Winning With Out-of-Favor Stocks

In the 30 years since they founded Sound Shore Management in Greenwich, Conn., Harry Burn and Gibbs Kane have seen all kinds of markets. Throughout, they've practiced being "greedy when others are fearful and fearful when others are greedy," says Burn, echoing Warren Buffett. Now, he says, is the time to nuzzle up against the bear and cull opportunity from its jaws.

By adhering to this contrarian approach, Burn and Kane have delivered steady results at Sound Shore Fund (symbol SSHFX). Over the past year through September 3, Sound Shore lost 6%. That beat Standard & Poor's 500-stock index by six percentage points and the average large-company value fund by 14 points, according to Morningstar. Over the past ten years through August 29, the fund gained an annualized 8.5%, topping the S&P by an average of four percentage points per year and the average large-company value fund by three points a year.

Since the fund's inception in 1985, Burn and Kane have stuck with the same tried-and-true stock-picking strategy. Along with John DeGulis, who joined the firm in 1996 and became co-manager of the fund in 2003, they focus on digging up out-of-favor stocks.

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The managers start with a universe of 1,250 U.S.-listed companies with market capitalizations of at least $1 billion and rank them on the basis of price in relation to earnings and book value (assets minus liabilities). They look at companies with price-earnings ratios that are low on an absolute basis and relative to their historical norms and to those of similar stocks. They also take earnings growth into account.

The managers then subject the cheapest 250 stocks to further investigation, speaking with management, competitors, and customers. Then they invest in the stocks that they believe will perform best over a one- to three-year period. At last report, Sound Shore Fund held 39 stocks.

One company that passed the test was Barr Pharmaceuticals (BRL). Burn says Sound Shore bought shares of the generic-drug manufacturer in 2007 and added more when their value dropped about 20% over the first six months of this year. By June 30, Barr was the fund's largest holding. And on July 18, Barr agreed to be acquired by Israel-based Teva Pharmaceutical Industries, the world's largest generic-drug maker. Barr's stock, which closed September 4 at $67.70, is up 71% from its 2008 low. "We used the opportunity to add to it and have been rewarded for it," says Burn.

A more controversial name in Sound Shore's portfolio is Credit Suisse (CS), bought this year. The Zurich-based financial-services company avoided many risks other investment banks took, says Burn, and it's "not getting credit for its wealth-management and asset-management businesses." Putting aside the turmoil in financial markets, Burn thinks the stock is worth $70 to $75 a share. It closed at $44.93.

Sound Shore Management controls assets worth $7.2 billion, $2.5 billion of which are in Sound Shore Fund. The fund requires a minimum $10,000 investment and charges a below-average 0.92% in annual expenses.