Five Questions for Marketocracy's Ken Kam

The rise of the Internet in the late 1990s spawned several mutual funds based on the idea that you could tap into the collected wisdom of the stock-picking masses to build a portfolio. None of those funds ever gained traction, and only one, Marketocracy Masters 100 (symbol MOFQX), survives. It has $42 million in assets.

But even Marketocracy doesn't simply invest in what the masses are buying. Rather, Ken Kam, a co-founder of tech-stock shop Firsthand Funds, serves as the portfolio manager and has the final say on its holdings. For help in picking stocks, he can call on a large stable of amateurs who maintain model portfolios at his Marketocracy.com Web site. But he relies most heavily on the work of the ten best, as determined by a software ranking system that takes into account a stock-picker's ability to generate returns in different types of markets.

The fund gained 12% over the past year through August 31, beating Standard Poor's 500-index by nearly three percentage points. The fund is not quite five years old. Over the past three years, it returned 8% annualized, versus 11% for the SP. Although Kam can invest in companies of any size, the fund currently tilts toward small companies. We recently sat down with Kam in New York to discuss the fund as it approaches its fifth anniversary in November.

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KIPLINGER'S: You have a lineup of top ten stock pickers. How often does that lineup change?

KAM: Different kinds of markets call for different kinds of skills. If you're running a baseball team, you don't want a whole team full of right-handed batters. So if you find yourself in a choppy market, with no clear-cut trends, you need people who are very skilled at moving between sectors and not wedded to any one. We call them generalists. Over time they've delivered their returns not by staying in one sector or one style all the time but by moving around. That gives us some confidence that if energy falls out of bed, for example, they'll get you out of it. If we were running this system in the late '90s, we probably would have been picking really good tech-stock-pickers and health care guys. But they only would have been tech and health care guys, so when tech fell out of bed, it would have been up to us to replace them with people who were good at financials, which did well after that.

How do you decide which of their stock picks go into your portfolio? For the past 18 months we've been developing what I call our concept of a "best-idea" stock. Every portfolio has it. Each portfolio may cover 50 stocks, but there are only one or two that will do really well; the kind that can double in a couple of years. Each manager would like to put a lot of money into just those stocks, but that would make the portfolio too vulnerable, so they can't. We have a team, and each one of those guys has their best-idea stocks. It's a diversified portfolio of best-idea stocks. So they don't all have to come to fruition. You can be wrong on some of them. But those [best-idea stocks] are the ones you want to bet more heavily on.

What's one of your best-idea stocks? Elan (ELN) is our single biggest position [about 6% of the portfolio]. It was picked by two of the top-ten guys. That's how it got on our radar screen. The company makes a drug for multiple sclerosis patients, but they had to withdraw the drug from the market after some people using it died. The stock went from $30 to $3 in like a week. We bought it at $7, but the key question was, is this drug dead? If it was dead, the stock was going to go from $3 to zero. If it was not dead, it was a drug that had already gone through three phases of Food and Drug Administration approval and had displayed good efficacy, so the stock was worth more than $3. Now the drug has been re-approved by the FDA and is available in Europe, so it has a bigger market potential now than it did when the stock was selling at $30. [The stock closed at $15.96 on September 18.] And the same drug is shown to be effective against Crone's disease, which might be a bigger market than multiple sclerosis.

So you don't simply pick the stocks that turn up most often in the model portfolios on your site? There's a misconception that the fund is kind of a democracy. It's not a democracy. It's a meritocracy. Warren Buffett says that in the short term the market is a voting machine. But even there, it's not "one man, one vote." You get as many votes as you have dollars. The people who have the most dollars, and therefore the most votes, aren't necessarily the most skilled investors or the most knowledgeable about companies. They do not necessarily have the best track records. The people who really know are people who we found have a very different background than the typical Wall Street background. But they don't have a lot of votes because they don't have a lot of capital to move prices. So we're basically putting our capital behind the people who have demonstrated skill in picking stocks.

What's in it for them? We sign research contracts with them. We have a long-term and short-term compensation program. A lot of them are doing other things. They're trying to become professional managers. Some of them have used their track record to start up hedge funds. We would like for our fund to grow big enough to make it a full-time job for lots of them.