Riding Out a Slump

Bill Nygren, manager of Oakmark Select fund, is a true superstar in the mutual fund constellation. Through 2005, his annualized return since launching the fund more than nine years ago was 19%, versus 8% for Standard Poor's 500-stock index and 10% for the Russell 1000 Value index of large undervalued stocks. Our firm has long been a big fan of Nygren, and he is a sub-adviser to Masters' Select Value fund, for which Litman/Gregory is the adviser.

What's going on?

But Nygren's performance in the past couple of years has been relatively poor. Although Oakmark Select returned an annualized 14% over the past three years, it trails the Russell 1000 Value index by more than three percentage points annually and ranks in the bottom quartile of Morningstar's Large-Cap Value peer group. The more diversified Oakmark fund, which Nygren also runs, has done even worse.

If you're a shareholder or thinking about investing in Oakmark Select, what should you do? There are a couple of reasons for Nygren's poor performance in 2004 and 2005. First, his portfolio largely ignored energy. The energy sector gained roughly 30% in both years, but Oakmark Select owned only one energy stock during this time.

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Nygren avoided energy because Oakmark's analysis concluded that oil and natural-gas prices would not remain high for long. In hindsight, he was mistaken. Still, looking ahead, Nygren said during a January conference call that it's "highly unlikely that cyclicals and energy stocks will get another big step up in their profitability."

Instead, Nygren has been focused on what he calls "above-average businesses selling at average prices." These are large, high-quality companies that can deliver above-average long-term earnings growth. In the late 1990s, most of these companies sold at big premiums to the overall market. Now the pendulum has swung the other way. Their stock prices have dropped and their earnings have continued to grow. Nygren believes the market will eventually re-price these companies at premium price-earnings ratios, as has been the case historically.

So, for example, the fund has a large weighting in media companies, such as Time Warner, Viacom (MTV, Nickelodeon), Liberty Media (QVC), Discovery Holding Co. (Discovery Channel) and Knight Ridder (newspapers). Although the performance of these stocks has been disappointing, Nygren believes the companies' business fundamentals remain solid: "Eventually, either the fundamentals will get worse or the stocks start doing better. We think the latter is much more likely."

With just 20 stocks, Oakmark Select is a very concentrated fund, so it typically will perform very differently from the broad market indexes. That's a plus. In order to outrun an index, your portfolio has to look significantly different. Moreover, because Nygren and his team have a multiyear investment horizon, they often buy stocks that are out of favor and may be early to the party. This has certainly been the case recently.

Patience as a virtue

This is a marathon, not a sprint. Patience is especially critical when investing alongside long-term, contrarian, concentrated and value-oriented investors such as Nygren. His approach has led to excellent long-term performance since the inception of the fund.

History has often shown that it pays to stick with great managers (and, even better, to add to your positions) during their inevitable slumps or when their investment approach is out of sync with what's "working" at the moment. We wouldn't hesitate to do so now with Bill Nygren.

Steve Savage and Jeremy DeGroot are partners in Litman/Gregory, which publishes the No-Load Fund Analyst newsletter and also advises the Masters' Select mutual funds (www.litmangregory.com).