‘Focused’ Value Funds Hot With Investors
When a strategy works on Wall Street, investors tend to want it in concentrated doses.
That’s happening now with “value” stock mutual funds: As value stocks continue to lead the market, funds that offer a focused value approach--meaning a portfolio of a relative handful of shares--are particularly hot with investors.
A focused portfolio approach can make sense for aggressive investors, analysts say. But just as with the focused “growth” stock funds that were the rage in the late-’90s, concentrated funds of any kind carry extra risk.
For now, many investors are tantalized by the performance of focused value funds.
Veteran value manager William Nygren’s Oakmark Select fund, which holds only about 20 stocks and is up 11.1% year-to-date and nearly 33% in the last 12 months, has been one of the best-selling equity funds this year, according to Financial Research Corp.
Nicholas Gerber’s Ameristock Focused Value, launched Jan. 1, rocketed 31% in its debut quarter.
Many other focused value funds have posted only minor losses so far this year--while the blue chip Standard & Poor’s 500 index has fallen more than 10%.
Several giant financial firms, including Prudential Investments and Massachusetts Mutual Life Insurance, say they plan to launch focused value funds later this year.
Value funds, of course, typically invest in stocks with low price-to-earnings or low price-to-book ratios--in other words, shares that are relative bargains, by those measures, versus the broad market.
Growth funds, in contrast, tend to buy stocks of fast-growing companies whose shares usually carry much higher valuations.
Over the last year, the crash of technology shares has hammered growth-oriented funds. At the same time, fearful investors have flocked back to value shares.
Now, “The fact that Nygren and some of the others have done so well is catching people’s eyes, just as two years ago Scott Schoelzel [at Janus Twenty fund] and Jim McCall [then at PBHG Large Cap 20] were shooting the lights out with focused growth funds,” said Russ Kinnel, head of fund research at Morningstar Inc.
“But the focused-value thing makes sense for other reasons, too,” Kinnel said. “Several years ago, investors had one or two funds, but now they may have five to 15 and not much need for more diversification” in their overall portfolio.
Though a few focused-value funds, such as Clipper, Longleaf Partners and Sequoia, have been around for decades, the majority have been launched in the last five years or so, according to Morningstar. There is no official definition of focused value, but Morningstar says there are about 50 value funds that own 40 or fewer stocks and have at least $20 million in assets.
The average diversified stock fund, by contrast, owns more than 100 stocks.
The idea with any type of focused fund is that you’re getting only the manager’s best ideas.
“This is the fund I would have started five years ago if anybody knew who I was,” said Gerber, whose flagship fund, Ameristock, has beaten 99% of its large-cap value peers over the last five years.
In a novel move, he hopes to close the new fund when it reaches $100 million to $200 million in assets, and turn it into a publicly traded company, if shareholders approve. “Rather than trade at net asset value [per share], we could trade at a premium to the net asset value, or book value, as most companies do,” he said. He would convert it into a corporation rather than a closed-end fund.
Fund managers and industry analysts say focused portfolios can maximize the talents of a smart stock picker. “If a fund has 100 or 200 names, that tells us the manager doesn’t have a whole lot of conviction,” said Bruce Veaco, who runs the Clipper and UAM Clipper Focus funds with co-managers James Gipson and Michael Sandler at the funds’ Beverly Hills-based advisor, Pacific Financial Research.
“We’re not market timers or master economists,” Nygren said. The Oakmark Select fund “highlights our greatest ability: stock selection.”
As Kinnel put it, “If you’re buying active managers, don’t you want them to make some sizable bets?”
But a lot of stocks are cheap for good reason, so the key to running a successful value fund is finding those being punished unfairly, managers say.
Ameristock Focused Value’s top holding, tire retailer TBC Corp.--which accounted for 22% of the portfolio at the end of the first quarter--had been “doubly punished,” Gerber said, for being in two unpopular areas: retail and auto supplies. But as bargain hunters have found the stock, it’s up 30% this year.
Gerber also bought retailer Restoration Hardware at about $1 a share, then quickly sold it at nearly $5 when it accounted for about 15% of assets.
“We went to the stores and counted the cash register lines for a month,” Gerber said. “We looked at how many pedestrians were going inside, versus the Williams-Sonoma store next door. Restoration’s stock was priced like the company was going out of business, but it wasn’t.”
Veaco said his team looks for leading companies whose stocks are selling at 70% of their fair value. The team, for example, thinks American Express, which recently warned of higher-than-expected junk-bond losses, is worth $50 a share. So when the stock recently fell to $35, the managers added to their positions.
“We knew the long-term franchise was intact,” Veaco said.
Whatever their supposed edge, there are risks with concentrated funds. With fewer stocks in a portfolio often comes more volatility.
An individual stock holding in a diversified fund is generally limited to 5% of fund assets, but with a fund that is chartered to be nondiversified, one stock can account for as much as 25% of fund assets.
“We gained 30% in the first quarter but we could just as easily lose 30% in a quarter if a stock blows up,” Gerber acknowledged.
“There will be extended rough periods with any focused fund, especially when that investing style is out of fashion,” said Phil Edwards, head of fund research at Standard & Poor’s Corp.
Still, “There is a built-in risk-reducer in the value approach,” argues Nygren, who also runs the semi-concentrated Oakmark fund. “Expectations for these stocks are so much lower. With a growth fund, their holdings might lose 50% in a day if they have an earnings disappointment, but if one of our companies has a shortfall the stock might drop 10% or 20%.”
Though Clipper typically holds only about 30 stocks, the fund has been less volatile than its average large-cap value peer over the years because of the managers’ asset-allocation moves: They can invest in bonds or cash-equivalent securities as they see fit, so Clipper often acts like a “balanced” fund.
UAM Clipper Focus, however, is designed to be fully invested in stocks.
Naturally, funds such as Ameristock Focused Value that hold smaller stocks and make bolder bets are riskier than their blue-chip or semi-diversified brethren, experts note.
“You should know how big and well-established the holdings are, but also how the managers define ‘focused,’ ” Kinnel said. “Some define it as 4% to 6% of the portfolio in a [single] holding, but for others it’s 10% or 15%.”
Manager tenure also matters. “Investors should look at a manager’s experience in running a concentrated fund,” Veaco said. “If a portfolio has 200 names, it doesn’t matter too much if you make a couple mistakes. But a lot of these newer offerings may be from people that don’t have a long track record.”
For anyone considering a focused value fund, could the biggest risk now be buying high?
“In hindsight, ’98 or ’99 may have been the best time to buy them,” Edwards said. “And by the same logic, if you really believe in a focused growth manager, now might be the time to buy that fund. But the bigger picture is to be diversified and not have to worry about chasing hot stocks or funds. And if your portfolio is growth-heavy, then a deep value fund could be the perfect counterbalance.”
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‘Focused Value’ Funds: A Sampling
Many “focused value” stock mutual funds have posted big gains, or at least held up relatively well, in the last year as the market has favored value investing again. Here is how the 20 largest value funds with 40 or fewer stock holdings (based on the latest portfolios made available to Morningstar) have done:
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Fund Total return: Net assets Fund type* YTD 1-year UAM Clipper Focus LV -0.9% +50.2% Clipper LV +0.1 +39.4 Oakmark Select MV +11.1 +32.7 Longleaf Partners MV -0.2 +29.4 Vanguard Selected Value MV +8.1 +25.7 FAM Value SV -0.9 +24.9 Longleaf Partners Small-Cap SV +0.2 +20.3 Sequoia LV -5.7 +11.9 Flag Investors Equity Part. LV -0.5 +10.3 Evergreen Capital Growth LV -10.1 +6.9 Strong Schafer Value MV +2.2 +6.6 Huntington Income-Equity LV +0.6 +2.9 Pilgrim Corporate Leaders LV -2.0 +1.4 Neuberger Berman Focus LV -6.9 -0.6 Torray LV -3.2 -0.8 Galaxy Equity Income LV -6.7 -0.9 FPA Capital SV +2.2 - 1.4 Legg Mason Value LV -2.3 -2.5 Nvest Growth LV -14.7 -12.9 CGM Capital Development MV -12.4 -15.1 S&P; 500 index -10.3 -14.8
Fund Fund (in millions) UAM Clipper Focus $237 Clipper 1,558 Oakmark Select 2,506 Longleaf Partners 3,829 Vanguard Selected Value 283 FAM Value 363 Longleaf Partners Small-Cap 1,508 Sequoia 3,944 Flag Investors Equity Part. 204 Evergreen Capital Growth 247 Strong Schafer Value 379 Huntington Income-Equity 212 Pilgrim Corporate Leaders 341 Neuberger Berman Focus 1,614 Torray 1,732 Galaxy Equity Income 162 FPA Capital 425 Legg Mason Value 10,602 Nvest Growth 1,167 CGM Capital Development 456 S&P; 500 index
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* Morningstar categories: LV = large-cap value; MV = mid-cap value; SV = small-cap value
Sources: Morningstar Inc., Bloomberg News
