Publications

- May 1, 2017: Vol. 4, Number 5

Staking Out the Middle: Fairpointe Capital CEO Thyra Zerhusen and co-CEO Mary Pierson have proven how sweet mid-cap equities can be

by Mike Consol

During the early 1990s, a Panamanian pitching phenom broke into the big leagues in none other than New York Yankee pinstripes. The rap against the tall, lean right-hander was that he threw one — and only one — pitch called a “cut fastball,” or “cutter” for short. The baseball pundits sneered. Among them was Keith Olbermann, one of the premier sportscasters and commentators of the era. How, they mused, could anyone possibly build a successful Major League pitching career throwing just one pitch to the greatest batters in the world? Surely batters would decode the repetition of his delivery and turn him into a historical baseball footnote.

That individual turned out to be relief pitcher Mariano Rivera, widely considered the greatest closer in Major League Baseball history, and a shoo-in for the Baseball Hall of Fame at Cooperstown, N.Y.

There you have it, another baseball analogy, that most overused of rhetorical tropes. Still, there was no avoiding the Mariano Rivera association when speaking with Fairpointe Capital CEO Thyra Zerhusen and co-CEO Mary Pierson, whose equivalent to the cut fastball is the mid-cap segment of the stock market. Zerhusen, the firm’s chief investment officer, and Pierson, portfolio manager (along with portfolio managers Marie Lorden and Brian Washkowiak), are focused on mid-caps. While most investment managers have constructed portfolios dominated by large- and small-cap shares — reasoning that big and small publicly traded companies sufficiently straddle the market — Zerhusen and Pierson demur, contending that mid-caps are the sweet spot, sporting companies that have matured beyond the volatile early stage, yet are still young enough or well positioned enough to offer the kind of tremendous upside potential that many large-caps have experienced already and are unlikely to encore for shareholders.

“The problem is that some institutional consultants don’t allocate to mid-cap,” Pierson says. “The mid-cap market is not a very well understood designation, so it’s overlooked.”

Pierson believes U.S. mid-cap equities should represent the core component of any U.S. equity investment portfolio because, over time, mid-caps have outperformed their larger and smaller peers.

Buttressing their argument is a track record of performance that landed CIO Zerhusen on a 2010 cover of SmartMoney alongside Warren Buffett. The magazine dubbed Zerhusen among “the world’s greatest investors” for two consecutive years.

Though Zerhusen and Pierson do not play at the titanic AUM stratosphere occupied by the Oracle of Omaha, their $5.5 billion firm has racked up annual gains that, when averaged over the course of the most recent 14 years, have outperformed the S&P 500, as well as 90-plus-percent of their mid-cap peers, according to Morningstar rankings. Even during 2001, when the Sept. 11 terror attacks chopped the market off at the knees, Fairpointe’s portfolio rose 15 percent, while the S&P 500 went into a 12 percent retreat.

“How do you like that?” Zerhusen quips, with a dash of playful hubris. “We look really good in long-term performance. We are beating our Morningstar benchmark by quite a bit, and we also beat Berkshire Hathaway by quite a bit.”

Zerhusen, whose first name is pronounced “Tura,” is committed to challenging the maxim that no investor can outperform the market over the long term, and she argues that since 1999 Fairpointe Capital has done exactly that.a

“We don’t do it every year,” she says in a marked German accent that is one of her hallmarks. Indeed, the mid-cap strategy plunged 43 percent during 2008. “But we came back with a vengeance in 2009, when we were up 65 percent.”

More bragging rights come in the form of a foundation whose assets Fairpointe Capital has managed since 2002, at which time they totaled less than $10 million. Over the past 15 years, the foundation has pulled $15 million to meet operating requirements. The foundation still has more than $11 million left in its investment coffers.

MEET US IN THE MIDDLE

The stocks in Fairpointe Capital’s mid-cap portfolios are companies with market capitalizations of $2 billion to $26 billion, mirroring the cap range of the Russell Midcap Benchmark. Companies such as Apple Computer, Monsanto and Yahoo have moved through Fairpointe portfolios during their ascension to the large-cap space. A more recent homerun has been Nvidia, which Fairpointe owned through its mid-cap tenure and now touts a market capitalization of more than $50 billion. Originally selected by Zerhusen when it was trading at $11 per share, the designer and manufacturer of semiconductors for high-speed computing now trades at around $105 per share.

Among the firm’s current largest holdings are Juniper Networks, Stericycle, Time Inc., TEGNA Inc. and Varian Medical Systems.

“We are fundamental long-only equity managers,” Pierson explains. “Our investment horizon is three to five years, and our holding period is now more than five years, on average. So we have very low turnover compared to a lot of other equity managers, and our longer-term investment horizon is one of the key factors that underpins our bottom-up approach. We’re looking to invest in companies that are going to thrive over an entire business cycle. In other words, companies with vital technologies and services that are durable enough to withstand business cycles.

“We’re not looking to time the market.”

But the team will take a fast, hot return when it finds one. A prominent example is when Fairpointe bought a position in Dow Jones & Co. for about $32 per share back in 2007. Just months later, while Zerhusen was traveling in Europe, she got a call saying the stock had spiked by 55 percent on the strength of a $5 billion buyout bid by Rupert Murdoch. She quickly sold shares and raked in a whopping return.

“That was a great year,” she says.

Z FORMULA

Zerhusen’s method as a stock-picker is to eschew companies heavy with debt and to be “value conscious,” catching companies while their shares are “inefficiently priced,” meaning they might have experienced a short-term problem that shrank share value well below the company’s valuation history relative to other companies in its industry and relative to the S&P 500.

“One thing we apply in terms of valuation would be a relative P/E — the P/E of the company versus the P/E of the S&P 500,” she says. “That has worked for me really well over longer periods, especially if you have a longer-term outlook.”

Also taken into account is the price-to-revenue ratio.

“We need an attractive valuation,” Zerhusen remarks. “We like good balance sheets, and we sit down with management. Because we are long-term holders in most of these stocks, we have repeated meetings with them. They know us.”

When a new stock is selected for the portfolio, Zerhusen will often stake out a small position and opportunistically add to the position. During that period, she is likely to size up management by listening to their conference calls with securities analysts.

Both Zerhusen and Pierson refer to the enormous amount of easily accessible data today versus pre-Internet days.

“But is the data actually information?” Pierson muses. “I think it's not always information. Incremental data doesn't always change our view second to second.”

Zerhusen adds: “There’s so much noise.”

In addition to the data and the noise, there is an element of intuition that comes into play for Zerhusen. “A past boss once said that I had the ability to know who can be trusted and who cannot,” she recalls. “This has been an asset when evaluating management teams”, Pierson added.

GO SMALL OR GO HOME

Fairpointe Capital, located on North Franklin Street in Chicago, is a 15-person firm and that works to its favor, according to Pierson. Because the organization has a limited number of accounts, the team can focus on research and dedicate more time to portfolio management. Those accounts include several sub-advised mutual funds, as well as public pension funds, foundations, corporate clients and some high-net-worth individuals.

“Our clients are choosing us because they have already decided they want to make an allocation to mid-cap equities,” Pierson explains. “These are clients who have said, ‘Okay, I want to have 10 percent or 15 percent of my assets in mid-caps and I’m picking this particular mid-cap manager.’ So we have to keep in mind we are being hired to be mid-cap managers. That is who we are.”

Fairpointe also has certain high-net-worth clients who want separate small, balanced accounts.

“But that’s an exception in the sense that it’s a balanced account,” Pierson says, “whereas the vast majority of our clients have hired us to manage mid-cap equities. Diversification for us means 40 to 50 stocks in the portfolio so that we don’t concentrate the risk in one company.”

One would imagine a firm with Fairpointe Capital’s track record would have a legion of investors lining up to participate in its portfolios. “Not necessarily,” says Pierson, who adds: “Our assets have varied. We started the firm with around $4 billion in assets under management, and our assets are now approximately $5.5 billion.”

TAKE MY ADVISING

In its sub-advisory capacity, Fairpointe Capital is hired by organizations that own mutual funds and want the firm to manage their U.S. equity mid-cap fund. Fairpointe has three sub-advisory relationships. The largest is with AMG (Affiliated Managers Group), owner of the AMG Managers Fairpointe Mid Cap Fund. AMG pays Fairpointe a fee to manage the fund’s assets, while AMG personnel concentrate on selling participation in the fund to U.S.-based investors.

BNP Paribas is another such client. “We manage the portfolio, but they own the fund,” Zerhusen says. “They hired us in 2006 beginning with $10 million and now the fund assets are about $830 million.”

Pierson adds: “Our role is to make the day-to-day investment decisions and to actually do the trading for those funds.”

“So our role is very specific, very focused in doing the actual investing,” Zerhusen says.

PERFORMANCE ORIENTATION

Zerhusen and Pierson emphasize they are pursuing a performance strategy rather than a growth strategy.

“We were on the big growth path and we actually slowed things down,” Zerhusen says. Zerhusen, who points out the firm’s “soft close” on its biggest account (a sub-advised mutual fund) several years ago because they did not want its performance to be hindered by too much “sudden money” flowing in. The fund has since reopened.

Pierson adds: “If someone gave us a billion dollars to invest tomorrow, we would consider that a problem because it’s too much money in a market where valuations are stretched.”

“If we get $10 million or $30 million, we know what to do with that,” Zerhusen says. “We are very focused on performance. We want to outperform our mid-cap benchmarks, and we want to outperform the S&P 500. That’s our focus.”

In a vote of self-confidence, Zerhusen says virtually all of her investable assets reside in the funds she manages.

Pierson broadens that statement by adding: “All of our portfolio managers have a significant portion of their financial assets in our mutual funds.”

BEGINNINGS AND ENDINGS

Zerhusen was the principal founder of Fairpointe Capital in 2011. Zerhusen — who hails from Germany and was educated in Switzerland, has lived in Chicago since 1970 — also spent four years at Talon Asset Management as a portfolio manager, where she began managing the Aston (now AMG) Fairpointe Mid Cap Fund. She has managed the fund without interruption for more than 18 years.

Prior to co-founding Fairpointe, Pierson and Lorden worked for seven years as members of the mid-cap investment team, led by Zerhusen, at a predecessor firm. Though Pierson says investment decisions are consensus-driven and the team was handpicked by Zerhusen, she acknowledges they engage in active debates and often disagree.

 

Mike Consol (m.consol@irei.com) is editor of Real Assets Adviser.

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