Value Investing...By a Nose

Because a 50-1 long shot named Giacomo won this year’s
Kentucky Derby, a few lucky trifecta punters cashed in on a
$133,184 payday. Meanwhile, the hordes of bettors who
plunked down money on the favorites walked away with
nothing but regrets.

Betting on favorites rarely produces satisfactory results,
whether at Churchill Downs or on Wall Street.

Out on the racetrack, the old-time handicappers know it’s
best to "copper the public," or to bet against the
favorites. In the stock market, a few savvy investors have
produced brilliant results by doing exactly the same thing:
betting against the favorites, while betting on the
underdogs.

In August 2000, Fortune magazine published a list of its
favorite stocks, entitled "10 Stocks to Last the Decade."
Here’s a list of the companies in the report:

Broadcom
Charles Schwab
Enron
Genentech
Morgan Stanley
Nokia
Nortel Networks
Oracle
Univision
Viacom

Pity the investors who heeded Fortune’s advice…

"[These stocks] were the glory stocks of the fin-de-siecle
bubble," recalls Louis Lowenstein, professor of Law and
Economic Studies at Columbia University, "and their high
price-earnings ratios – only one under 50 – reflected the
faddishness of the age. Fortune, swallowing the popular
perceptions whole, said they were ten stocks to let you
‘retire when ready.’"

On the contrary, owning these stocks probably pushed
retirement back several years for many of Fortune’s
readers. Collectively, these stocks lost more than 80% of
their value within two years. Even as the decade approaches
the halfway mark, Fortune’s "Top 10" is still producing
abysmal results.

But there were some investors who didn’t own any of these
names. In fact, Lowenstein, in his paper (titled "Searching
for Rational Investors in a Perfect Storm") found ten of
them. Lowenstein asked Bob Goldfarb of the well-respected
value shop, Sequoia Fund, to select ten funds that
practiced "true blue" value investment disciplines, as
opposed to the many who simply wear the label. Goldfarb
identified the following ten funds for Lowenstein:

Clipper Fund
FPA Capital
First Eagle Global
Longleaf Partners
Legg Mason Value
Mutual Beacon
Oak Value
Oakmark Select
Source Capital
Tweedy Browne American Value

Lowenstein found that all of them steered clear of the
names on Fortune’s ignominious list, with one small
exception. The celebrated Bill Miller of Legg Mason owned
Nokia, but since it represented less than 2% of his
portfolio, and since he bought it in 1996 and was holding a
1,900% gain – well, it’s hard to be overly critical.
(Mutual Beacon was actually short Viacom and Nortel).

Lowenstein tested this group of funds for the years 1999-
2003, which he felt were among the most volatile in recent
history. During these five years, the S&P 500 actually
showed negative average annual returns of 0.57%. That’s
right, over the five-year stretch the market lost money and
thus, should make a fine test for this stable of value
funds.

Well, they performed brilliantly. The boring old value
disciples beat the market handily over that span – earning
an average annual return of 10%. "A five-sigma event,"
Lowenstein calls the achievement, "a statistical marvel
that pure chance cannot explain." More interesting, is how
they did it.

1) Own a Limited Number of Stocks

Contrary to the popular wisdom that advises holding lots of
stocks for purposes of diversification, these investors
pursued the opposite tactic. Most were fairly concentrated;
Longleaf’s top five stocks often represented one-third of
its total portfolio’s value.

These funds were choosy about what they put in their
portfolios and when they didn’t find what they were looking
for, cash filled the void. Sitting on cash is always better
than doing something dumb. It’s like the horseplayers who
know not to bet every race. Most of these funds held large
cash positions of 30-40% during the bubble years. Several
were closed to new investor because they didn’t want to
accept any new money for which they had no compelling
ideas.

The average domestic mutual fund holds about 160 stocks,
compared to 54, on average, for Lowenstein’s value group.
In fact, seven of the ten value funds surveyed owned 34 or
less, with the average being pulled higher by the
internationally diverse First Eagle and Mutual Beacon
funds.

2) Maintain a Low Portfolio Turnover

The average mutual fund has a turnover ratio of about 121%,
meaning they "flipped" their whole portfolio once every ten
months, on average, thus incurring heavy transaction costs,
while also reducing the amount of capital gains generated.
By contrast, the ten value funds held their positions for
five years – on average. However, these managers don’t buy
and hold forever; they sell when things get pricey. Miller,
for example, sold Nokia almost at the same time Fortune was
advising readers to buy it.

3) Stocks as Part Interests in a Business

The last trait is harder to quantify because it is not
statistical in nature. But Lowenstein found that each of
these outperforming funds shared a common philosophical
approach to investing – an approach inspired by Graham and
Dodd, the "fathers" of value investing. "The group of ten
all stands on the common ground of patient, company by
company analysis," writes Lowenstein, "always mindful that
the stocks they are buying are part interests in a
business." For this select group of mutual fund managers,
stocks are much more than mere ticker symbols. Each
represents an operating enterprise, with its own unique
attributes.

Each of the funds that Lowenstein examined applies its
investment philosophy in different ways. Some focus on
small caps, some on large caps and some on international
stocks. But they all seem to embrace the idea that
successful investing relies upon a long-term commitment to
a few, well-chosen stocks.

The three main tactics common to the 10 managers that
Lowenstein studied all seem pretty straightforward and
intuitive. Yet, very few investors bother to pursue a
similar approach. Bill Ruane at Sequoia Fund once estimated
that only 5% of all professionally managed money follows
the basic principles of value investing.

Instead, most investors – professional and non-professional
alike – prefer to bet on the favorites, and that’s a
strategy that almost always raises the odds against
success.

Decision Point tracks actual cash flowing into and out of
Rydex mutual funds, and, while cash flow normally runs
parallel to price, divergences can often appear ahead of
price reversals.

Back in December I wrote an article on the Rydex Precious
Metals Fund showing how rising prices and negative cash
flow will usually result in a price correction. Now we have
a situation where cash flow into the Precious Metals Fund
has been flat and now positive, while prices have been
falling like a rock. This indicates that bulls are trying
to hold their ground and that accumulation of precious
metals shares has been taking place. The end result will
probably be a rally in precious metals shares.

While a longer-term rally could ensue, my observation is
that these cash flow divergences only have short-term
implications. Also, it is important to remember that the
Rydex Precious Metals Fund only accounts for a small slice
of the total market in gold stocks, and this small picture
may not be representative of the big picture.