Standout Funds Find Success by Sticking to the Basics

In a market so dreary that only 3% of stock mutual funds are in the black this year, a strong performance by a portfolio manager may just be relative.

Funds that have eked out modest gains this year, or posted losses much smaller than their category average, arguably are doing a more impressive job for shareholders than those that simply rode the tailwinds of the 1990s bull market to lofty gains, some analysts say.

The other possibility is that some funds just got lucky.

One small-cap value fund whose performance has stood out this year is Royce Special Equity, which rose 8.7% in the first three quarters. Being a “dyed-in-the-wool balance sheet skeptic” has helped manager Charlie Dreifus steer clear of landmines, said Morningstar Inc. analyst Shannon Zimmerman.

New York-based Dreifus said his stock-picking starts with a search for strong, undervalued businesses. Screening for firms with high return on capital leads him to solid business niches, he said. Then, his assessment of a company’s takeover value based on the sum of its parts tells him whether the share price is a bargain, Dreifus said.

But the most important research is poring over financial statements in a search for “accounting purity,” he said. It’s a task Dreifus relished long before this year’s avalanche of accounting scandals, he said.

“It’s my way of requiring companies to portray the economic reality. If you’re going to the library to look at the company’s financial statements, they should be in the nonfiction section.”

Dreifus can sound a bit like Shirley MacLaine when he sums up his methods: “It sounds rather strange but financial statements talk to me,” he said. The filings of fewer than one in 10 companies that he reads give him enough comfort to invest, he said.

“The financials are a mosaic, a puzzle that comes together,” Dreifus said. Pieces of the puzzle that might not sit right with him include changes in research spending or provisions for doubtful accounts--numbers that might be massaged as a firm stretches to meet its quarterly financial goals.

Other things he watches for include potential dilution from stock options, joint ventures with unspecified partners and asset-depreciation schedules longer than the industry standard.

Dreifus said he sometimes undertakes another form of “detective work” to check on a company’s frugality: “I’ll drive around the [company] parking lot looking for cars with sequential license plates, a leased fleet,” he said. “Are we looking at a multitude of Mercedeses or Ford Tauruses? You can guess which I’d rather see.”

Dreifus, who described his portfolio as filled with “mundane businesses,” acknowledges that his cheapskate investing style has not always fared so well. In the go-go market of 1999 his fund lost 9.6%--dismal even for the then out-of-favor small-value category.

“I was totally out of sync with that market,” Dreifus said. “It made no sense to me.”

His recent holdings have included casual shoemaker K Swiss Inc., restaurant chain Bob Evans Farms and everyday gift maker Russ Berrie & Co.

In the mid-cap value fund category, the Yacktman and Yacktman Focused funds, which lost 1.9% and gained 0.6%, respectively, in the first three quarters, were relative bright spots. Both funds are run by Buffalo Grove, Ill.-based Donald Yacktman, who like Dreifus champions a back-to-basics value-oriented approach.

“We have a methodology we’ve consistently stuck with,” Yacktman said. “In 1999 we looked dumb, and now we look brilliant. That’s the nature of this business.”

Yacktman said his portfolio generally lacks “the kind of stocks everyone likes to talk about at the cocktail hour.” One of his holdings, for example, is Lancaster Colony Corp., which is in such disparate businesses as specialty foods and truck splash guards.

But he also has taken a chance on beaten-up stocks such as Liberty Media Corp. in the broadcasting sector; conglomerate Tyco International Ltd., which Yacktman believes was oversold this summer in the wake of fraud allegations against its former chief executive; and the bonds of Qwest Communications International Inc., the beleaguered telecom firm that Yacktman believes can be viable under its new management.

In the large-cap value category, the team-managed Clipper fund is among this year’s relative performance leaders, with a loss of 13.1% in three quarters compared with a 25% drop for its category average.

The fund has consistently avoided some of the weakest areas of the market, such as technology and telecom, said Bruce Veaco, one of five managers who steer Beverly Hills-based Clipper.

One of the keys to successful value investing is determining whether stocks are cheap for good reason, Veaco said. “We look at sectors or stocks that are out of favor and try to determine, ‘Is the concern justified?’ ” he said. “We looked at the telecom industry, for instance, and said, ‘Hmmm, these concerns are justified.’ All the overspending of the late 1990s will take more time to work off.”

But in July, the Clipper crew found several companies in other industries that met its main criterion for purchase: A discount of at least 30% to the managers’ estimate of the stock’s “intrinsic value.” The fund, which had held about 30% of assets in cash over the last several years, spent that down to about 10%, Veaco said.

Clipper added drug stocks Pfizer Inc., Merck & Co. and Wyeth, believing the shares were oversold because of investor concerns about weak product pipelines and possible government price controls.

Clipper also has added to holdings in grocery chains Safeway Inc. and Kroger Co., which have tumbled on worries over recent earnings weakness and competition from Wal-Mart Stores Inc.

Like all stock-pickers, the Clipper managers have made mistakes.

Veaco said McDonald’s Corp., which the fund bought last year, is more of a troubled business than the managers realized. Clipper has revised its intrinsic per-share value estimate for the firm to $30 from $40, he said. But with the stock now around $18, “We’re not even thinking about selling it,” he said.

For growth-fund investors, managers who have held this year’s losses to less than 15% may look like heroes, relatively speaking.

In the large-cap growth sector, Chase Growth, managed by Derwood Chase, has limited its year-to-date loss to 9.1%, versus 30.9% for the category average. Marsico Focus, whose manager, Tom Marsico, helped build the Janus funds into an industry powerhouse in the 1990s, is down 14.1%.

Small-cap growth funds that have held up well include Hennessy Cornerstone Growth, whose manager, Neil Hennessy, uses a computer-driven model to pick stocks; Neuberger Berman Fasciano, run by Michael Fasciano; and Baron Growth, run by Ron Baron. These funds are down 6%, 9.4% and 12.1%, respectively, versus the category average of 31.4%.