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In this issue...Mutual fund and personal finance writer Lori Pizzani interviews Kevin C. O’Boyle, lead manager of the $1.1 billion Meridian Value Fund (MVALX) O’Boyle is also the senior vice president of research at the firm’s adviser Aster Investment Management of Larkspur, Calif. O’Boyle has been managing the fund (inception 2/94) since June 30, 1995.

Manager Insight by Lori Pizzani
November 19, 2002

In light of the weak economy and ravaged stock market, it isn’t easy finding an equity fund that has sustained a positive double-digit return over the past five years. But the Meridian Value Fund fits the bill, despite facing a much more difficult year 2002. With its bent toward small- to mid-sized companies and its value strategy that includes more flexibility of valuations than other value funds, this fund has found some great companies that have fallen out of favor, but are staging a comeback. A dearth of new companies to love has meant some of their veteran winners are still on the roster.

FundEmail: The Meridian Value Fund is ranked number 13 among Morningstar’s list of top 25 funds rated by their five year returns. That’s impressive. Yet the fund is in the red so far this year, down 20.3% through September 30. What has made this year more challenging?

Kevin O’Boyle: This year, the breadth of the market decline has been broader and more extensive. Last year, and in 2000, there were entire industry sectors that were undervalued. Even earlier this year, no stocks were undervalued, and many companies were experiencing operating difficulties. There was no place to hide in this market, but things are a bit different now.

Also, last year we found companies like Waste Management and Dial which did well despite the weakening economy. This year, it’s much harder to avoid the economic fallout.

We’ve also seen changes internally. By 1999 we had built up a good track record, but back then, nobody wanted you unless you were a tech fund or momentum manager. Then we were “discovered.” Fund assets went from $100 million to $1 billion in just two years. We also instituted a fund policy change under which our cash position cannot go above 10%.

We’ve also made a few more mistakes this year. The much greater incidence of fraud has caused valuations to drop across a sector even though the fraud was just committed by one company. Also, we owned Adelphia. In March, when they had their conference call and announced how bad their problems were, we got out that same day, but it still cost us 130 basis points (1.30%) of our performance.

We also misjudged Sprint, which we had bought for their local phone business’ strength even though their wireless sector was faltering. Their wireless segment ended up being much more significant a problem to the company than we expected

What has this difficult market taught you?

The one thing I’ve learned over the last eight to nine years is that avoiding big mistakes is more important than picking great stocks -- although picking great stocks certainly helps!

Unlike many mutual funds that target stocks of a certain size, the Meridian Value Fund is an “all-cap” fund, right?

Yes, the fund has always been an all-cap fund. In the mid-90s, we tended to emphasize small- to mid-sized stocks because of the small size of our fund and the heritage of our firm, Aster Investment Management. We felt that strategy would work best. Even now that the fund is much larger, we still have a pretty significant holding in small caps. Between 1/4 and 1/3 of the fund is in small cap stocks right now.

As a value fund manager, how do you define your “value” strategy?

Our strategy is to identify companies that have had operational problems or poor operating results, which has resulted in the stock’s price declining. We often see companies whose price has declined 50% or more. We start by identifying those companies with three down quarters. We look for companies that are struggling but ones that are also good businesses that have growth potential going forward, but are temporarily out of favor. We also make the important distinction between those companies that are down, and those that are down and out.

The latter being those that have no possible chance to execute a turn around?

Right.

What are the other components to your screening process?

Every month we screen for companies with a minimum market cap of $200 million and those with certain trading volumes. We do have some micro cap stocks, but not many, and only those with significant secular growth. Then we highlight which of these have had three consecutive down quarters. We’ll decide which of these new companies to add to our monitor list. From there we do research on the companies. We attend events, presentations, conference calls, web casts, and, if we are interested in the company, we’ll go through their 10Qs, 10Ks, proxies and other documents.

What do you look for in a company’s financials?

We look for companies that are generating decent returns on capital. We also want to see companies producing enough cash flow to sustain their businesses. We don’t mind a leveraged company, if it has sufficient cash flow during bad times to keep going. But when we see cash flows deteriorating, then we need to see a cleaner balance sheet.

We can’t always predict a company’s return to glory. The only thing that helps us from getting killed is a stronger balance sheet which tells us that the company will persevere.

What else do you look at?

We identify what caused the problem the company is experiencing and assess what will enable it to restore profit margins and to grow revenues. I look at the drivers to its particular business and try to identify what indicators will cause improvements.

We look at a company as compared to its industry and ask, is the industry growing even if the stock is ailing? Do we think the company can grow faster than the industry? Does it have plans for a new technology, new products or a have a competitive edge?

Valuation is also very important. But we don’t have fixed parameters on how far a company’s price must have fallen. Instead we come up with a normalized earnings number for a company that we think can be achieved within three years, and then decide if its current valuation is reasonable based upon the future estimates.

Okay, so if you’ve decided you like a particular company, then what?

If we like a company, we will take an average position of 2%. If it’s a smaller company with, say a market cap of $1 billion or below, we’ll take a smaller position; more like 1/2% to 1% of the fund’s assets then build up a position. By prospectus regulation, we can invest as much as 10% in any one stock, but we’ve never gone above 5%.

And on the flip side....what does your sell discipline look like?

There are three things that would cause us to sell. First, if we’ve made a mistake and our original investment thesis was incorrect, we will sell.

That happened with Keane, a leading IT consulting and outsource services firm. The company had a strong track record, but suffered four or five down quarters that we thought was due to the aftermath of the Y2K bubble. We assumed that when the price had been slammed to the single digits, the company would form a platform from which to recover. That didn’t happen. We realized we didn’t know where the bottom was for the company, so we had to lower our estimates. We then decided that a turn around was farther off than anticipated so we sold it.

But we might also sell a company if our investment thesis was successful and the company increased to our price target, but then stopped improving, or began faltering. If this happens, we usually sell and replace the stock with others that are earlier in the turn around process.

And what is your third criterion for selling?

We will sell a company if our investment thesis has been successful, a company’s business fundamentals remain great, but the stock has traded up to a momentum--like valuation that we just can’t rationalize.

We do hold some of our winners when their fundamentals are strong and valuations are reasonable. Especially if it becomes challenging to find other alternative stocks that we feel are poised for a turn around.

What industries comprise the bulk of the fund’s assets?

As of September 30, health care made up between 23% and 24% of the fund. That includes health care products and also service companies, pharmaceutical firms, and even REITs, which own properties such as hospitals and outpatient facilities. Our second largest sector is consumer products and services at between 15% and 20%. The retail sector, under which we include restaurants, is another 12% of the fund, and the technology sector is between 11% and 12%.

What’s so appealing about the health care sector?

Since the spring of 2000, we’ve focused on finding companies that can produce revenues and increase earnings in a stagnant economy. In early 2000 we actually sold a lot of our tech holdings and went into the health care area. The 20% to 25% of the fund that we had in tech companies provided 3/4 of our earnings in 1999. And our sale of those, and move into health care helped us avoid the slide of the tech sector.

The health care sector is relatively insensitive to the economy, and many companies have successfully navigated a turn around. Health care companies often stumble operationally, no matter if there are good times or bad times around them. We’re confident that many can fix their problems and move up.

In particular we like OmniCare which is a leading distributor of drugs for the elderly residing in nursing homes. The company has significant free cash flow, is in a business with good demographics and one which can benefit from the increasing medicinal needs of elderly patients. Also, the increasing use of generic drugs has improved its margins. Its operation was hurt when Medicare reimbursements were changed, but it restructured its operations and was able to buy a competitor at a very attractive price. The stock has doubled since we bought it.

What’s your largest overall holding?

Waste Management, which accounts for 4.2% of the fund. The company hauls trash for both businesses and homeowners. Three years ago they had an accounting scandal over an acquisition. The board was ousted, new management came in, and the company continues its operational turnaround, despite flat earnings of $1.35 this year. We bought it two years ago, and believe the company has earnings potential of $2.50, even though next year's earnings are expected to be $1.55.

Any manager’s pet stocks right now?

We like a retail chain, Payless Shoes, which is the largest value shoe retailer. The company has had problems for the past two years, had inventory issues because they overestimated growth in their stores and missed a fashion trend. But they brought in a new merchandise manager and have restructured to lower costs. The company generates significant cash flow and uses it to buy back its stock. While there is almost zero growth opportunity for them in the U.S. market, they are ramping up stores in Central America and just entered the market in South America.

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