Monday, March 10, 2003

The Case For Mid-Caps

With the broader market bouncing around at 1997 levels, Tony Rosenthal, who helps oversee a $2 billion portfolio at New York's TimesSquare Capital Management, sees opportunities in mid-cap stocks, or those with market values between $1.5 billion and $10 billion.

"Mid-caps combine the best of both worlds," says Rosenthal. Unlike large stocks, he explains, mid-caps can be relatively "undiscovered," particularly as the big brokerage firms pare down their equity research operations. On the other hand, mid-caps are usually more liquid and less volatile than smaller capitalization issues, which often get crushed when a big holder bails out.

A growth investor, Rosenthal looks for companies he thinks will increase sales, earnings and free cash flow by at least 15% over the coming three years. He pays particular attention to free cash flow, which Forbes defines as net income plus depreciation minus capital expenditures. The metric gives a sense of a company's ability to buy back stock, pay down debt, make acquisitions and plow cash back into the business.

Example: Moody's, the New York publisher of opinions, ratings and research on issuers of bonds and other credit obligations. The company certainly has a good track record generating free cash flow; its free cash flow margin, or free cash as a percentage of revenue, stands at a very robust 29% for the past 12 months.

Moody's shares are down 15% from a 52-week high of $52 set last August. Driving the decline are worries that an eventual rise in interest rates will slow down the issuance of new bonds, meaning less business for rating agencies like Moody's, Fitch and Standard & Poor's. Another fear: Financial reforms will weaken the strong market position that Moody's has enjoyed.

Rosenthal says such concerns are real but overdone. Although he expects Moody's business to soften, he predicts that the firm, of which Warren Buffett's Berkshire Hathaway owns 15.5%, will continue to deliver healthy free cash flow in 2003.

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