Mid-cap value stocks could be the Goldilocks investment for today’s market. Eleven years into a bull run, valuations for large blue-chips are high, yet smaller, cheaper companies have weaker businesses, more vulnerable to a long-overdue economic downturn. Mid-caps may offer the bed for your assets that’s “just right”—less expensive than large, more resilient than small—especially if broader markets change course.
Of the mid-cap value funds, Wells Fargo C&B Mid Cap Value (CBMAX) is one of the best. Its 12.5% 10-year annualized return beats 92% of its peers in Morningstar’s Mid-Cap Value fund category and its benchmark, the Russell Mid Cap Value Index (.RMCCV). (The fund carries a 5.75% load, but that fee is waived at major brokers such as TD Ameritrade (AMTD), Charles Schwab (SCHW), and Fidelity.) To be sure, value funds have underperformed growth strategies of late—hence the opportunity in today’s extended markets.
C&B Mid Cap Value is subadvised by Cooke & Bieler, a private money manager that has existed since 1949 and oversees $9.8 billion. The firm isn’t part of Wells Fargo (WFC). Cooke & Bieler employs an unusual managerial structure for the fund. It has eight co-managers who control their own portion of assets and buy and sell the stocks in that portion themselves. There is no “lead manager” since every co-manager is also an analyst.
“We’ve built the firm so the analysts who’ve done the research are 100% accountable for the results,” says co-manager Edward O’Connor. “They don’t have to worry about what their boss thinks about an idea.” For added motivation, 40% of each manager’s compensation is determined by the performance of their stock picks versus relevant benchmarks.
The freedom to control their own destiny is one reason managers who work for Cooke & Bieler tend to stay there—the firm’s average managerial tenure is 16 years. Three of the fund’s co-managers have worked on it since its February 1998 inception, including Mehul Trivedi. He interned at the firm during business school. “Ultimately, that sort of decision-making authority is what attracted me, and the compensation system,” he says. “It’s a meritocracy.”
Individual managers still have to justify their stock picks to the team via a written “accountability statement,” an investment thesis describing what the manager expects from the stock. The team reviews that statement every quarter to see if the investment is living up to expectations.
The fund’s portfolio typically has fewer than 50 stocks, and for a new name to be added, another usually has to leave. Assets aren’t divided equally among the managers, but based on the opportunities available in the industries each individual manager covers. Since their compensation is so heavily dependent on smart stock selection, no manager is tempted to control the entire portfolio.
O’Connor covers financial services, consumer discretionary/retail, and telecom stocks, while Trivedi covers energy and technology. One stock O’Connor started buying in 2018 and continued to buy throughout 2019 is clothes retailer American Eagle Outfitters (AEO), now the fund’s fifth-largest holding. “Retail obviously has some structural issues with the internet [i.e., Amazon.com (AMZN) taking market share] and has always been a super-competitive business,” he observes. But American Eagle—the No. 2 jeans brand in America behind Levi Strauss (LEVI)—has already transitioned more than 25% of its business to online and has a strong social-media presence, according to O’Connor.
The managers tend to focus on finding high-quality companies first before considering valuation, and that has given the fund an edge over peers lately, when growth stocks broadly have crushed value. In general, the team seeks companies with manageable debt levels, good returns on capital, and some kind of sustainable competitive advantage. That last factor could be an oligopolistic industry structure where the company is a market leader, or high switching costs for customers to stop buying the company’s products, O’Connor says.
In American Eagle Outfitters’ case, quality emerges not only from its strong position in denim, but its liquidity. The company has two dollars a share in cash on its balance sheet, O’Connor says. He notes: “Balance sheets are very important in retail because retail companies can get in trouble very quickly.”
The fund’s 13.8% allocation to consumer-discretionary stocks, which includes retail, exceeds the Russell benchmark’s 9.1%. So does its 11.5% tech weighting, versus the benchmark’s 7.6%. Yet the fund’s tech holdings aren’t the typical market darlings. Early in 2019, Trivedi started buying shares of Leidos Holdings (LDOS), a government information-technology services contractor. After a merger with a Lockheed Martin (LMT) unit in 2016, the company streamlined its bidding practices for government contracts. “We see a company that is well diversified between different government agencies, whether it’s civil versus defense versus intelligence,” Trivedi says. Leidos “is winning more than its fair share of government contracts” and building a backlog of them.
Currently, the fund’s largest sector weighting, though, is in industrial stocks, which account for 25.4% of its portfolio. Hexcel (HXL) is a typical Cooke & Bieler industrial investment, O’Connor says. It is a dominant player in a small but essential part of the supply chain for a much larger industrial process—manufacturing airplanes. “Hexcel makes lightweight, high-performance, structural material out of carbon fiber,” which is used in the housing of engines to increase their efficiency and reduce noise, he says. The stock benefits from the industry’s oligopoly structure, O’Connor adds: “There’s a lot of R&D required and strict aerospace qualifications that are involved in getting your materials to be used in airplanes.”
Boeing (BA) and Airbus (EADSY) are major Hexcel customers. But because of safety problems with Boeing’s 737 MAX jet—which was grounded last year after two deadly crashes—Hexcel stock has become cheap. Hexcel’s products are vital to both companies, and Boeing’s loss likely will be Airbus’ gain as airplane manufacturing shifts. Either way, Hexcel profits.
That kind of sturdy business model is exactly what makes the cheap stocks in the fund more resilient than those of its peers, and should come in handy when the next downturn finally arrives.
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