Tales of Erring-Do
You can learn a lot about investing by listening to mutual fund managers discuss their winning stock plays. And you might learn even more important lessons from discussions of their losing ones.
Naturally, it’s not easy to find out about the miscues. Fund managers typically don’t elaborate on their setbacks in interviews, shareholder newsletters or annual reports. And, just as naturally, when they do discuss errors, they tend to put a positive spin on it all.
But there are exceptions. To help individual investors think about their own mistakes, several fund managers each agreed to discuss a trade that went awry and the lessons to be drawn from the experience.
CHRISTOPHER DAVIS
Background: The father-son team of Shelby and Christopher Davis runs the Davis New York Venture Fund, with offices in New York and Santa Fe, N.M. This value-oriented growth fund has been a standout performer, returning 17% annually on average over a 10-year period through Jan. 31 and capturing a top rating of five stars from fund rater Morningstar Inc. of Chicago. Christopher Davis also calls the shots for the younger Davis Financial portfolio, a sector fund whose annual returns averaged 25.1% over the five- year period ended Jan. 31. Both funds ([800] 279-0279) carry a maximum 4.75% sales charge.
Mistake: Christopher Davis recounted that the management team in the early ‘90s purchased shares in 20th Century Industries, the California insurance company. The firm was a low-cost leader in providing auto coverage, and when it diversified into homeowners policies, the Davises thought that was a good move. What they failed to notice was that 20th Century had concentrated its homeowners insurance business around its headquarters in the San Fernando Valley, that concentrating such insurance business in one geographic area presents a risk should there be any kind of natural disaster. Furthermore, the Valley is in an earthquake zone. The 1994 Northridge earthquake brought a surge in claims against the company, bringing down 20th Century’s earnings and stock price dramatically.
Lesson: Turn over as many stones as you can before investing in a stock. Then turn over some more. “It’s often something listed in the company’s financial footnotes that kills you,” Christopher Davis said. The geographic concentration of 20th Century’s insurance underwritings was no secret, but it had to be noticed.
RICHARD EARNEST
Background: Earnest is lead manager of Stepstone Value Momentum Investment, a mutual fund run by Union Bank of California in Los Angeles. The fund (4.5% load; [800] 734-2922) has not quite reached its fifth birthday, yet sports an above-average four-star rating from Morningstar. Its annual returns average 19.8% over a three-year period ended Jan. 31. Earnest is a value investor who focuses on large and medium-sized companies.
Mistake: Earnest late last year invested in Aames Financial, a Los Angeles mortgage-banking company with offices primarily in California. Aames specializes in lending to homeowners with lower credit standings who have high equity in their dwellings, reasoning that these people will be more likely to sell their properties than to walk away from them should they have problems making payments. Aames has a good record of avoiding loan losses, Earnest says, and the company is expanding its operations outside of California. But the stock price fell, partly because of rising interest rates, accounting complexities and a problem of perception--a case of mistaken “guilt by association,” as Earnest puts it--stemming from the publicity over some companies’ problems with high-risk auto loans.
Lesson: “If your stock has fallen faster than the market, somebody’s giving you a clue that you have to look further,” Earnest said. Although he continues to like Aames, Earnest believes that this case offers a reminder that it’s important to reevaluate such positions and verify that your analysis remains sound.
L. ROY PAPP
Background: The 6-year-old L. Roy Papp Stock Fund (no load; [800] 421-4004) in Phoenix holds a concentrated mix of blue-chip growth stocks. Lead manager L. Roy Papp achieved a 14.5% average annual return and a four-star Morningstar rating over the five-year period ended Jan. 31. The company’s four-star Papp-America Abroad Fund follows a similar investment strategy but with a greater global flavor. It aims to capitalize on world trade through U.S. exporters, thereby avoiding the accounting peculiarities and currency risks of direct investments in foreign nations.
Mistake: Papp purchased a stake a few years back in Hartford Steam Boiler Inspection & Insurance, a Connecticut company that combines engineering work with insurance. The firm had an experienced management and an impressive record of profitability. In addition, property-casualty insurance stocks had been undervalued for a fifth consecutive year--an unusually long stretch. “We felt the insurance industry would turn,” Papp said. “It had been a fairly predictable cycle.” But the hoped-for improvement didn’t materialize. Hartford Steam Boiler’s profits dropped amid price-cutting pressure in the industry, and Papp unloaded the stock at a loss.
Lesson: Relying on any stock selection system, including “business cycle” patterns, isn’t always going to work. In this case, Papp says he did not realize the nature of the business had changed. “We felt the insurance business would turn. It had been a fairly predictable cycle.”
JOHN ROGERS
Background: Rogers has guided the conservative Ariel Growth Fund (no load; [800] 292-7435) to a 13.1% yearly compounded return over the past 10 years through January. Morningstar gives it a four-star performance rating and grades its riskiness as low. The Chicago-based fund was formerly called the Calvert-Ariel Growth Fund and carried a sales charge. Rogers pursues a value bent in targeting small and medium-sized companies. His is a concentrated portfolio of stocks, and he spends considerable time meeting with managements.
Mistake: Rogers said he focused on the wrong things when investing about three years ago in Payless Cashways, a Kansas City, Mo.-based company that runs a chain of home improvement stores. Rogers said he recognized that Payless carried relatively high debt for its industry and that it was a second-notch competitor against rivals such as Home Depot. But he bought the stock anyway on hopes that the company’s management, which he still admires, could propel the firm into a leadership position. “One of Warren Buffett’s principles is that you want to buy companies that you feel virtually certain will be more profitable in five, 10 or 20 years,” Rogers said. “Payless, in hindsight, didn’t pass that test. We were hoping rather than having that virtual certainty.” Rogers sold the stock about a year ago at a loss.
Lesson: Payless “occupied a little niche in a field that was dominated by larger competitors,” Rogers said. “The lesson is that you can’t buy second-tier companies.” A corollary lesson, he adds, is that high debt only makes things worse.
