It's easy for a mutual fund manager to look smart these days if his portfolio contains shares of Philip Morris Companies Inc., which have risen like a smoke signal over the last year.
But think back to late 1999, when the company's tobacco litigation woes spawned a media frenzy and market nightmare. By the end of December, Philip Morris stock would be down 54% for the year. It was one reason that Clipper Fund finished 1999 with a 2% loss, at a time when the S&P 500 Index and tech-heavy funds were zooming. Even many of Clipper's peers in the large-cap value group, though straggling behind growth funds, did better.
As investors who had stuck with the tobacco stock for years decided enough was enough and bailed out, Michael Sandler, co-manager of the Clipper Fund, picked up some more. By the end of the year, the stock accounted for 7.11% of assets. In Clipper's annual letter to shareholders in December 1999, Sandler and his co-managers felt compelled to justify the presence of what they called "our most controversial stock."
"As an operating business, Philip Morris is well-managed, remarkably profitable and cash generating," it read. "About $3 billion of that cash was used to repurchase its own stock last year. As a stock, it is statistically one of the cheapest available with a price/earnings ratio of seven times and a yield of over 8%."
As for litigation concerns, the letter noted that appeal procedures "will reach far into the new millennium" and that "a massive legal judgement is unlikely to be allowed to shut down an entire industry which serves 45 million customers and provides over $27 billion in annual government revenue."
At the time, it was hardly an easy call. "A lot of people I knew, even a few who work with me, didn't believe those arguments were enough to make investors overlook the litigation threat," says Sandler. "A lot of them have changed their minds."
"Stick to your guns," the mantra of true value investors, goes double for Sandler and Clipper co-managers James Gipson, Bruce Veaco and Peter Quinn. As other value funds edged into growth stocks in the late 1990s, and said it was appropriate to do so to change with the times, Clipper's managers kept loading up on market castoffs like Philip Morris. That faithful tenacity looked more like sheer stubbornness from 1996 through 1999, when the fund failed to keep pace with the S&P 500 Index.
But shareholders who stuck things out are probably glad they did. Last year, the fund scored a total return of 37.4 %, as the S&P 500 sank into negative territory. As of March 9, Clipper was up 3% year-to-date, compared with a drop of 6.4% for the index.
Heel-dragging in strong bull markets and solid returns in sideways and down markets are fairly recognizable patterns in a true value fund. In Clipper's case, Sandler and his team use a deep value strategy that centers around what a rational private buyer would pay for a similar business. If a stock is selling for at least 30% less than this intrinsic value, which they calculate with their own valuation models, it piques their interest. The focus is on dominant companies that are generating excess cash flow and are out of favor with investors.
Examining public companies though a private market prism comes naturally to Clipper's management team, most of whom cut their teeth in private industry before joining Pacific Financial Research, which Gipson founded in 1980. Sandler's hard-to-place accent is a product of growing up in South Africa, where he lived until he moved to the United States to attend the University of Iowa in 1974. He went on to get a law degree there, and joined International Harvester in 1981 as a "manager of asset redeployment"-the company's euphemistic title for the person charged with liquidating its assets. "Eventually," he says, "I liquidated myself out of a job."
But not before he learned about how to value a company from the inside out, which was one reason Gipson invited him to join his fledgling firm in 1984. Gipson, a former U.S. Navy officer, had worked as a management consultant at McKinsey & Co. and as a portfolio manager for Batterymarch Financial before founding his firm. Gipson and Sandler have co-managed Clipper Fund since its inception in 1984. Veaco, a certified public accountant who once worked with Price Waterhouse, joined the team in 1986. Quinn joined Pacific Financial Research in 1987, after getting his MBA.
Few Bargains Around
With technology stocks so battered, some value fund managers are starting to edge into that territory, even if they haven't set foot there in years. Not Sandler and the Clipper team, whose fund last owned a technology stock six years ago.
"Yes, tech stocks have landed with a thump," he says. "But they are down from valuations that were off the charts. These aren't necessarily bad businesses, but their stocks just aren't cheap enough."
In fact, says Sandler, there isn't much out there that fits Clipper's bargain-basement-buy criteria. Last year about this time, Clipper's managers were loading up on Philip Morris, Freddie Mac and other stocks that looked cheap. That brought the fund's cash position down to 22%-high by most mutual fund standards, but fairly narrow for this fund, which always keeps an ample cash cushion on hand.
Now standing at 34% of assets, that cushion has turned into a couch. Late last year, Clipper's managers began paring some stocks that had had a good runup, including Tenet Healthcare, Allstate and Nike. By then, the world had discovered the virtues of value stocks, making them pricier than Sandler was willing to pay. So he put some of the money from those stock sales into cash.
"When a stock becomes fully valued, we're not afraid to sell it. And when we can't find anything we want to buy, we're not afraid to let our cash position rise. And really, there is not much out there we find attractive right now. The largest losses have taken place in the stocks that were most unreasonably priced. That's made them cheaper than before, but not cheap enough to buy."
Sandler insists that the fund's propensity for taking big cash positions is not the same as timing the market. "Timing the market is when someone tries to predict short-term market swings, which isn't our goal here. The fact that there's a high cash position in Clipper just means we can't find companies that fit our valuation parameters."
Moving into cash, however, isn't an option in Clipper's sister fund, the $250 million UAM Clipper Focus. While both funds have the same investment philosophy and approach and generally own the same stocks, UAM Clipper Focus keeps all but about 5% of its money in equities at all times. The managers compensate for the lack of cash by holding proportionally larger asset weightings in each name.
Launched in 1998, UAM Clipper Focus is the more aggressive and volatile of the two funds, says Sandler, because it doesn't have a fixed-income component to help smooth out the stock market bumps. Still, in terms of a risk-reward profile, this is more a spicy Clipper than a Clipper on steroids. When the stocks in the two funds are doing well, UAM Clipper Focus will rise a bit more than Clipper, but it will drop more noticeably in bear markets.
Last year, for example, Clipper and UAM Clipper Focus rose 37% and 44.3%, respectively. In the last quarter of 1998, a bearish period, the firm's institutional accounts that correspond to the investment strategies of Clipper and UAM Clipper Focus fell 1.4% and 4.7%, respectively-both well below the S&P 500 Index's 10% drop.
Sandler says financial advisors don't necessarily gravitate to one or the other. "You'd think they'd prefer Focus because it fits more neatly into asset-allocation models, but that isn't always the case," he says. "I think there's a class of advisors who like funds with a fully invested posture. But there is also a large group that prefers Clipper's lower risk profile and lower turnover." Some may prefer Clipper's lower expense ratio of 1.09%, compared with 1.4% for UAM Clipper Focus. Sandler says the latter fund's expense ratio is higher because it is available through no-transaction-fee is available through no-transaction-fee programs at discount brokerage firms.
Sandler thinks that the market will continue in a downward pattern over the next couple of years and is positioning the fund defensively by beefing up positions in companies he considers best prepared to weather an economic and market slowdown. In the real estate investment trust sector, his largest holding, Equity Residential Properties Trust, focuses on apartments because "people always have to live somewhere." The fund also added to its position in McDonald's Corp. a few months ago. Even though the burgermeister's stock has fallen nearly 15% since the beginning of the year, Sandler is, characteristically, keeping the faith. "The weak Euro hurt earnings last year, and monthly restaurant sales have been lumpy," he says. "But over the long-term, it's the company's great franchise that really counts."
Clipper Fund Facts
Inception date: 1984Expense ratio: 1.09%
Assets: $1.4 billion
Average weighted market capitalization: $27.027 billion
Turnover rate: 45.6%
Top five holdings:
Freddie Mac (7.2%)
Philip Morris (6.7%)
Staples Inc. (3.9%)
Equity Residential Properties Trust (3.3%), Fannie Mae (3.3%)
Source : Clipper Fund