Hedge Fund Team Goes Mainstream

The hedge fund and mutual fund worlds seem to occupy parallel universes. Hedge funds cater to the wealthy, luxuriate in secrecy and relish risky tactics, such as selling stocks short and employing borrowed money to magnify their bets. Mutual funds are aimed at ordinary folks, and are more transparent and tightly regulated.

But now comes Tilson Focus, a mutual fund launched in March 2005 by Whitney Tilson and Glenn Tongue, two seasoned hedge-fund managers. The pair use the same stock-picking strategy for the mutual fund that they use for their three hedge funds (except they do not leverage or sell short in the mutual fund). In fact, they often buy many of the same stocks for all four funds.

So far, it's hard to argue with the hedgies' results in the mutual fund world. For the one-year period to November 1, Focus (symbol TILFX; 800-773-3863) returned 29%, beating Standard & Poor's 500-stock index by 13 percentage points. Over the period, it was the third-best performer among mutual funds that specialize in large-company stocks.

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Tilson and Tongue are hard-core value investors. For them, growth is but a component of value, and cash flow (earnings plus depreciation and other noncash charges) is king. "Net profit is an opinion. Cash is a fact," says Tilson, alluding to the ability of accountants to manipulate reported profits. And a stock is of no interest to the duo unless they can buy it for at least 30% less than their calculation of the company's intrinsic, or true, value.

Tilson and Tongue run a highly concentrated portfolio. Just six stocks account for almost half of the fund's $11 million in assets. "Sometimes months go by and we don't find a single opportunity," says Tongue.

Like many other bargain hunters nowadays, Tilson and Tongue are gravitating toward well-known growth companies whose shares have been beaten down, such as Wal-Mart and Costco. "Ninety-eight percent of the time, blue chips are not where you find value," says Tilson. "But some of the world's highest-quality businesses have fallen deeply out of favor."

Give the managers of Tilson Focus credit for instituting a performance-based management fee. But even if the fund lags its benchmark, its annual management fee can never fall below 1.05%, which is well above average -- and it can reach as high as 1.95% if the fund beats its bogey. And those figures don't include other expenses. For now, the total expense ratio is capped at 2.40% per year. The minimum initial investment is $2,500.

Favorites: High-quality bargains

Whitney Tilson likes Berkshire Hathaway (symbol BRK.B for Class B shares) because it's "safe, cheap and rapidly growing." Its operating businesses throw off mountains of cash for investment maestro Warren Buffett to allocate.

Tilson and co-manager Glenn Tongue note that McDonald's (MCD) is also a cash generator, partly because of the way it depreciates company-owned property on which it earns a steady flow of franchise fees.

With Microsoft (MSFT) overhauling Windows, Office and its server software in 2007, the duo think Wall Street grossly underestimates the software giant's earning power.