Inside Wall Street: Why Volatile Times Call for Mid-Cap Value Stocks

Yes, fundamental research is still valid and valuable -- despite the market's vulnerability to turbulence. And we've seen plenty gut-wrenching moves lately, thanks largely to massive high-speed computerized trading. Buteven when frenzied volatility is the order of the day, relying on opportunistic strategies and research based on well-grounded metrics such as earnings power, growth and valuation invariably protects portfolio gains over the long haul and preserves investor sanity.

For instance, some investors were shaken by the Dow's nearly 300-point plunge last week even as they tried to survive the market onslaught. But portfolio managers Peter A. Zuger and Donald E. Cleven of Lee Munder Capital Group, which utilizes a classic value-driven fundamental investment process, stuck to their guns during the downswing, arguing that stocks that pass the managers' own in-depth research and analysis to identify attractively priced securities should prevail

They cite as an example the performance of Touchstone Mid Cap Value Fund (TCVAX), of which Lee Munder Capital is an adviser. Since its inception on Sept. 30, 2009, this fund has outscored its benchmark, the Russell Mid-Cap Value Index.

Most Portfolio Managers Are Underweight in This Group

Zuger and Cleven point out that "mid-cap value" stocks with market capitalization ranging from $1.5 billion to $14 billion have outperformed "all other classes of assets over the long term." It's the group, they argue, that usually produces huge potential gains over the long term in any kind of market environment.

Using the Russell indexes as proxies, they note that the Russell Mid-Cap Value Index outscored the other Russell indexes in annual returns from 1985 through 2009, with an annualized gain of 11.4% vs. the 9.9% gain by the Russell Mid-Cap Growth Index, and the 9.6% return by the Russell Top-200 Value Index. Zuger defines value stocks as companies with long-term growth prospects that trade inexpensively based on various metrics, including price-to-sales and price-to-capital ratios and free cash flow.

Portfolio managers are generally underweight or underinvested in mid-cap stocks and more so in "mid-cap value" stocks, according to Zuger and Cleven, even though these stocks exhibit considerably less volatility on a relative basis than large-cap value or so-called growth stocks. Mid-cap companies generate more growth and have less-complex business models, argue Zuger and Cleven. Their pitch: "Our rigorous fundamental analysis focused on return on invested capital, cash flow, balance sheet strength and valuation provides our portfolio with healthy upside potential -- with limited downside risk."

Three Stocks That Fit the Bill

So which companies currently classified as "mid-cap value" do they now see as attractively valued? Three that Zuger and Cleven favor are Avery Dennison (AVY), a major maker of radio-frequency identification labels (RFIDs); Cintas (CTAS), which rents out workplace uniforms to manufacturing and service companies; and Comerica (CMA), a Dallas-based bank holding company with operations in the U.S., Mexico and Canada.

Avery Dennison, the biggie in RFID labels that help retailers electronically track their inventories, trades at $34 a share, or 7.5 times its earnings before interest, taxes, depreciation and amortization, notes Zuger. He figures the stock, which pays a dividend yield of 2.3%, is worth $50 a share. The RFID business is a "growth opportunity" for the company, says Zuger, more so when the economic recovery starts gaining traction.

Cintas, whose uniforms help companies promote their identity and brand, has been hurt by high unemployment levels. Its fiscal fourth quarter (ended May 30) revenues rose roughly 4%, while earnings fell 8%. But management issued an optimistic outlook for 2011 based on what it sees as a gradual economic recovery. Management forecasts revenues to rise to a range of $3.55 billion to $3.75 billion and earnings of $1.50 to $1.58 per share.

Although the consensus analysts' profit estimate is $1.60, Zuger and Cleven forecasts are higher, at $1.55 to $2 a share. They note that the company continues to cut costs, and with its "strong cash flow and solid balance sheet, they expect Cintas to recover faster than expected. Now trading at $26 a share with a dividend yield of 3.2%, the stock is worth $38, according to Zuger.

Fundamentals Matter

Comerica, with 436 branches in the U.S., mainly in California, Texas, Florida and Michigan, and a total of $40.2 billion in deposits, is expected to restore paying dividends in the first quarter of 2011. Zuger says the bank's credit quality is steadily improving, and with its stock down to $36 a share from a 52-week high of $48 on Apr. 21, 2010, Comerica is now attractively priced.

It posted better-than-expected second-quarter results, reflecting improving credit quality, says Terry J. McEvoy, analyst at Oppenheimer. The bank's "financial strength puts Comerica in a favorable position to participate in future M&A opportunities in Texas and California," adds McEvoy, who rates the stock as outperform with a 12-month price target of $50.

A variety of problems will always batter the market over time, but Lee Munder Capital's Zuger and Cleven maintain that for the long term, few if any investment process can outdo a "disciplined classic value strategy focused on strong companies" that get buffeted by transitory, near-term woes.

No doubt, fundamentals determine stock prices. So rigorous fundamental analysis focused on high return on invested capital, cash flow strength, a clean balance sheet and low valuation, Zuger insists, is unbeatable even in times of stressful market volatility. Like now.