A Glimpse Behind the Curtain at FMI Large Cap

Pat English,  FMI Large Cap's (FMIHX) lead manager, is looking for stocks he says he could put in a lockbox for five years. FMI Large Cap's 28% turnover rate does suggest a three- to five-year average holding period, and the fund's oldest positions are approaching 10 years as part of the portfolio. This long time period requires that the companies English and his team of six analysts buy possess two impor­tant characteristics: a strong, predictable business and a cheap price. These criteria are doubly important for such a compact portfolio of 25 stocks, where each holding can have a meaningful impact on performance.

The fund's process has evolved over many years. In the mid-1980s as he was starting his career at Dodge and Cox, English spent more time thinking about book value, returns on equity, and price/book ratios--until write-offs swept the corporate-accounting landscape, making those figures less meaningful. Next, at FMI (he joined in 1986), English looked harder at price/earnings ratios, until the 1990s brought, as English says, "the bastardization of P/E ratios," thanks to the likes of Jack Welch and other CEOs intent on giving Wall Street what it wanted and keeping "cookie-jar reserves" to help them do so.

Contrarian Mind-Set
English says that returns on invested capital and enterprise value/revenue are now more-stable measures to consider, especially given the near-peak profit margins that many corporations are enjoying. (Some investors might alternatively consider enterprise value/EBITDA.) But he really likes price/sales figures because they "give a better notion of buying the whole company." That emphasis shows when you look at FMI Large Cap's value measures: While numbers including the portfolio's average P/E and P/B ratios are in line with competitors', the fund's P/S ratio tends to come in much lower.

It's clear that a contrarian mind-set permeates FMI's work. The managers like to buy stocks that are under some cloud or whose prices are otherwise suffering and sell stocks into strength. Whereas that contrarian bent once led the fund to consumer defen­sive names--English first picked up  Kimberly-Clark (KMB), for example, in 2002's first quarter;  Diageo (DEO) in 2004's first quarter; and  Nestle (NSRGY) in 2009's third quarter--he now thinks many of these stocks are "expendable" because they are fairly priced, at best, as investors have embraced high-quality stocks of late and have favored staples firms that aren't as vulnerable to weak economic trends. He says that he's inclined to trim solid companies Kimberly-Clark and Nestle because their valuations have surged. In fact, he sold the fund's Diageo position in 2012's third quarter.

Let's Get Cyclical
Valuations are pushing the fund toward some more-cyclical names, as well as a few special situations. The fund's cyclicals include some old favorites, such as financial  Bank of New York Mellon (BK), which English describes as a "sleeper," from here. The fund has owned it since 2006, and it's actually come down in position size. Still, after suffering a 10.85% annualized decline during the past five years through Oct. 26, 2012, English says BNY Mellon is cheap at 9 times normalized earnings--and Morningstar has given the wide-moat stock 4 stars. He likes that the company is getting stronger from a reserve standpoint. Other cyclical names include several new purchases, such as advertiser  Omnicom Group (OMC) (second-quarter 2011), regional bank  Comerica (CMA) (second-quarter 2011), and Wisconsin-based  Kohl's Corp's (KSS) (second-quarter 2012). Of these, Kohl's seems the most troubled, but English is confident the proven management team will straighten out its merchandising--plus the stock's price/sales ratio is 0.70, one of the portfolio's smallest.

English also sees tremendous opportunity in oil and natural gas play  Devon Energy Corp (DVN). English first bought the energy stock in 2010's third quarter (while not at its multiyear low, it was substantially off its mid-2008 high). The contrarian in him says that there is undeniable pressure for natural gas prices to move higher and Devon has "enormous leverage" to gas prices. Today, English says he likes the firm's oil assets better than its gas assets, but he also says Devon is priced as a free call option on natural gas. The fund also owns  Schlumberger (SLB), which has exposure to natural gas, and while he respects the team at fellow value firm  Longleaf Partners (LLPFX),  Chesapeake Energy  has "too much hair" on it even for his tastes; English is more impressed with Devon's disciplined management.

Excellent Execution
For all of its optimism and patience, the firm will sell on signs of fundamental deterioration. FMI's director of research and this fund's comanager Andy Ramer points to one stock that had been skating on thin ice:  Staples . English, Ramer, and company had built a position over two years beginning in 2010's second quarter, but they halved their 4% position in 2012's second quarter and then dumped it altogether in its third quarter. Ramer says Staples has proved one disappointment after another, as white-collar unemployment has failed to turn around and as the paperless office takes a firmer hold. Surely Staples qualified as a contrarian pick, but the managers here try not to delude them­selves into thinking a company can return to its glory days just because.

Perhaps what's been most impressive about this fund that buys strong businesses at attractive prices is its execution. Over its more than 10-year life span, performance attribution analysis shows stock selection has won out, particularly in the important areas of consumer staples as well as industrials. Over time, the fund has generated strong results on a risk-adjusted basis, performing particularly well in tougher markets. Today, the fund feels riskier consid­ering its move into more-cyclical fare, especially given the uncertainty surrounding global economics, but we have confidence in English and his team.