By now, most investors know the investing mantra: Diversify, diversify, diversify.
But what about buying mutual funds that don't spread their assets very widely, choosing instead to concentrate their holdings in a fairly small number of stocks? How do these portfolios rate?
It turns out many perform surprisingly well.
In fact, a new study by Morningstar Inc. of Chicago argues that most large-stock mutual funds have become bland by holding too many investments. Wide diversification makes sense for funds that own volatile small stocks, Morningstar adds, but it's not so crucial with blue-chip companies.
Morningstar attempted to identify superlative large-stock fund managers who appear to be following in the footsteps of Warren Buffett. The billionaire investor has a penchant for taking big holdings in a short list of blue-chip stocks, with great results.
But Morningstar found few good Buffett mimics among large-stock fund managers. Such portfolios hold 73 stocks on average and thus are more widely diversified than is warranted, given the moderate riskiness of such well-established, well-researched companies.
"Most broadly diversified blue-chip funds can't be defended," wrote John Rekenthaler, editor of the Morningstar Investor newsletter. "They own too many stocks to ever post distinctive [performance] numbers."
Of those funds that take a concentrated approach, owning roughly a couple of dozen or fewer stocks, Morningstar noticed good results.
Topping its list was the Sequoia Fund in New York, a $2-billion portfolio that follows a strict value-investing approach. In fact, the fund's largest stake is in Berkshire Hathaway, the Omaha holding company that Buffett heads.
Unfortunately, it's tougher to get into Sequoia than a presidential inaugural ball: The fund has been closed to new investors since 1982.
Another concentrated bet that earned kudos from Morningstar is the Clipper Fund of Los Angeles.
Like Sequoia, this portfolio seeks value stocks--those selling at markdowns from what management believes are the firms' true worth as ongoing businesses.
"We try to buy things selling for 70 cents on the dollar," says Michael Sandler, who helps to oversee the fund in Beverly Hills.
Clipper holds just 19 stocks, plus a 23% cash weighting that reflects a current inability of Sandler and fellow manager James Gipson to find bargains. Much of their time is spent looking under rocks for stock possibilities.
"We don't find that many good ideas in a year," says Sandler.
Clipper, like a few other portfolios on Morningstar's list, does not meet the Securities and Exchange Commission's definition of being well-diversified. Yet the broad operations of many blue-chip stocks help to limit risk, Sandler says. In particular, he and Gipson favor large multinationals such as Philip Morris, PepsiCo and McDonald's to lessen the fund's dependence on the U.S. economy.
Also scoring highly were two other compact portfolios, the Pilgrim America MagnaCap Fund in Phoenix and Lexington Corporate Leaders in Saddle Brook, N.J.
MagnaCap isn't as compact as when Morningstar examined the numbers around mid-year: Portfolio manager Howard Kornblue has upped his holdings to 40 stocks from 23 in early summer, primarily because the market correction in July created some good buying opportunities, in his view.
Even so, Kornblue holds barely half as many stocks as the typical blue-chip fund, and he's comfortable with such a high concentration.
"These are well-managed companies with very strong financial resources, and their fundamentals aren't subject to abrupt changes," he says. "If we can get to understand these companies really well, they are not very risky investments."
Lexington Corporate Leaders is an unusual offering that has survived the test of time. It started operations in 1935 with 30 stocks perceived back then to be industry leaders. The fund still owns shares in most of those original stocks or their successors, although a few fallen stars have been dropped over the years for reasons ranging from failing financial health to cutting out dividends.
The roughly two dozen stocks now owned by Lexington are concentrated in heavy manufacturing, oil, consumer products and the utility business, reflecting a snapshot of America's corporate titans during the Depression.
The Sequoia, Pilgrim, Lexington and Clipper funds have all had stellar returns; their five-year annualized returns have been 17.5%, 15.2%, 16.0% and 18.0% respectively.
One other compact portfolio with a lengthy history, the New England Growth Fund, earned mixed reviews from Morningstar. The research firm says the portfolio's performance has been lackluster in recent years. It's five-year annualized return is 10.7%.
Morningstar also identified three small, young concentrated funds that it believes are worth watching.
They are White Oak Growth Stock (no-load;  932-7781) in Akron, Ohio; the Philadelphia-based Focus Trust (no-load;  665-2550); and Papp America-Abroad (no-load  421-0131) in Phoenix. All three count fewer than $30 million in assets.
While compact funds in general offer the potential for higher gains, the flip side of the equation is that they also tend to be more risky.
The real reason so few funds opt to emulate Buffett, Morningstar believes, is that the concentrated format tends to frighten shareholders.
"Compact funds virtually ensure themselves of occasionally lagging far behind the [Standard & Poor's 500] index," writes Morningstar's Rekenthaler.
When that happens, investors forget about them for a year or two.
Russ Wiles, a financial writer for the Arizona Republic, specializes in mutual funds.
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Compact and Powerful
Here are three highly rated funds identified by Morningstar Inc. as having the fewest holdings earlier this year--fewer than two dozen companies each.
* Clipper (800) 776-5033
* Lexington Corp. Leaders (800) 526-0056
* Pilgrim America MagnaCap A (800) 334-3444