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Hotchkis & Wiley Mid-Cap Value Portfolio Manager Stan Majcher, 50, looks for cash flow. (Hotchkis & Wiley)

The $519 million Hotchkis & Wiley Mid-Cap Value Fund (HWMIX) is in a small winners' circle of diversified stock mutual funds that are both outperforming the market so far this rocky year and have actually gained ground.

The fund's 7.18% year-to-date return through month's end was way ahead of the 12.76% loss by broad market, represented by the S&P 500. It was even ahead of the 3.43% setback by midcap value funds tracked by Morningstar Direct.

So how have the fund's main managers, Stan Majcher and Hunter Doble, found gold where so many other investors have found only dross?

In a nut shell, Majcher and Doble seek undervalued midsize companies that have sustainable cash flow, strong balance sheets and potential for long-term capital appreciation.

Ideally, their stocks are out-of-favor or misunderstood only temporarily.

The fund's two largest sectors are energy and financials, with weights of 23.7% and 23.3% respectively as of March 31.

The portfolio also includes stocks whose traits CAN-SLIM investors will appreciate.

Energy names Kosmos Energy (KOS) and PDC Energy (PDCE), which are oil and gas explorers and producers, as well as field services provider Halliburton (HAL) have IBD Composite Ratings of 96 to 99.

A Composite Rating of 96 means that a stock is in the top 4% of all stocks on a number of technical and fundamental factors, including both price performance and earnings. Watch for stocks that have 90-plus Composite Ratings and are forming bases or are in follow-on buy areas. That way, you spot the best-positioned stocks before they start big price runs. Look up a stock's Composite Rating at IBD Stock Checkup.

And as of May 31, year-to-date returns for those stocks ranged from Halliburton's 78% to Kosmos' 124%.

Consumer cyclical Allison Transmission (ALSN), which makes transmissions for medium- and heavy-duty vehicles, had an IBD Composite Rating of 94. Shares were up 11.24% for the year.

Basic materials company Huntsman (HUN) has a Composite Rating of 96 and was up 5%.

Health care stock Centene (CNC), which provides programs and services to underinsured and uninsured Americans, had a Composite Rating of 93. It was down about 1%.

Majcher and Doble, both age 50, discussed their investment approach with IBD from their offices in Los Angeles.

A-class (HWMAX) and C-class (HWMCX) shares may be bought initially for as little as $2,500.

IBD: Given your focus on undervalued midsize companies, I'll take a wild guess that you fellows are not shopping for FAANG stocks. Megacap tech stocks like Facebook (FB) parent Meta Platforms, Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet-parent Google (GOOGL) are not your targets, right?

Stan Majcher: Yes, that's the way I would describe it.

IBD: How would you elaborate on your strategy?

Majcher: As an investor, you're buying a future stream of cash flows. We're trying to buy those cash flows at a discount. We're looking for businesses that earn a lot of money, generate cash and create value for shareholders.

IBD: Would you add anything to that, Hunter?

Hunter Doble: Midcap value stocks that we find tend to be a really interesting place to invest because you have the potential to find companies that may not be getting all of the attention that some of the megacaps get there. But they're still substantial business. They have the ability to weather difficult environments. That's really a key when you're buying a business that may be temporarily struggling or have something cyclical going on. You want to make sure they have the financial resources to get through the difficult period to reach their value.

IBD: Is it fair to say you take a contrarian approach?

Majcher: It's not that we set out to be contrarian. It's that we believe in mean reversion. And there are opportunities in looking at things where there's some temporary issue that is likely to revert back to a more normal level. We try to avoid situations where there's excessive optimism.

IBD: What's your most interesting energy name?

Majcher: Probably the most interesting is Kosmos. It's not only undervalued because of where commodity prices are. But they also have assets that are in production that could produce LNG (liquefied natural gas).

IBD: In what way is it undervalued?

Majcher: The world needs more natural gas, particularly in Europe. So LNG projects are very valuable. Kosmos has a large project, Tortue Phase 1 LNG, that is due onstream in 2024. Kosmos will generate the equivalent of $1.50 per share in free cash flow then, including $0.35 from Tortue. That is a lot of new free cash flow for Kosmos.

IBD: Why do you like PDC Energy, which is seeking and producing energy in Colorado, Ohio and West Virginia?

Majcher: It is generating a lot of free cash flow. It is trading at a very large discount. It's buying back stock.

And at the current price of oil, it's trading at something like five or six times free cash flow. So if we were to see a drop in oil price, they'd still be fine. If oil's price were to fall to about $65 per barrel (from May 31's approximately $115 for West Texas Intermediate crude), PDC would be trading at about 10 times free cash flow.

IBD: And that would be cheap compared to what?

Majcher: The S&P 500's fiscal year 2021 price-earnings ratio was 17.5. I assume price-free cash flow (FCF) is about the same. We use FCF interchangeably with economic earnings. Accounting earnings can be distorted by write-offs and intangible amortization.

IBD: What is your thesis for oil field services company Halliburton?

Majcher: In general, the oil services companies have underperformed the producers. The reason for that is unlike past cycles, spending has been restrained. We think that eventually more will need to be spent. So Halliburton is in a good position to see some benefit.

We don't think spending is going to get back to what it probably needs to be. But once things normalize, Halliburton will be trading at about 10 times earnings. It's trading now about 22 times this year's earnings.

IBD: Is Allison Transmission a play on people keeping vehicles a long time and needing to replace parts?

Doble: Allison is the dominant player in truck and bus transmissions. The transition to electric vehicles will take place. Allison has some important drive-chain technology that would be valuable in the EV space. That might be a little bit more competitive than the current environment. But they're well positioned to play in it. And when you look at the valuation of the stock today, it's about five or six times current earnings. It's very cheap.

IBD: Popular (BPOP) is the holding company for Banco Popular, which has branches in Puerto Rico, the U.S. Virgin Islands, Florida, New York and New Jersey. What's your thesis?

Doble: They have a little more than 45% market share in Puerto Rico. The number two and three players each have about 20%. That concentration among three players produces very profitable banks. It earns about $10 (per share). The stock's around 80.

On top of that, it has a huge amount of excess capital. Their common equity tier 1 ratio at the end of the quarter was about 16.5%. I believe Popular could very comfortably operate at 11%. The difference is about $2 billion. When you ascribe some value to the excess capital and include it in the earnings they already generate, you have a really undervalued stock that is very profitable and well-positioned.

IBD: Centene (CNC) is a managed health care services provider. Its quarterly earnings per share have been choppy recently. They were flat three quarters ago, then up 120% and 12% the next two stanzas. What do you like there?

Doble: Centene is the clear market leader in a business in which scale is a big competitive advantage. That's the managed Medicaid market. We also think that's a market that has better than average growth prospects. The government expects Medicaid spending will grow by 6% per year over the next decade.

IBD: When did you initiate your position?

Doble: We had the opportunity to buy into it several years ago after they lost the renewal of a contract with one of the states. It was up for rebid. It hit the stock significantly. Gave us a chance to buy in the mid-40s. (At May's end it was trading in the low 80s.) Its normal earnings power is something like $5.75.

It trades at an attractive roughly 14 times normal earnings. The business grows faster than the market. And it diversifies the portfolio.

IBD: Huntsman (HUN) makes specialty chemicals used in a variety of products, such as the clamshell container that many fast-food burgers are served in. Quarterly earnings per share growth is strong but slowing. Any concerns?

Doble: We bought in late 2020. At that time the business had undergone a fairly big change. They divested some of the more commodity businesses like TiO2 (its pigments and additives business) and paid down a lot of its debt. They turned the business into what was essentially a higher value-added chemicals company focused on polyurethanes.

The valuation is very attractive at something like seven and a half times current earnings. It's a cyclical business, sensitive to the economy. It's pretty substantially undervalued on the kind of franchise that it has today.

IBD: KBR (KBR) provides engineering and construction services for infrastructure companies. Since energy companies aren't spending a lot to drill additional wells, does that hurt KBR?

Doble: Five or 10 years ago, this business was heavily focused on the oil and gas industry. Today the business is 80% government services. They work with the defense department, FAA (Federal Aviation Administration) and intelligence agencies.

Their investor day presentation last year targeted roughly $4 to $6 of earnings per share in 2025. We think that's a conservative estimate given their end markets. It's a very stable, steady, high-return business.

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