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Mid-cap stocks are oftenunfairlyoverlooked. In a coronavirus-stricken economy where giant tech companies keep powering the market higher as small companies struggle to survive, mid-caps are an excellent compromise. They generally have lower valuations than the most beloved blue chips and stronger businesses than the small fries.

In fund tracker Morningstars Mid-Cap Blend category, the $552 million Madison Mid Cap fund (ticker: GTSGX) is one of the best. The no-load fund has beaten 95% of its category peers in the past three years and 85% of them in the past 15. Equally important, it is less volatile than its Russell Midcap benchmark, while matching the indexs 11.8% average annual return in the past 10 years. (Although officially this Y-share class of the fund has a $25,000 minimum investment, brokers such as Fidelity, Charles Schwab, TD Ameritrade, and E*Trade allow clients to get into the fund with an investment of $2,500 or less.)It has an expense ratio of 0.95%.

Manager Rich Eisinger, 55, has been at the helm since 1998, but he also relies on Haruki Toyama, co-manager since 2015, and Andy Romanowich, co-manager since 2019. Eisingers connection with Toyama, 49, goes way back. They first met at an investment club in the 1990s at Cornell Universitys business school, and both were Warren Buffett fans. We showed up at a room for new club members, and this fellow student got up, and started talking about options this and options that, and Rich and I kind of looked at each other and were like, Whats this guy talking about? We just want to buy great companies at a cheap price, Toyama recalls. They have been friends since then, swapping investment ideas, going on research trips together, and sharing investment philosophies.

Eisingers investment style, like Buffetts, has evolved from a more traditional value approachseeking cheap stocksto trying to invest in great businesses with strong durable cash flows. Over time, weve realized, especially in the mid-cap space, the value of paying up for a great business and watching that free cash flow compound over many years, Eisinger says. Madison Mid Cap tends to hold stocks for the long termthe funds turnover ratio is 25%, indicating a typical holding period of four years. Forty percent of our portfolio weve owned for over a decade, Toyama says.

The fund is also concentratedanother Buffett hallmarkhaving just 29 stocks as of Sept. 30. Concentration increases individual stock risk, as any blowups in a 5% position hurt returns more than a 1% one, for instance. But the funds volatility is low, despite its small number of stocks, reflecting the high quality of its holdings and the rarity of individual company blowups.

To make it into the portfolio, a company should have a strong business model with an economic moat that prevents competitors from reducing profits. It must also have a superior management team with preferably strong insider ownership, conservative accounting and earnings projections, and a history of wise capital-allocation decisions regarding share buybacks, acquisitions, and debt repayment. Finally, the valuation must be reasonable for a strong business.

Note: Holdings as of Sept. 30. Returns through Oct. 26; all returns are annualized.

Sources: Madison Funds; Morningstar

Health-care diagnostics company Laboratory Corp. of America Holdings (LH), commonly known as LabCorp, exemplifies the funds buy-and-hold strategy. Were in the 17th year now of ownership, Eisinger says. LabCorp and Quest Diagnostics (DGX) are the two largest clinical diagnostics labs in the country, controlling 25% of the independent lab business, he says. Eisinger sees a long runway for earnings growth between 10% to 11% a year because LabCorp is the low-cost provider of diagnostic tests relative to hospital labs. Theres more emphasis on [health-care] cost containment than theres ever been, so [LabCorp] is going to start gaining more market share in the next decade.

Moreover, in 2015 LabCorp acquired drug developer Covance, which specializes in personalized medicine, such as targeted gene therapies. Covance can utilize LabCorps huge database of patients to get candidates for their drug trials and their drug development, Eisinger says. That patient access should give Covance an advantage in the burgeoning personalized medicine business.

Another favorite, property and casualty insurer Arch Capital Group (ACGL), has a CEO, Marc Grandisson, who embodies the Buffett-like qualities that the fund managers seek. In fact, in the 1990s, Grandisson actually worked at Berkshire Hathaway (as did his predecessor, Constantine Iordanou, who is now retired). Under Grandissons aegis, Arch has been an excellent capital allocator and one of the few insurers to make a profit from its policy underwriting, Toyama says. Historically, the industry has lost money underwriting, and made it up in investments, he says, referring to how insurers typically use money from policy premiums to buy bonds and stocks.

Archs insurance underwriting has been successful because Grandisson is willing to walk away from business when a policy type becomes less profitable or commodity-like due to competition, Toyama says. It has decreased its major casualty insurance business over the years as it got more price competitive, he explained. The companys stock has taken a shellacking in 2020, down 29%, because of claims related to Covid-19. But it is precisely after such calamities that insurance premiums go up and profitability increases, Toyama says. The fund is staying put.

Typical of a high-quality mid-cap portfolio, many of the funds holdings are industry leaders but not household names. So 16% of its portfolio is in technology, but not in the Amazon.coms (AMZN) of the world. Instead, the fund invests in companies like tech research publisher and consultant Gartner (IT).

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Gartner has a very attractive business model in that its core product is a written research service that is sold on a subscription basis, Romanowich says. So, it has very visible, highly recurring revenue. The company has a major advantage as the leading research intermediary between tech buyers and sellers, he says. Gartner knows what end users want, and what corporations tech road maps look like. They also know what tech vendors are thinking and what their technology road maps look like.

That informational advantage provides an economic moat any Warren Buffett fan would admire.

Write to editors@barrons.com

Read more from the original source:
This Mid-Cap Stock Fund Wins With Warren Buffetts Strategy - Barron's

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