Updated with third-quarter numbers reported by BB&T on Oct. 18.
Investors are often impressed with a “big idea” while forgetting to consider how much they are actually paying to buy a company’s stock.
This approach can help you pick a winner in a rapidly growing industry, but it can also cause your portfolio to underperform over the long term. Value-based stock selection strategies have tended to trail growth strategies during the bull market, but their lower risk can increase overall returns over very long periods.
Indeed, diversifying your portfolio by investment selection approach and company size be worthwhile during this period of increased volatility, as it may lower your risk and improve your overall long-term results.
In his annual letters to shareholders, Berkshire Hathaway BRK.B, -0.86% BRK.A, -0.63% CEO Warren Buffett always talks about compounded growth rates — the seemingly magical result of the time value of money. (You can, and should, read Buffet’s annual letters.)
Risk is not inherent to an asset. It is related to what you pay. You can overpay very easily for a great neighborhood and a great house. John Mowrey, co-manager of the AllianzGI NFJ Mid-Cap Value Fund
Building on this idea, “if you dampen volatility, it increases your ability to compound over time,” according to John Mowrey, chief investment officer for value equity strategy with Allianz Global Investors. He co-manages the AllianzGI NFJ Mid-Cap Value Fund PRNIX, -1.13% which has $1.3 billion in assets and has a five-star rating (the highest) from Morningstar for its institutional shares. The fund’s class A shares PQNAX, -1.14% are rated four stars by Morningstar.
Mowrey’s team is headquartered in Dallas and manages about $13 billion in mutual funds and private accounts. Allianz Global Investors manages about $600 billion in assets globally. It and Pimco are subsidiaries of Allianz SE AZSEY, -1.20% ALIZF, -1.25% ALV, +0.74%
Strategy
“There are great companies and good investments. It is easy to overpay for great companies, as investors did [during the dot-com bubble] in the late 1990s,” he said in an interview on Oct. 15.
As an example, he said, “Amazon is a great company. The question is, are people overpaying?”
Amazon.com AMZN, -3.33% has been an amazing performer over the long haul, even though the stock tend to trade at a very high level to earnings. The shares have returned an incredible 3,483% over the past 10 years, according to FactSet, compared to a total return of 270% for the S&P 500 SPX, -1.44%
But Amazon is now trading for 76.3 times the consensus earnings estimate for the next 12 months among analysts polled by FactSet. That compares to a forward price-to-earnings ratio of 16.2 for the S&P 500. While no one can say with certainty whether Amazon will continue to be one of the stock market’s best performers, there’s no question that it is an expensive stock.
Mowrey’s strategy for the AllianzGI NFJ Mid-Cap Value Fund is to hold about 100 equally-weighted stocks in various industries. The companies are worth between $3 billion and $39 billion, putting Amazon, for one, out of reach.
The team excludes those that don’t pay cash dividends on common shares and those that are losing money. Perhaps surprisingly, about 26% of companies included in the Russell 2000 Index were unprofitable during the first quarter, according to Bloomberg data cited by Mowrey.
After making a first cut and “applying more quantitative tools,” Mowrey’s team drills into about 150 industry subsectors to make sure of a broad selection. Some industries are more likely to be included than others. Biotechnology companies, for example, often trade at high valuations or show negative earnings as they research new treatments. They are also less likely than companies in other industries to pay dividends, so they are likely to be excluded from the fund.
Mowrey emphasized the importance of the midcap strategy, in light of most the asset management industry’s trend toward large-cap and small-cap strategies. Mowrey believes this is a poor approach because “midcap tends to have a higher return relative to volatility.”
He cited long-term statistics from Bloomberg to emphasize “the sweet spot” between risk and return for midcap stocks:
From the end of Q1 1979 through Q1 2018 Average annual return Standard deviation Mega-Cap (Russell Top 200) 11.40% 14.74% Large-Cap (S&P 500) 11.85% 14.81% Midcap (Russell Midcap) 13.33% 16.43% Small-Cap (Russell 2000) 11.64% 19.21% Source: AllianzGI using data provided by Bloomberg.
Granted, this is a very long time period, but it makes the case that midcap stocks should be included in a diversified portfolio.
Going a bit deeper, Mowrey said that for dividend-paying stocks among the Russell Midcap Index, the average annual return from the end of 1996 through the end of 2017 was 12.7%, while the average return for those that didn’t pay dividends was 9.7%. Standard deviation, a measure of price volatility, for the dividend payers was 16.6%, annualized, compared to a standard deviation of 24.2% for the non-dividend payers, he said — another sweet spot.
Fund holdings
With a strategy of holding about 100 stocks with equal weighting, a top-10 list for the fund’s portfolio would simply show which stocks had performed the best lately and are mostly likely to be trimmed to maintain the portfolio’s balance. So Mowrey named five representative holdings of the fund. You can click on the tickers for more information about each company, including news and financial information:
• Dollar General DG, -0.77% trades at a forward P/E ratio for 16.8, according to FactSet. The shares have returned 21% this year through Oct. 16. The company’s sales for the quarter ended Aug. 3 were up 11% from a year earlier, while same-store sales rose 4%. Its earnings for the quarter improved to 29 cents a share from 26 cents a year earlier.
Mowrey described the company as “somewhat immune to the threat from Amazon; they cater to a group that may not quickly hop on Amazon Prime.”
• Kansas City Southern KSU, -1.28% has a forward P/E of 15.3 and the stock is up only 1% this year with dividends reinvested. Second-quarter revenue was up 4%, while EPS improved to $1.45 from $1.27.
“We picked it up around NAFTA fears last year,” Mowrey said.
President Trump’s new agreement with Mexico and Canada, assuming it is ratified by each country’s legislature, is far better for railroad operators (and trucking companies) than a continuing disagreement over North American trade. Mowrey said KSU was particularly attractive as “one of the smaller operators in the space.”
• Kar Auction Services KAR, -1.86% provides a service that is increasingly important as more and more leased cars in the U.S. are returned to dealers. The stock has returned 18% this year and trades at a forward P/E of 18.0, which Mowrey said is down from 20. Second-quarter revenue was up 11%, while EPS increased to 69 cents from 41 cents a year earlier.
Mowrey said Kar has advantages because “the car auction market does not have new entrants coming in,” and that “there is less margin pressure than in other businesses.
• Mowrey said “some of the regional banks look particularly attractive here, with healthy net interest margins [NIM] and balance sheets.” At this point in the economic cycle, loan quality is very unlikely for any large regional bank.
One regional lender he named is BB&T BBT, +1.19% of Winston-Salem, N.C., which had a third-quarter NIM of 3.47%. The stock trades at a forward P/E of 11.2 and is down 3.2% this year. The dividend yield of 3.44% is, by far, the highest among the five stocks Mowrey named. BB&T’s third-quarter return on average assets (ROA) was 1.49%, unchanged from the previous quarter but up condsiderably from 1.16% a year earlier. The bank’s return on average common equity (ROCE) was 11.69% for the second quarter, down slightly from 11.74% the previous quarter but improving from 8.82% a year earlier.
• Mowrey also mentioned M&T Bank MTB, -0.70% of Buffalo, N.Y., which had third-quarter NIM of 3.88%. The stock is down 6% this year and trades at a forward P/E of 11.9. The company recently increased its quarterly dividend to a dollar a share from 80 cents, for a current yield of 2.52%, and Mowrey is also impressed with M&T’s plan to repurchase $1.8 billion worth of shares through the second quarter of 2019.
M&T’s third-quarter ROA was 1.80%, compared to 1.70% the previous quarter and 1.18% a year earlier, while its ROCE also improved, to 14.08% for the third quarter from 13.32% in the second quarter and 8.89% during the third quarter of 2017.
Fund performance
The AllianzGI NFJ Mid-Cap Value Fund has several share classes. The two that probably offer the best value to most investors are the institutional shares PRNIX, -1.13% with total annual expenses of 0.64% of assets (considered “low” by Morningstar) and the class A shares PQNAX, -1.14% with an annual expense ratio of 0.99%. Morningstar lists a $1 million account minimum for the institutional shares, but there’s a good chance that your broker can offer you the shares at their own much lower minimum. The Class A shares have a maximum sales charge of 5.50%. Many brokers and investment advisers have arrangements with AllianzGI through which the sales charge is waived.
Here’s how the institutional shares and the class A shares (excluding sales charges) have performed for various periods, against the Russell Midcap Value Index and their Morningstar category:
Average annual returns through Oct. 16 1 year 3 years 5 years 10 years 15 years AllianzGI NFJ Mid-Cap Value Fund - Institutional PRNIX, -1.13% -0.6% 12.1% 10.2% 14.1% 8.4% AllianzGI NFJ Mid-Cap Value Fund - Institutional - class A PQNAX, -1.14% -1.0% 11.7% 9.8% 13.7% 8.0% Russell Midcap Value Index 3.8% 9.6% 9.3% 13.9% 10.1% Morningstar Mid-Cap Value category 3.9% 9.2% 8.0% 12.7% 8.5% Sources: Morningstar, FactSet
Also see: Here’s a dividend-investment strategy designed to outperform in down markets
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