FICS Editors' note

Mid-cap stocks can be riskier and more volatile than larger stocks. Do your research or consult an adviser before deciding if they’re right for you.

The case for E*Trade stock, according to a mid-cap fund manager

  • By Sarah Max,
  • Barron's
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

It’s easy to lose perspective when your assets under management are counted in billions, and even modest market swings amount to daily losses or gains in the tens of millions.

Working for a firm whose aim is to “help people be wise with money and live generously” offers a regular reality check. “There are people who have $5,000 in our fund, and they are counting on us every day to manage that money like it is our own,” says Brian Flanagan, lead manager of the $2.1 billion Thrivent Mid Cap Stock fund (AASCX), which has returned an average of 9.8% a year over the past 15 years, better than 98% of its mid-cap blend peers.

Flanagan, whose tenure with the fund is also 15 years, aims to identify medium-size companies that are positioned to improve their return on invested capital or, in the case of companies that have exceptional ROIC, maintain it. The mid-cap space offers a large and varied universe for finding companies that are typically more evolved than small companies—with proven management teams and multiple business cycles behind them—and potentially have more opportunity for growth than their larger peers. “You kind of get the best of both worlds in the mid-cap space,” Flanagan says.

To improve the odds for outperformance, Flanagan and his two co-managers tilt the portfolio between value and growth, depending on the market cycle. There are times, namely early in a recovery, when there are true bargains to be had, and other times, typically late in the cycle, when cheap stocks are usually priced as such for a reason. “Looking at the spread between value stocks and growth stocks gives clues about whether seemingly cheap stocks are truly bargains or potential value traps,” he says.

Born and raised in Appleton, Wis., Flanagan got his bachelors and masters in finance at the University of Wisconsin, and went to work in the investment department of an insurance company in Milwaukee. Then an opportunity opened up to work as a fixed-income analyst at what is now Thrivent Mutual Funds, based in Minneapolis. While the firm is affiliated with Christian membership organization Thrivent Financial, its funds are available to all investors. The $18 billion fund shop recently ranked No. 4 in Barron’s annual Best Fund Families, thanks largely to this fund’s category-leading returns last year.

To identify names for the 50- to 60-stock portfolio, Flanagan and his co-managers combine their own bottoms-up analysis, which is supported by a deep bench of 20 equity researchers, with a quiver of more than a dozen quantitative screens. The screens, run monthly, score stocks based on valuation, capital deployment, earnings quality, and market dynamics.

Given that the U.S. economic cycle is looking long in the tooth, Flanagan and his team are inclined to pay a little more for higher quality companies right now. That is, unless there is a catalyst, such as new management, a key acquisition or a breakthrough product, or widely held misconceptions about a stock or sector.

Flanagan thought the last was the case with financials a few years ago. While the consensus view was that more-stringent capital and liquidity requirements equaled less profit, Flanagan saw the positive: “While they may grow a little bit less than historically, we also thought they were safer than they were historically,” he says.

The team focused on midsize banks with the best potential to improve their operations and increase their market share. That included what is now a top holding, Zions Bancorporation (ZION), which was trading around $27, or less than its tangible book value, when the fund first bought in 2015. The team liked the Salt Lake City–based bank because its nearly 450 branches are in growing Western markets, and there were opportunities to reduce costs by automating more of the loan-approval process and consolidating multiple bank charters. The bank has since made those changes, helping boost return on equity from the high-single digits to nearly 15% today.

Around that time, the team also increased the fund’s position in San Francisco–based First Republic Bank (FRC). The investment thesis was simply that First Republic would continue to do what it was already doing. “They are myopically focused on customer service, and they have an incredible platform to attract high-net-worth clients, service those clients, and get those clients to own many products across the bank’s portfolio,” says Flanagan, noting that the bank grew its loan business by an impressive 20%.

Two things sparked Flanagan’s interest in E*Trade Financial (ETFC) a couple of years ago. “The first thing was it had an attractive valuation,” he says. “The second thing was they had a plan for improving their return on invested capital.” In 2017, the company announced its 2018 acquisition of the Trust Company of America, which provides custodial services to registered investment advisors. This was a critical move, says Flanagan, because although E*Trade has a successful corporate-services arm that manages employee stock options, it was losing business when employees vested their options and sought professional advice. “E*Trade didn’t have an advisor platform to turn over those customers,” he says. The company has since boosted its return on equity from 10% in 2017 to what Flanagan figures is at least 16% today, but at a recent share price of $49, it is trading for less than 10 times 2020 consensus estimates.

Home-furnishings company Restoration Hardware, now renamed RH (RH), also has a plan for improving profitability. RH has retooled its business model by, among other changes, replacing regular promotions with a membership model in which customers pay $100 a year for 25% discounts. The change has dramatically improved its inventory and supply-chain management, says Flanagan, and puts RH on a path to nearly double its operating margin from 7% in 2017 to 13% this year.

“They own the product development, the product distribution, and the customer relationship,” says Flanagan, who added the stock to the fund last spring. So, while many retail companies are at risk for being “Amazon-ed,” RH has built itself a comfy competitive moat.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

For more news you can use to help guide your financial life, visit our Insights page.


Copyright © 2019 Dow Jones & Company, Inc. All Rights Reserved.
Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.