Q: How has the fund evolved since inception?

Cooke & Bieler, L.P., which sub-advises The Wells Fargo C&B Mid Cap Value Fund, was founded in 1949 as a boutique investment manager. When I joined the firm in 1993 it was essentially a one-product firm with a large-cap value strategy.

In the late 1990s, we became interested in starting a mutual fund focused on the mid-cap segment of the market. At that time, almost everything, except mega cap and tech stocks, was out of favor. Because we saw such unusually attractive values in the mid-cap space in particular and were already covering part of that space in our large-cap strategy where we were willing to own stocks with market caps as low as $1 billion, we believed it was a good time to start a mid-cap strategy.

On February 18, 1998, the Mid Cap Value Fund was launched. After handling it ourselves for a number of years, we realized that important aspects of the business – like back office administration, compliance, and distribution – typically required much greater scale. We partnered with Wells Fargo, and in 2004, the firm adopted our mid-cap and large-cap value funds while we stayed on as subadvisor to both.

Q: What is the mission of the fund?

Our mission is to outperform our benchmark index but to do so in a low risk manner. By that we mean we strive to outperform meaningfully in challenging market environments and generally keep up in rising markets. This is a very desirable pattern if you think about the math of negative compounding. 

It sounds simple but we do this by investing in high-quality companies at reasonable valuations. For us, “high quality” means companies with advantaged business models, favorable underlying economics, and strong balance sheets that can be both a source of value creation and a financial shock absorber during challenging times. Because we are value-oriented, a great deal of time is dedicated to valuing companies using our proprietary long-term discounted cash-flow model. We build in upside potential and a margin of safety by investing when a stock is trading at a meaningful discount to its DCF derived intrinsic value. 

By investing in companies that have such characteristics, the fund typically does quite well in difficult environments. In up-markets, it tends to keep up or stay ahead, depending on what’s going on. Although it has lagged in certain boom periods, the fund has more than made up for that during the busts that followed.

Q: What core beliefs drive your investment philosophy?

The first of our three core beliefs is that fundamentals drive stock prices; over the long term, a company’s underlying fundamentals are what cause its stock to increase or decline. Essentially, the return on capital a company generates and the rate at which it is able to invest that capital create a profile of earnings growth; the longer the investment horizon the more underlying fundamentals drive the total return equation.

Because of this fundamental perspective, we focus on understanding how businesses work, how they generate earnings and cash flows, their inherent risks, and whether management teams have a proven record of being good allocators of capital and doing what’s best for shareholders.

Having long-term fundamentals at the core of our philosophy gives us a big advantage because in our view, the market tends to be short-sighted making stock prices much more volatile than their underlying businesses. When a company underperforms and disappoints investors, but its long-term fundamentals remain intact, we can often invest at an attractive valuation. 

Second, we believe that capital preservation improves returns – again the math of negative compounding is irrefutable – so we strive to avoid permanent impairment of capital at the security selection level by investing in companies with favorable underlying economics and strong, appropriately leveraged balance sheets. Also, it’s crucial to build a margin of safety into the purchase price and view a company through the framework of our long-term discounted cash-flow valuation.

Third and perhaps most important, we believe a firm’s culture shapes its investment decisions – how people are organized, how they interact with each other, and how they are compensated. For a smaller, boutique firm with $5.5 billion under management to have survived nearly 70 years speaks to the unique nature of our culture. Everything we do is about maintaining continuity and stability across the organization – particularly on the investment team.

We don’t have a chief investment officer or a head portfolio manager. Instead, a team of six to eight people manages the fund, with members being equally important and largely interchangeable. Importantly, our decision-making is decentralized with buy and sell decisions made by career analysts. This embodies our beliefs that individuals make better decisions than groups and the individual who does the actual work on a company is in the best position to make the right decision. We’ve spent a lot of time structuring incentives and compensation to strike a good balance between the pursuit of individual and team success.

Q: How would you describe your investment process?

We focus on identifying high-quality companies that have sustainable competitive advantages and produce favorable returns – the formula for success we believe allows a business to compound value in the long term. We identify these companies and follow them over time, waiting for an opportunity to invest at a reasonable valuation.

Our investable universe generally includes the 800 or so names in the Russell Midcap Index, which are companies with market capitalizations between $2.5 billion and $30 billion. We follow sectors up and down this market-cap spectrum, dividing our universe according to size and industry, with at least two of us being involved in each sector.

We don’t apply an overarching screen across our entire universe. Instead, members of the team have created screens relevant to their own sectors and the kinds of companies they are looking for. For instance, a screen applied to energy stocks would tend to differ from one used in the technology sector.

Our discounted cash-flow framework underpins our assessment of intrinsic value. By discounting future cash flows back to the present value, we determine a stock’s target price. Companies that meet our quality criteria become candidates for the portfolio when their target prices are 20% to 30% higher than the current market price.

Q: What is your research process?

The meat of our process includes fundamental analysis and due diligence. On average, we spend several months digging deeply into any company we’re interested in: we go through publicly available information like 10-Ks, 10-Qs, and transcripts of earnings reports; attend investor conferences; and meet with companies, their competitors, and suppliers. We doggedly follow this rigorous fundamental, bottom-up process to ensure we’re investing in quality companies and to hone in on the critical assumptions that drive our valuation framework.

Q: Can you elaborate on your research process with some examples?

A few years ago, we invested in Laboratory Corp. of America Holdings, a healthcare diagnostics company. About five years before that, I’d heard the company’s CEO, David King, speak at an investor conference. Not only did the company have attractive characteristics, but also I was impressed with King – I liked how he thought about the business, its opportunities, and capital allocation. 

At the time, the company’s valuation wasn’t attractive; its stock price was higher than the intrinsic value we assumed based on its long-term cash flow generation. However, LabCorp’s balance sheet was quite strong and we liked other characteristics about the business. 

In 2014, following the implementation of the Affordable Care Act (ACA), government reimbursements to clinical labs were reduced. Both LabCorp and its biggest competitor, Quest Diagnostics Inc, saw their stocks underperform significantly. At that point, we saw a business with characteristics we liked, a good balance sheet, and strong management team – and which was now attractively valued. 

There was also light at the end of the tunnel regarding the impact of the ACA on its business. In fact, this was part of our investment thesis: low-cost providers of clinical lab services which were competitively advantaged would ultimately be big share gainers because they aligned with the ACA’s interests in reducing costs and achieving more consistent standards of care. We invested in the company in the spring of 2014 and it is still in the portfolio today.

Q: Why did you choose LabCorp over Quest Diagnostics?

Actually, we’ve owned both. Both companies have built national infrastructures and operate at huge scale in a business in which scale is the primary factor in establishing and sustaining competitive advantage. 

Further differentiating LabCorp is the fact that the company maintains standardized equipment and IT across its network of clinical labs, and forces the companies it acquires to adopt them. Largely because of this consistency, LabCorp is in a leading position to service consumers, physicians, and payers. We think this advantage is well reflected in LabCorp’s volume growth which has exceeded industry averages nearly year in and year out. 

Back in the mid-2000s, we purchased Quest because it met our quality criteria and unlike LabCorp at the time was cheap relative to our long-term fundamental expectations. We held it until 2014 when we had the opportunity to move into a much more attractively valued LabCorp.

Q: Can you give another example in a different industry?

Axalta Coating Systems Ltd was formerly known as DuPont Performance Coatings when it was part of DuPont’s American chemical empire. The company was rebranded and taken public after The Carlyle Group purchased it in 2013.

More than 40% of revenues and 50–60% of earnings come from the business of selling coatings to body shops used to refinish damaged automobiles. As the dominant global player in its industry, Axalta has unrivaled breadth and scale allowing it to efficiently provide coatings and valuable service and technology support to a very fragmented base of body shop customers. As a result Axalta operates at high margin levels supported by a high degree of pricing power. 

We see a number of likely attractive scenarios over the next three to five years. Being spun out will allow management to improve efficiencies and margins – efficiencies that will enhance already strong generation of free cash flow which should give management opportunities to add value through capital allocation. Also, Axalta’s market expansion, particularly in the Asia-Pacific region, creates the opportunity to accelerate revenue and EPS growth. 

Q: What is your portfolio construction process?

Portfolio construction is a bottom-up fundamental process which is driven by individuals but involves the entire team. The person who has done the work on a stock pushes for an idea and ultimately decides whether it will go in the portfolio – but only after getting input from the entire team through every stage of the investment process. We are more collaborative when looking at positioning, using an iterative method that encourages ideas about what might be added to or trimmed. 

Because we are benchmark aware rather than driven by it, at times the fund can be significantly different from the Russell Midcap Value Index. As a result, analyzing our concentrations or lack of exposure in certain sectors is a crucial. We drill down as deeply as possible into economic exposure that might hold across sectors as we believe this adds value, and we want to be sure that variances from the benchmark are due to conscious decisions we’ve made based on our bottom-up perspective.

We believe the portfolio can be appropriately diversified with 40 to 50 holdings, and our average holding period tends to be three to five years. If a stock is nearing our price target, we would potentially trim it if we have more attractive ideas.

Q: How do you define and manage risk?

We think about risk from a singular perspective: it is the possibility of losing money, and more specifically, the possibility of having capital permanently impaired. Our stock selection and research process is designed to weed out investments where this risk is possible. 

For example, we would never invest in a stock simply because it would provide exposure to a sector in the benchmark. If there is the potential for substantial risk, we won’t force ourselves to own something – which is where we are right now with utilities.

The way we manage risk is through understanding the companies in our portfolio and essentially managing the business risk within it. We invest only in companies with dependable and durable business models that have favorable underlying economics characterized by strong returns on invested capital and attractive reinvestment opportunities which will allow them to compound value over time.