As the debate over large-cap stocks vs. small-cap stocks continues, Robert Lanphier and David Ricci of the William Blair Mid Cap Growth Fund are taking the middle road. They believe mid-caps provide investors with the best of both worlds. Mid-cap companies are nimble enough to achieve fast growth rates like small-caps, yet established enough so that a momentary economic setback doesn't overturn their apple cart.
"The earnings growth rates are not dissimilar to small-caps, but the volatility profile is much more similar to large-caps," Lanphier says.
A mid-cap company - one whose market capitalization is between $1.5 billion and $14 billion - is less tied to the economy's growth than a large company is, Lanphier explains. When the economy is sluggish, the ability of such firms to be in control of their financial destiny provides the managers a measure of reassurance. And mid-caps can be acquisition targets of large firms needing to juice their growth. "But unlike a small-cap, if any one individual gets hit by a bus, that company doesn't implode," Lanphier says.
The duo also seeks the middle ground between growth and value, looking to bulk up on fast growers when they're on sale. "We like companies that are 'growthy,' but we don't want to overpay for them," Ricci says.
Lanphier started William Blair's mid-cap growth strategy in 1997 and introduced the mutual fund six years ago. In all, the team manages $2.6 billion in that style.
Their approach has led the mutual fund to superior performance, especially in difficult market climates. Over the past three years through Feb. 7, the fund returned an average of 23.4% a year and placed in the top 30% of mid-cap growth funds, according to Morningstar; over the past five years, the fund is up 6.2%, landing in the mid-growth category's top 13%.
PIECING IT TOGETHER
To find the 60 or so names for the fund, Lanphier and Ricci look for firms with low debt, high return on capital, strong management (the pair spend two days a week meeting with managers), sustainable business models with high barriers to entry and recurring revenues.
They are less focused on identifying fast-growing sectors than on finding companies that can dominate their industries. In fact, some of the portfolio managers' best ideas do not reside in what are traditionally considered growth sectors. Technology and biotech do not rule at this fund; instead, industrials and consumer cyclicals do, largely because Lanphier also heads up William Blair's industrials research team.
One stock with characteristics that the managers crave is Fastenal, a distributor of nuts, bolts and drill bits based in Winona, Minn. "Talk about a mature category," Lanphier says. "This is a firm that's in a very mundane commodity business."
But what allows Fastenal to grow year after year, Lanphier says, is its service model, and that is a result of innovative management. Fastenal allows its store managers to pick inventory and set prices locally. "The branch in Oklahoma City that's serving the energy markets may have different needs than the branch in Minnesota that's serving the paper market," Lanphier says.
Nonetheless, managers are expected to meet profit thresholds. While nuts and bolts may seem like a nongrowth lineup, Fastenal is indeed growing robustly. The company logged a year-over-year earnings gain of 34% in 2011, and its shares were up 47.8%.
Similarly, CarMax puts the used-car buying experience in a different gear. Through its network of dealerships, CarMax is able to transform that experience into something bordering on pleasant. The company uses a deep research approach to determine the correct price of used cars. Its franchise of stores provides an inventory that is much bigger than a single lot. And a generous return policy assures buyers that they're purchasing the right car for them.
Though CarMax has only a 2% to 3% share of the used-car market, Lanphier and Ricci believe that this highly fragmented industry, run mainly by mom-and-pop enterprises, is ripe for a smooth operator like CarMax to swoop in and gain share.
As good as CarMax's results have been, it struggled during the recession, as car-buying stalled. The firm posted earnings of 36 cents a share on $2.2 billion in revenues in the third quarter of the 2012 fiscal year, 2 cents shy of expectations. The stock was down 4.4% in 2011.
Another way companies can protect their profits is by establishing themselves in industries that are difficult for potential competitors to enter. That has been the case for Stericycle, which collects and disposes of medical waste.
Again, medical waste is not a terribly glamorous business, but that's just the point, the portfolio managers say. The sector deals with government regulations on how medical waste should be handled, and these rules only get stricter. Most medical providers would rather not undertake this task themselves, so they outsource it.
"Here's a company that at once has incinerators and a driver that can collect the waste," Lanphier says. "And it can do it in a much more cost-effective method than a hospital or a clinic could do on their own," Lanphier says.
Further, Stericycle uses long-term contracts with built-in price increases. This business model insulates the company from any changes coming to the health care industry as a result of new laws. "There's no reimbursement risk associated with these guys," Lanphier adds. Over the last 12 months, Stericycle returned 5.7%, ahead of both the stock market and the waste management industry.
NEW WAYS TO GROW
Another type of company Lanphier and Ricci favor is one that's creating new ways to grow. One such player is Green Mountain Coffee Roasters. Coffee is a mature market, yet Green Mountain, based in Waterbury, Vt., transformed itself from a purveyor of coffee to a peddler of the single-serve coffee pods that are now a mainstay of the workplace break room. Since its 2006 acquisition of Keurig, Green Mountain has grown primarily through its K-Cup sales. A deal with Starbucks in 2010 to sell the coffee giant's product in the cups increased sales further. "The K-Cup is giving the category a whole new avenue of profit growth that consumers are willing to pay for," Ricci says.
Lanphier and Ricci are probably good judges of success in the coffee business, having earlier scored big with another coffee stock. They were early investors in Starbucks because they were impressed with management's ability to charge ever-higher prices for the company's goods. They rode Starbucks all the way to large-cap land, when it unfortunately grew too big for the portfolio.
"What we loved about Starbucks was that they had the flexibility to raise prices," Lanphier explains. "And that 10-cent raise on a cup of coffee went straight down to the bottom line."
They see those same qualities at Green Mountain. But the road to success isn't always smooth. Last fall, hedge fund manager David Einhorn of Greenlight Capital criticized Green Mountain's accounting and recommended shorting the stock. The shares are down 41% since their peak in mid-September. Still, at $66.27 on Feb. 7, the stock was up 67% for the previous 12 months.
William Blair Mid Cap Growth
Credentials: B.S. in management, Purdue University; MBA, Northwestern University
Experience: Portfolio manager, William Blair Mid Cap Growth (2006-present); principal, William Blair & Co. (1987-present); director of international marketing, sales and service, Emerson Electric (1986-1987); strategic planning and international business development, Emerson Electric (1982-1986); assistant vice president for operations, Mellon Bank (1979-1981)
Fund inception: February 2006
Style: Mid-cap growth
AUM: $261 million
Three-year performance as of Feb. 7, 2012: 23.4%
Five-year performance as of Feb. 7, 2012: 6.2%
Expense ratio: 1.35%
Front load: None
Min. investment: $5,000
Alpha: 5.57 vs. S&P 500
Ilana Polyak, a New York writer who contributes regularly to Financial Planning, has written for The New York Times, Money and Kiplinger's.