4 Stock Picks from a Manager of a Kiplinger 25 Fund

Many investors view the past ten years as a lost decade for the U.S. stock market. That’s certainly true for big-company stocks. During that period, Standard & Poor’s 500-stock index returned 1.0% annualized (through December 7). But it’s a different story as you go down the capitalization ladder. Stocks of midsize companies, in particular, have delivered impressive results. Over the past ten years, the S&P Midcap 400 index returned 7.2% annualized. Year-to-date, the mid-cap index has gained 23.8%, compared with 11.8% for the S&P 500.

Mark Giambrone, co-manager of Vanguard Selected Value (symbol VASVX), calls mid-cap stocks a “unique area of the market.” The companies are large enough to be past the stage at which investors have to worry about their survivability, but they’re small enough to achieve relatively high growth rates, often in attractive product or service niches. In addition, Giambrone says, most institutional investors buy small- or large-company stocks but often ignore those of midsize companies, causing many of the stocks to be mispriced.

Selected Value, a member of the Kiplinger 25, uses several quantitative screens to populate its portfolio of undervalued mid-cap stocks. Giambrone and co-manager Jim Barrow, who together manage 75% of the fund’s assets (Donald Smith & Co. controls the rest), seek stocks trading at lower ratios of price to earnings and price to book value (assets minus liabilities) and with higher yields than comparable ratios in the mid-cap value index. They want firms that can generate faster growth than the overall market and boast higher free-cash-flow yields (free cash flow is earnings plus depreciation and other noncash charges, minus the capital expenditures needed to maintain the business; divide that by market capitalization and you get free-cash-flow yield).

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Giambrone and Barrow, who are based in Dallas, hold an eclectic portfolio. Giambrone says they purchased shares of Royal Caribbean Cruises (RCL), the number-two player in the cruise industry, because the vacations it provides are considered to be a good value and the cruise business continues to take share in the leisure market.

Selected Value’s largest holding at last word was Goodrich (GR), a large supplier of aerospace parts, such as wheels, seats and brakes. The world airline industry is rebounding, which means that more miles are being flown (half of Goodrich’s revenues are from after-market parts) and more planes are being ordered (half of part sales are for new planes).

Advance Auto Parts (AAP) is “not about a robust economy,” Giambrone says. He likes the stock because the longer people hang on to their cars, the more maintenance they need and the greater the demand for parts (many of which carry high profit margins), sold in Advance’s retail outlets. Family Dollar Stores (FDO), which Giambrone calls a “mini Wal-Mart,” is another play on consumer frugality. The stock has rocketed 85% this year.

Year-to-date Selected Value is up 16.3%, trailing the S&P Midcap index by seven percentage points. But over the long haul, the fund has been a winner, returning 9% annualized over the past ten years, trumping the index by an average of two points per year. The annual expense ratio is a modest 0.52%. With Barrow and Giambrone controlling the bulk of the fund’s assets, Selected Value is in the strong hands of investors with a nose for bargains.