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Mutual Funds

Those Bargain-Hunter Blues

Value investing is being put to the test. Yet some sharp managers have stayed on key.

The past year or so has been humbling for most value-fund managers. Many all but missed the commodity boom. Then, to add insult to injury, too many of them bet too heavily on financial stocks, which got pummeled in the credit maelstrom.

Of the two miscues, excessive exposure to bad banks and other troubled financial institutions is the more egregious. Most value investors describe preservation of capital as a vital part of their investment mandate. Risk to a value investor is not defined as volatility, but rather as the potential for permanent loss of capital. Yet, by investing in companies with disastrous risk-management systems, managers exposed their share-holders to unacceptable levels of danger.

Susan Byrne, manager of Gamco Westwood Equity fund, says many value investors were seduced by what on paper appeared to be bargains in financial stocks. The stocks offered high dividend yields and traded at low prices relative to earnings and book value (assets minus liabilities). "As a veteran, I've learned that the book value of financials is a moving target," she says. Byrne adds that because banks hold so many assets off their balance sheets, you can only infer how much a company is earning and how much exposure it has to problematic debt.

We examine the records of four value investors to glean lessons about the past year's debacle -- two who didn't exactly cover themselves in glory and two who did well at protecting their shareholders' money.

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Humbling of a legend. Bill Miller's reversal of fortune is stunning. The manager of Legg Mason Value Trust fund (symbol LMVTX) famously beat Standard & Poor's 500-stock index for 15 straight years through 2006, the investment world's equivalent of Joe DiMaggio's 56-game hitting streak. But over the past year to September 8, Value lost 35%, 21 percentage points worse than the S&P 500. The performance of Miller-managed Legg Mason Opportunity fund (LMOPX), a member of the Kiplinger 25, has been nearly as dreadful.

How does Miller explain himself? He wouldn't talk to us. But we did speak with him in March 2007. Recalling that conversation and reviewing Miller's portfolios, it's clear that he severely underestimated the severity of the gathering storm in the housing and credit markets. He thought oil was overvalued at about $60 a barrel. And he was far too bullish on the U.S. economy and stock market.

In that interview, Miller said he thought homebuilders were undervalued, so he was buying shares of Centex, Lennar, Pulte and Ryland Homes. He noted that stocks of builders were selling near book value, well below the norm of 1.6 times book value.

With the benefit of hindsight, we know that homebuilders' book values and stocks have collapsed since then. Miller made matters worse by holding large positions in mortgage and other financial stocks crushed by the housing-induced credit crisis -- companies such as AIG, Bear Stearns, Citigroup, Countrywide Financial and Freddie Mac.

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If Miller's blind spot for energy had merely been a sin of omission -- failure to hold the stocks -- it wouldn't have been so bad. But he compounded his error (at least in Opportunity) by selling short two energy-related exchange-traded funds, a move that certainly hurt results in a period of sharply rising energy prices.

Hammered twice. Bill Nygren graciously agreed to talk about his funds' recent woes. Over the past three years, Oakmark Select fund (OAKLX), a former Kiplinger 25 member that he co-manages, lost an annualized 4%, an average of six percentage points per year behind the S&P 500. Over the past year, it surrendered 21%.

Nygren divides his weak performance into two periods, through the first half of 2007 and from then on. His failure to invest in energy and other resources stocks mostly explains his weak performance during the first period. Like many value investors, Nygren generally shies away from those kinds of businesses because it's hard for them to distinguish themselves from rivals. "The determinant of success is the underlying price of commodities, over which they have absolutely no control," says Nygren.

He is far more chagrined about his fund's lousy results since the second half of 2007, when the roof caved in on housing and financial stocks. "As a value investor," he says, "you believe the stocks you invest in have much less risk of permanent loss of capital. This ended up not being true for several of my holdings."

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The severe decline in residential-property prices blindsided Nygren. He says he expected a leveling off of prices -- the historic pattern in weak residential markets -- instead of a drop of 20% or more. "We got the housing-price outlook wrong, therefore we made mistakes in the mortgage business," he says. That's because so many loans to homeowners were made at dangerously high loan-to-value ratios, in defiance of Banking 101. Oakmark Select, a concentrated fund that holds about 20 stocks, was burned by its positions in Pulte Homes, Home Depot and H&R Block (the tax preparer wrecked a perfectly good business by an ill-considered diversification into the subprime- mortgage industry).

But the big whopper of a mistake was the fund's huge 15% allocation to Washington Mutual, the nation's largest thrift. WaMu held a portfolio of $200 billion in mortgages, says Nygren, who never guessed the bank would eventually book $20 billion in losses from mortgage holdings. The stock shed 90% of its value over the past year.

They got it right. Now let's look at two prominent value investors who have (mostly) coped with the market's duress. Steve Romick's FPA Crescent fund (FPACX) returned 0.7% over the past year, while Bruce Berkowitz's Fairholme fund (FAIRX) lost 1%. Both investors gave a wide berth to financials, loaded up on energy stocks (although Berkowitz recently cut back) and held a lot of cash.

In fairness, it should be noted that Crescent normally does not place more than 70% of its assets in stocks. Still, had Romick been less careful with his stock picks, the fund could easily have spilled red ink. "My returns have been generated as much by what we don't own as what we do," says Romick, who stopped buying financial stocks five years ago. He and his partner, Bob Rodriguez, manager of FPA Capital fund, have been remarkably prescient -- and vocal -- about the risks embedded in the U.S. financial sector.

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Romick says many ostensible bargain hunters were fooled by the high returns on equity and other measures of profitability of U.S. banks. From 1996 to 2006, he says, those numbers were inflated by esoteric products and excess leverage, which should call for lower share values, not higher ones. "It was like a ten-year bubble for banks," he says.

Even after the recent collapse, Romick says, he's still not terribly interested in banks because rising inflation is bad for bank stocks. Plus, he figures that reduced leverage, greater regulatory scrutiny, more bad debts and fewer exotic products aren't a recipe for rising bank earnings. Berkowitz used to own financial stocks in the late 1980s and early '90s, when "you were able to understand who they were and what they owned." Today, he says, banks are so complex that "unless you're able to dig down into the underlying collateral," you don't know what you're buying.

Energy player. While Miller was betting against the oil sector, Berkowitz was loading up on low-cost energy producers, such as Canadian Natural Resources. Over the past few quarters he's booked a gusher of oil profits and moved the money into depressed health-care stocks, such as Pfizer and Wellpoint.

A value investor with an open and independent mind, Berkowitz is even doing the sacrilegious: paring his stake in Berkshire Hathaway. He says the law of large numbers is catching up with Berkshire, and that value-investing demigod Warren Buffett is spending more of his time on non-Berkshire activities.

Berkowitz also hews to a strategy of keeping a large pile of cash, in part to have ammunition to buy stocks when others are forced to dump them. "Cash is the equivalent of financial Valium," he says. "It keeps you cool, calm and collected."