Fund Spy

This Excellent Fund Profits From Market Overreactions

Alec Lucas, Ph.D.
The following is our latest Fund Analyst Report for FMI Large Cap (FMIHX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

FMI Large Cap receives a Morningstar Analyst Rating of Gold for its ability to profit from market overreactions.

Anchored by CIO Patrick English and research director Jonathan Bloom, the fund's 10-person management team combines pickiness with valuation sensitivity when buying stocks. The team began building a position in Twenty-First Century Fox (FOX) in 2016's first quarter, around the time its shares had dropped a third from their 2014 peak. It looked past worries about pay-TV profitability and saw the opportunity to get the global media company's assets on the cheap. A later bidding war between Walt Disney (DIS) and Comcast (CMCSA) to acquire some of those assets helped unlock their value, and shares of Fox surged 41% in 2018 versus the S&P 500's 4.4% loss.

A mixture of caution and contrarianism informs the team's sales, too. Concerns about Comcast's acquisitiveness led it to exit the position in mid-2018. The team also then sold longtime holding Microsoft (MSFT) because its valuation had become stretched relative to historical norms, even factoring in changes to the company like its switch to a subscription software model and growing cloud business.

The fund's 20- to 30-stock portfolio tends to be fairly diversified across sectors, but that doesn't mean it looks like the benchmark. Selling Microsoft dropped the fund's typically light tech stake to 11.8% in June 2018, 14.2 percentage points less than the S&P 500 at the time.

Steering clear of most tech names has been a headwind in recent years, but the fund continues to prove its worth in downturns. Thanks to losing 3.5 percentage points less than the S&P 500 during late 2018's near bear market, the fund preserved capital better than the benchmark for the calendar year and placed in the large-blend Morningstar Category's top quintile. That adds to the fund's superior since-inception record.

Reopened to new investors since mid-2016, the fund is an even more compelling long-term option after a fee cut in 2019.

Process Pillar: Positive | Alec Lucas, Ph.D. 01/03/2019
The fund receives a Positive Process Pillar rating for its use of FMI's firmwide collaborative, high-conviction approach. Unlike smaller-cap sibling  FMI Common Stock (FMIMX), this fund limits its investment universe to stocks with market caps above $4 billion. Both funds look for companies with durable business models and strong management that generate superior profitability through a full economic cycle.

Valuation work drives the decisions here. In consultation with CIO Patrick English and research director Jonathan Bloom, members of FMI's portfolio management committee appraise potential investments based on what it would cost to acquire them outright. They pay close attention to historical valuations versus peers' and the S&P 500 but only buy stocks trading meaningfully below their estimated intrinsic worth. Such bargains tend to occur because of controversy, uncertainty, or short-term headwinds. The team typically shies away from firms with high debt levels, but it will buy those whose cash flows are steady enough to support their leverage. The team trims or sells stocks as they become fully valued. Meanwhile, steep share price drops spur re-evaluation. If the stock presents an even greater bargain without undue risk, management buys more; if something is amiss, it sells.

Annual portfolio turnover tends to be well below most large-blend peers'. In fiscal 2018, it was 21% versus the 50% category median.

The fund holds a focused portfolio of 20 to 30 stocks because few companies meet management's stringent investment criteria. The team, though, keeps a watchlist of good businesses so it can be ready to act if shares dip to bargain levels. Cash is a residual of the investment process. A 5%-10% stake is typical, but it has risen to 15% of assets in the past.

Management limits exposure to any single company by capping top positions at 8% of assets. Initial position sizes vary from about 2% to 4% based on valuation and fit within the portfolio, including risk. In 2016's third quarter, for example, management built a position at the lower end of that range in Level 3 because of its then-50% debt/capital ratio. CenturyLink CTL subsequently acquired Level 3 at a sizable premium, vindicating management's decision in this case to buy shares of a leveraged company.

Although typically diversified across sectors, over- and underweightings versus the S&P 500 can reach the double digits. Valuation concerns led management to exit the fund's seven-year stake in Microsoft in 2018's second quarter, and its tech underweighting dropped to 14.2 percentage points. Sector bets have otherwise been modest in recent years, but management has sought the best bargains within industries. In 2018's third quarter, the team swapped Progressive (PGR) for fellow insurer Chubb (CB) because of the valuation gap between the two.

Performance Pillar: Positive | Alec Lucas, Ph.D. 01/03/2019
The fund merits a Positive Performance rating for its strong record under longest-tenured manager Patrick English. Its 8.5% annualized gain from his late-2001 start through year-end 2018 beat the S&P 500 by 1.7 percentage points and all but a few large-blend category peers. Its risk-adjusted results were similarly superior.

Launched amid the early-2000s bear market, this valuation-sensitive, focused fund showed its worth early on. It outperformed the S&P 500 and large-blend category norm each calendar year and between 2002 and 2006, a period in which value stocks on average trounced their growth counterparts.

The portfolio has repeatedly proved resilient, too. The fund's 46.8% peak-to-trough loss during the 2007-09 credit crisis beat the S&P 500 by 8.2 percentage points. It also held up better than the benchmark during 2011's May to October equity market correction and late 2018's near bear market. Thanks to losing 3.5 percentage points less than the index during 2018's Sept. 21 to Dec. 24 drop, for example, the fund's top-quintile 3.9% calendar-year loss edged the index. Twenty-First Century Fox contributed to those results with a 41% gain.

The fund's value orientation has been a headwind in years when growth stocks outperform. That was in the case in 2013, 2015, and 2017. In each of those years, the fund lagged the index and placed in the category's bottom third.

People Pillar: Positive | Alec Lucas, Ph.D. 01/03/2019
The fund's stable 10-person management team has a healthy mix of seasoned and more-junior members who collaborate effectively and invest alongside shareholders. It receives a Positive People Pillar rating.

CIO Patrick English, who joined FMI in 1986 from Dodge & Cox, helped shape the firm's similar committee-based approach. English and research director Jonathan Bloom vet each team member's investment ideas for this fund, smaller-cap sibling FMI Common Stock, and  FMI International (FMIJX). The whole group scrutinizes promising stocks before they enter portfolios at a weighting and price target set by the lead analyst in consultation with English or Bloom. A generalist analyst structure facilitates this approach. There is some specialization, though. Matthew Goetzinger's coverage duties often include financials stocks, and Andy Ramer's energy names.

The team boasts ample experience as four members have been in the industry more than 20 years. Yet, newer additions can still make major contributions and earn more responsibility. Bloom, for example, joined FMI in March 2010 and helped prepare FMI International for its launch at the end of that year. He became research director of international equities in late 2015 and then domestic stocks in 2018.

Each manager owns all three FMI funds. English invests more than $3 million across the lineup; three others invest over $1 million apiece.

Parent Pillar: Positive | Alec Lucas, Ph.D. 03/23/2018
Independent, Milwaukee-based Fiduciary Management, Inc. is an industry standout and earns a Positive Parent rating. The firm has built up $26.1 billion in assets under management, as of year-end 2017, through prioritizing strong long-term results in its three-equity-fund lineup. The firm keeps close tabs on their capacity and has not been shy about closing them to new investors. With FMI International FMIJX reopening in April 2018, all three funds will be simultaneously available to new investors for the first time.

The FMI lineup’s accessibility comes amid persistent outflows, but the firm remains in excellent financial health. It has no debt and could manage about a fifth of its current assets without making cutbacks. FMI's robust balance sheet helps management stay focused on investing rather than asset maintenance during market slumps. While running its business conservatively and limiting asset size keep its funds from competing on cost with passive rivals, FMI has cut prices to keep them in line with most active peers’.

An orderly transition will keep FMI's future in the hands of its investment personnel. Co-founder Ted Kellner, who retired in mid-2017, is reducing his ownership stake to allow them a greater share. Under CEO Patrick English and research director Jonathan Bloom, FMI’s team is poised to build on its past success.

Price Pillar: Positive | Alec Lucas, Ph.D. 01/03/2019
The fund's falling fees merit an upgrade in its Price Pillar rating to Positive from Neutral. Effective Jan. 1, 2019, the expense ratios on the retail and institutional shares dropped 5 basis points apiece to 0.80% and 0.66%, respectively. Both are now cheaper than their peer medians. Trading costs as a percentage of net assets are also better than most. In fiscal 2017, brokerage fees of 0.02% of average net assets fellow below the 0.03% category median.

Fee breakpoints help keep a lid on costs. The fund charges 0.65% on the first $2.5 billion in assets, 0.60% for the next $2.5 billion, 0.55% for assets beyond $5 billion.

Sizable capital gains distributions each year since 2014 have hurt investors in taxable accounts. Those distributions topped 15% of net asset value in December 2018.

Alec Lucas, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.