Letting a Laggard Stock Fund Go Isn’t Easy--I Know

Warren Buffett has said that the best time to sell a stock is “never”--that is, assuming the investment does what you expected it to do, or better.

But even master investors like Buffett make mistakes. USAir Group was one of his--one he attempted to exit earlier this year after seven years of dismal performance.

This is a story about one of my mistakes, about a disappointing investment in which I have probably stayed too long, exhibiting what I thought was Buffett-like patience.

I am now, finally, considering selling, perhaps three years too late. I share this experience because many investors may be able to empathize with it, or with elements of it. Buying a stock or stock mutual fund is easy. Selling is far more difficult for most people, and it is the decision many have not yet faced (thanks to the long bull market) but will eventually. Even for long-term investors, there is a time to say goodbye.

What’s more, my experience reveals some of the peculiar risks of investing in stock mutual funds. For one, entrenched fund managers--those who call all the shots in a fund management company--usually don’t fire themselves, regardless of their performance.

Second, you are always in danger of being victimized by your fellow shareholders, whose intentions you cannot know and whose actions may have little to do with the quality of the investments in the portfolio. This too is a lesson many fund investors have yet to learn but probably will.

The investment on trial here, as it were, is Pennsylvania Mutual Fund, a 34-year-old fund that once was an industry star. Under Chuck Royce, who has managed the fund since 1973 through his Quest Advisory Corp., Penn was for most of the 1980s one of the premier names among funds that focus on small-company stocks. (The name Pennsylvania, I should note, has nothing to do with the fund’s investment focus.)

Penn was my first stock investment. The year was 1983, I was a relatively young 26, and the great bull market of the 1980s had just begun a few months earlier--although at the time, with the Dow Jones industrial average at 1,050, neither I nor most other investors had any inkling of how magnificent stocks’ performance was about to become.

For me, the feeling was simply that I needed to begin to buy stocks as a diversification move. Bond and money market yields were extraordinarily high back then (and thus appealing), and everybody was still making great money in real estate. But I remember thinking in 1983 that stocks might again become the lucrative investment that my finance books said they were in the 1950s and 1960s, before the inflation surge of the 1970s and the devastating 1973-74 bear market horribly tarnished the market’s image.

“You have to take the plunge sometime,” I remember telling a co-worker in 1983. Precisely how I settled on Penn as my first equity investment I can’t remember, but the concept of investing in small-company shares seemed to make sense (they had performed much better than blue chips from 1975 through 1981), and Penn had a sterling reputation.

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In addition, as a financial journalist my options were limited: Owning individual stocks invited conflict of interest, because I could find myself in the awkward position of covering a company or industry in which I had a meaningful (to me) ownership stake. Mutual funds, on the other hand, were diversified and left decision-making regarding individual stocks in the hands of the fund manager. To this day, the funds remain my principal vehicle for equity investment. I buy and hold.

So in 1983, I wrote a check for $1,000 to Penn Mutual and dropped it in the mail.

I would add to my stake over the years (and buy numerous other funds as well). And for most of the 1980s I was quite happy with Penn’s performance. Royce was a “value” investor, meaning that he hunted for stocks of underappreciated small companies--usually non-flashy, even downright boring firms in mundane industries.

The idea was to buy cheap, low-risk stocks that would pay off in the long run as the companies’ earnings grew and more investors took notice.

From 1985 through 1990, Penn matched or beat the performance of the Russell 2,000 index, the best measure of the small-value-stock market, every year but one. For the 1980s decade as a whole, Penn gained 258%, versus 127% for the average small-stock fund. Royce’s eye for true value seemed exceedingly sharp.

Not surprisingly, money began to pour into Penn. Between 1989 and 1992, the fund’s assets doubled, to $1.1 billion. I felt a touch smug: Other investors were finally discovering Chuck Royce’s talents, but I was there in 1983.

Instead of feeling smug, however, I should have been worried. As 1993 passed and I perused Penn’s annual report, I realized that my fund had become a laggard, at least relative to the Russell index. Penn’s gains were handsome enough in 1991, ’92 and ‘93--31.8%, 16.2% and 11.3%, respectively--but they were well below what the Russell index had gained. I and other shareholders were paying Royce a hefty management fee to beat “the market,” weren’t we?

Still, I convinced myself that patience was in order. I was a long-term investor, and Penn was only a small part of my total portfolio. Royce had just hit a rough patch, I rationalized. Penn’s results would improve.

In the 1994 market downturn, Penn in fact performed better than the Russell index, losing just 0.7%. But in 1995, as the market overall resurged, Penn again badly trailed the Russell, not to mention blue-chip shares. Penn gained 18.8% in 1995, versus 28.4% for the Russell.

Things haven’t improved this year: Penn is up 9.7% versus 13.5% for the Russell--and 25% for the blue-chip Standard & Poor’s 500 index.

Royce, in his June 30 report to shareholders, tried to focus us on the fund’s very-long-term performance and on its low-risk profile. Penn doesn’t race with the rest of the market, he essentially said, but neither will it lose as much in a market downturn. This was true. Yet in this now 6-year-old bull market, we Penn shareholders had forfeited a significant sum of money by sticking with Penn when we could have been in better-performing funds.

Penn gained 68% in the five years ended Sept. 30. The average small-stock fund rose 120% in that period. Even within Penn’s value-fund universe, fund tracker Morningstar Inc. terms Penn’s recent history “bottom of the barrel.”

What’s more, two issues began to loom large in my internal debate over what to do with Penn.

First, no matter what I thought about the fund, many of my fellow shareholders had already given up. The fund’s assets had shrunk from $1.1 billion in 1992 to $640 million by the end of 1995. The hemorrhaging hasn’t stopped: Penn was down to $500 million in assets by Sept. 30.

How much has this continuing asset drain hurt Penn’s performance? When I called Royce last week to discuss all of this, he said he couldn’t quantify the effect of the redemptions on the fund’s results, but he admitted that it created two big problems: He hasn’t had fresh capital to buy promising stocks as they’ve surfaced, and to meet the massive redemptions, he has had to sell stocks he otherwise might have kept, generating taxable gains for shareholders.

“You can draw your own conclusions” about the handicap that has posed for him, Royce said.

Second, even as Penn has lagged in recent years, the 57-year-old Royce was busy with two new small-value-stock funds, both created in 1992: Royce Premier owns some of the same stocks that Penn owns, but in concentrated doses, and Royce Micro-Cap invests exclusively in very small issues, some of which also are owned by Penn.

Both of those funds have grown in size since 1992, even as Penn has shrunk. And for the most part, both of the new funds have performed better than Penn.

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For Penn shareholders, the new Royce funds’ success just adds insult to injury. They certainly cannibalized Penn to some extent. And didn’t they take Chuck Royce’s attention away from his flagship fund--our money?

Royce says no. In fact, he argues, his experiences with Premier and Micro-Cap have given him insight into what has gone wrong with Penn.

As Royce views small-value-stock investing now, there are simply too many fund managers competing in the market. No longer is it the gold mine of inefficiently priced securities in which Royce prospected in the 1970s and ‘80s, he says.

Earning above-average returns, he says, now requires that a small-value-stock portfolio either hold a “very specific, limited” number of the most promising value issues, or that it focus on the “micro stock” arena--the smallest of small stocks, mostly ignored by Wall Street and thus potentially “where the greatest inefficiencies are.”

Royce Premier is the former portfolio; Royce Micro-Cap is the latter. And Penn, Royce says, is being remade into a mix of the two, and thus mid-range between them in terms of risk and potential return. Royce says he suspected five years ago that the two themes were the right directions to take in small-stock investing, “but it was theory and I couldn’t document it. Now I can.” And using those themes, he says, “I am 110% committed . . . to getting Penn back on the scoreboard” in terms of performance.

I don’t doubt that he has incentive to do so. Royce still has a large amount of his personal wealth in Penn. He knows what his investors are wondering. “ ‘Has Chuck gone senile?’ ” he asks rhetorically. “ ‘Has he lost it?’ ”

For me and other Penn shareholders, the question is whether we can afford to stay and find out. The older you get, the more investment underachievement begins to have real consequences. There isn’t time to make it up. In retirement, every missing dollar hurts.

What if Royce has “lost it”? He isn’t likely to fire himself--the usual solution for Fidelity Investments and other giant fund companies when a fund turns laggard.

Worse, what if other Penn shareholders continue to exit? Do I want to be the last one out the door?

What further complicates all of this is that the stock market may finally be turning in Royce’s favor: Rising volatility means Royce gets more opportunities to pick up bargains, and concern about the high prices of “growth” stocks could lead more investors back to Royce-style value issues that have been out of favor for much of the ‘90s.

Still, many financial pros believe that three years of significant underachievement by a stock fund merits the boot. Some surely wouldn’t stay that long. “Pull your weeds,” the old line goes, “and let your flowers bloom.”

I’m on the verge of weeding out my very first stock investment. If I have stayed too long, been too complacent, ignored too many warning signs, then at least I have learned from the experience--which is, of course, the only real value of investment mistakes.

As Michael Lipper of fund tracker Lipper Analytical Services puts it, “You should always have something in your portfolio that reminds you of your own fallibility.”

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Penn Mutual’s Faded Glory

A star in the 1980s, Pennsylvania Mutual Fund has been a laggard in the 1990s, sharply under-performing the Russell 2,000 index of small-company stocks. Total returns each year for Penn and for the Russell index.

Sources: Morningstar Inc., Frank Russell Co.