&P 500 Index, yet its holdings in aggregate take on less leverage to do so. In addition, 94% of the fund's holdings garner a narrow- or wide-moat, meaning virtually the entire portfolio is invested in firms with significant competitive advantages to keep competitors at bay.

With a compact portfolio comes increased stock-specific risk, so the analysts plow through nearly all available information about a company, looking for anything that may undermine the thesis for owning it. Their recommendations are then presented to the broader committee. Team members attempt to pick apart the thesis before collectively deciding whether the stock is worthy of the portfolio, as often it will mean selling a current holding.

Valuation Is Key
The fund is a stock-picker's domain, but the team has a clear eye on the world around it. When changes are made to the portfolio, the key driver is valuation. The team will sit on the sidelines and wait for an attractive company to come down to a reasonable valuation. At the same time, the managers will take money off the table rather than hold on, hoping to attain that last dollar of gains. The team, for example, trimmed its position in  Wal-Mart (WMT) at the beginning of 2009. Wal-Mart has been in the portfolio since 2005 and was one of the better-performing stocks in 2008. But the stock's valuation was starting to climb. In the same vein, the team also sold some shares of  Cintas (CTAS) and  Kimberly-Clark (KMB) earlier this year.

Growth matters to the team, but so does how a company achieves it. The team sold office-goods supplier  Staples  in late 2008 after it acquired European competitor Corporate Express. The deal was done in July 2008, but director of research Andy Ramer says that the high price forced Staples to rely on the capital markets for additional financing to close the deal. The risk of the firm's new debt profile reduced the company's appeal, so the team decided to take its gains and move on.

In late 2009, the team eliminated  Canon (CAJ) and  Best Buy (BBY) from the portfolio. With Canon, Ramer says that the stock's price gain had run past its operating fundamentals and was trading too high based on the team's projections of normalized earnings. The firm's foray into high-definition products and cameras is also being met with stiff competition, often resulting in price erosion. Best Buy, similarly, Ramer says, has not kept competitors--especially online retailers--at bay when it comes to consumer electronics and therefore will likely have to focus on acquisitions to grow, rather than growing organically, making the stock less attractive.

Pat English, FMI's chief investment officer, says that the firm recently has become more defensive based on its economic outlook. The team has been trimming the cyclical exposure in names such as  Rockwell Automation  (ROK) and  Cisco Systems  (CSCO) and in economically sensitive names such as  American Express (AXP). The team also sold  Time Warner Cable , a spin-off received from  Time Warner , because the former's heavy debt load and uncertain secular outlook diminished its appeal, Ramer says. Those proceeds were used to increase the fund's stake in Time Warner in mid-2009. Time Warner's new CEO, Ramer says, has shown a commitment to effectively deploying capital and maintaining the firm's robust network content.

English says that he doesn't see enough demand in the economy to support the robust growth assumptions of many large-cap stocks, so the team shifted toward defensive names. In addition to adding to Time Warner, the team recently increased the fund's exposure to stable stocks such as Wal-Mart and consumer foods icon  Nestle (NSRGY). Valuations of both became attractive again, and Nestle has strong operating margins from its emerging-markets exposure and a rock-solid balance sheet, analyst Matt Goetzinger says.

As evident by their patient, deliberate actions, the managers don't chase fads. The fund's 13% weight in financials is a similar exposure to the S&P 500 Index's 16% weighting, but the holdings aren't the same.  J.P. Morgan Chase & Co. (JPM) and  Bank of America (BAC) top the index's list, but the fund has stuck with tried-and-true stalwarts  Bank of New York Mellon (BK),  Berkshire Hathaway (BRK.B), and American Express.

A Stable Outlook
In 1986, Wilson and Kellner, the firm's cofounders, hired English as a research analyst; English was a Stanford graduate with just one year of experience at Dodge & Cox. The relationship has worked exceptionally well. English's progression to head of research allowed Wilson and Kellner to step back from research many years ago. They leave it to English and a handful of analysts to execute the firm's team-based approach.

The team is tight-knit, and continuity is central to the firm's appeal. Wilson retired at the end of 2009, but the transition plan had been in place for a decade. His and Kellner's stakes in the shop will be purchased by the firm's investment personnel over the next 10 years, erasing any doubt about future ownership. John Brandser, a partner, has been taking on Wilson's duties and will eventually assume the title of chief compliance officer.

A clearly defined investment philosophy and history of consistent execution led us to make this fund an Analyst Pick in March 2010. Assets continue to grow and have crossed $2.7 billion, up from $639 million at the end of 2007. Normally, an influx of assets could spell trouble, but the firm has a laudable history of closing Common Stock several times during its history rather than have new money dilute that fund's similarly high-conviction portfolio. English says that capacity isn't currently a concern, but expect that the same diligence and discipline will be exercised here over time.