Some mid-cap stocks don't get the ink, but they can be bargains

Dollars & Sense

October 20, 2002|By Christopher Davis | Christopher Davis,MORNINGSTAR.COM

Some mid-cap stocks are household names - we've all heard of or dreamed about mid-cap Krispy Kreme Doughnuts Inc.'s delectable creations, for example - but most don't get as much Wall Street analyst coverage or ink in The Wall Street Journal as giant companies such as General Electric Co. or Microsoft Corp. do. With fewer folks scrutinizing their prospects on a daily basis, the odds of unearthing bargains in mid-cap land are better than in large-cap territory.

Lately, we've been talking to a lot of mid-cap managers, and they report finding values in an array of sectors, ranging from financials and gaming to health care and retail. Below we've listed some of their latest picks.

Penn National Gaming Inc.: Ron Baron, manager of namesake Baron Asset, has delivered fine long-term results by going his own way. Instead of relying on Wall Street research, he and his staff meet with company management, competitors and suppliers to assess a potential pick's prospects.

Unlike some of his competitors, Baron isn't obsessed with short-term earnings numbers. Instead, he's looking for companies that can double their stock price in the next four or five years. Fitting the bill recently is casino and racetrack operator Penn National Gaming. The company has high margins, rapid growth, and the price was right. Baron is familiar with chief operating officer Kevin Desanctis from another investment and also expects cash-strapped states to approve gaming expansion

Davita Inc.: Meridian Value's Kevin O'Boyle looks for companies that have run into troubles but have catalysts in place to ignite a turnaround. Davita, the second-largest provider of dialysis services in the United States for patients suffering from chronic kidney failure, ran into trouble in the late 1990s when a debt-financed acquisition binge led to operating problems and regulatory issues.

As a result, earnings declined in 1998 and evaporated in 1999. But a new management team arrived in late 1999 and turned the business around in one year. O'Boyle argues the company's clinical quality is now very high, internal revenue growth has resumed, and the business is generating tremendous amounts of free cash flow. With debt at a manageable level, the company is using free cash flow to buy back substantial amounts of shares. At $22, O'Boyle says the stock now trades at 13 times estimated 2002 earnings and less than 12 times projected 2003 earnings.

J.C. Penney Co. Inc.: Several mid-value managers have told us they've been buying this retailer, including Merrill Lynch Mid Cap Value's Elise Baum and Hotchkis & Wiley Mid Cap Value's Stan Majcher. Both offer similar rationales for their purchases. For one, they think J.C. Penney has been unduly punished by fears of a prolonged economic downturn. They also argue the company's continuing turnaround will continue to improve margins. Further, the managers say J.C. Penney will be able to unlock the value of its Eckerd drug chain, probably through a spinoff.

Here are some other stocks that have been mentioned in our recent conversations with managers, most of which are mid-caps.

International Game Technology Inc. and Harrah's Entertainment Inc.: John and Nick Calamos, managers of mid-growth Calamos Growth, recently picked up these casino-related names, noting that when states run into deficits amid a slowing economy they often turn to revenue from taxes on gaming.

Merrill Lynch and Co. Inc., Goldman Sachs Group Inc., Everest Re Group Ltd. and Triquint Semiconductor Inc.: Although these financial and tech holdings have taken a beating this year, Olstein Financial Alert's Bob Olstein still says they're bargains and will produce superior long-term returns.

GulfMark Offshore Inc.: A big fan of investing legends Ben Graham and David Dodd, Delphi Value Retail's Scott Black looks for highly profitable companies selling at dirt-cheap prices. Fitting the bill is offshore oil-and-gas-exploration supplier GulfMark Offshore, which Black says returns 20 percent on equity and trades at just eight times forward earnings. He also bought Ryan's Family Steak Houses Inc. (15 percent ROE, 9 P/E) and Jones Apparel Group Inc. (19 percent ROE, 10 P/E).

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