Focused fund managers pick their best and brightest ideas.
They may go out on a limb, and they don't always get
it right. But one thing you have to say about managers of focused
funds-they aren't afraid to take a stand.
At a time when the average equity mutual fund owns over 100 stocks, and many index funds and exchange-traded funds spread their bets around even more, fund managers who run concentrated portfolios offer a refreshing departure from the increasingly popular practice of far-reaching, benchmark-centric investing. They are usually benchmark-blind in their investment strategies and, for better or worse, their fund's performance shows it. They are stock pickers in the truest sense of the phrase.
The ones who get it right stand apart from the pack. Bill Nygren of Oakmark Select, Kenneth Heebner of CGM Focus and Tom Marsico of Marsico Focus are a few of the more recognizable fund managers who run concentrated portfolios. Others, such as the trio of managers who run the Fairholme Fund or Alex Motola of Thornburg Core Growth Fund, have lower profiles but commendable track records. And then there's Warren E. Buffett, whose legions of fans have dubbed him the unofficial king of concentrated value investing.
Nygren says his approach gives shareholders their money's worth, and his fund owns just 19 stocks "out of respect for how strong a competitor index funds are. They're available to the investor at almost no cost. If a manager is going to charge a fee, I believe he needs to provide something very different from an index." Alex Motola of Thornburg, whose fund owns 35 stocks, concurs. "We're stock pickers, and we don't want to dilute the value in that. We want to be intimate with every name in the portfolio."
Although concentrated funds still represent a small corner of the market, the allure of the superstar stock picker hasn't been lost on the fund industry. During the late 1990s, when a small group of big companies accounted for a large chunk of the market's gains, fund companies churned out dozens of focus funds. Today, 361 U.S. stock funds and 27 international stock funds own between ten and 40 stocks, according to Morningstar.
To capitalize on the appeal of this approach, AIG SunAmerica recently launched a family of seven style-specific focused funds, each containing 30 stock picks from three different managers. In summarizing the attraction of focused investing in today's market, the firm's promotional literature notes, "Stock pickers are critical during volatile markets when company fundamentals are the distinguishing feature among winning and losing stocks." In other words, when the tide isn't lifting all boats, you need to jump into the right ones.
One problem with jumping into a focused fund is that they may be more or less "focused" than they appear. There is no official rule about how many stocks a fund can own and still bear the label "focus" or "select." Some have only 15 or 20 stocks and keep one-third to one-half of their assets in their two top names. Many extend the definition a bit with 30 or 40 stocks, while a number have 80 or more holdings. And, judging by the number of stocks in their portfolios, it appears that a sizable number of focused investing practitioners prefer to keep a foot in the diversification door. Lower the maximum cutoff to 30 stocks, and the ranks of focused domestic stock funds in Morningstar's universe falls to 171, while the number of international funds drops to just eight. To add to the confusion, the names of some of the most concentrated funds, such as those offered by Longleaf Partners or CGM, offer little hint of their decisive nature.
What Focused Fund
Managers Are Focusing On
Regardless of how they define "focused," funds with concentrated portfolios usually have more on the table with each position than their more diversified competitors. That means returns from a few stocks, particularly top holdings, can turbocharge performance in either direction. Some of the funds underperform their peers spectacularly, while others have compiled admirable long-term track records.
William Nygren, the long-time manager of Oakmark Select, falls into the latter group. His largest holding, Washington Mutual, accounts for 15% of assets. An avowed contrarian, Nygren likes to own companies whose stocks sell at a discount to private value, and that have growing businesses. "The S&P 500 companies will likely grow earnings at an average rate of 5% to 6% over the next year or so, and the index has a dividend yield of about 2%. So we want companies that have a combination of earnings growth and dividend yield of at least 7%," he says.
Washington Mutual, the country's largest savings and loan, sells for just ten times next year's earnings, has a dividend yield of nearly 5%, and has increased its dividend every quarter for the last seven years. "Investors overreact to swings in the mortgage business but undervalue the retail banking franchise," he says. The fund's second largest holding, Yum! Brands, is the company behind several well-known fast food franchises, including Pizza Hut, Taco Bell and Kentucky Fried Chicken. Although the stock sells at a slight premium to the market, Nygren believes the company's strong presence in China will help it realize earnings growth in the range of 10%.
With about 35 stocks in its portfolio, Thornburg Core Growth Fund's Alex Motola spreads his bets a bit more than Nygren. Each holding, which spans the range of market capitalizations, typically accounts for 1.5% to 5% of assets.
Motola categorizes companies as growth industry leaders, consistent growth and emerging growth. Growth industry leaders are fast-growing companies that appear to have proprietary advantages in their industry segments, and their stocks generally sell at premium values. The fund's second largest holding, search engine Google, falls into that category. "Analysts chronically underestimate the earning power of this company," he says. "But it is one of the few large-cap companies that's generating 50% top-line growth. Its valuation is in line with peers such as Yahoo!, but its growth potential is much better."
Consistent growers generally sell at premium valuations and tend to show steady revenue and earnings growth. In this category, he likes Johnson & Johnson because "it could lose a small country as a client and that wouldn't have an impact on its ability to deliver."
The health care giant also has less exposure to patent expiration issues than its competitors. IMAX Corporation is an emerging grower involved in the design and installation of large-format theaters. While the company has been around since 1967, its technology has only recently begun to move from museums and science centers to commercial multiplexes. A lower-cost theater option for multiplex operators, combined with enhanced technologies that allow for inexpensive conversion of traditional movies into IMAX format, should lead to further theater orders in the U.S. and abroad.
Rob Lyon, who runs the ICAP International Fund, says his firm "defaulted into" concentrated investing. "We began putting European ADRs into our domestic portfolios, and eventually there were so many of them that we migrated them into a separate international portfolio," he explains. Today, the fund owns about 35 ADRs and foreign stocks of medium and large companies in Europe and Asia.
Lyon says that international markets, on average, "offer more growth at a lower price-earnings ratio than the United States. And the interest-rate cycle is not as advanced as it is here." The fund limited its investments to established European markets until May 2005, when Lyon's conviction that the Japanese economy was finally turning the corner prompted him to begin moving into Asia.
Mitsubishi, one of the fund's largest holdings, has also been its best performing stock this year. Although most people know it as an electronics company, Mitsubishi is also a back-door play on raw materials prices because of its hefty stake in mining companies, says Lyon. "It's a great way to take advantage of rising commodity prices, and it's more diversified than a mining company," he says. "Profits have doubled over the last year and the stock is up 50% in 2005, but it's still priced at just ten times earnings."
Despite its name, the $100-million Auxier Focus Fund, run by Jeff Auxier, owns about 100 securities. But he points out that most of those are small tracking positions, and the lion's share of assets are in the fund's top 30 holdings. "The focus," he says, "is usually around a theme."
Right now, the theme Auxier likes is insurance, and he added to his positions in companies like St. Paul Travelers and Marsh & McLennan soon after the fall hurricanes slammed stocks of property and casualty insurers. "In this industry, catastrophe takes out capacity," he says. "Some insurers will go out of business, but those that remain will have increased pricing power and will raise premiums." Although that cycle could take years to play out, Auxier is willing to wait. "Most of Wall Street is focused on the next three months," says Auxier, a former Smith Barney broker who owns a working farm outside of Portland, Ore. "I'm looking at the next three years."