Beating the Street (10 page)

We had decided to hire a group of managers and give each a portion of the stock portfolio. You could do the same by buying several funds of varying styles and philosophies. Our thinking was as follows: markets change and conditions change and one style of manager or one kind of fund will not succeed in all seasons. What applies to stocks also applies to mutual funds. You just never know where the next great opportunities will be, so it pays to be eclectic.

If you own only one fund, you may find yourself stuck in a situation in which the managers have lost their touch, or in which the stocks in the fund have gone out of favor. A value fund, for instance, can be a wonderful performer for three years and awful for the next six. Prior to the Great Correction in 1987, value funds led the market for eight years while growth funds fell behind. Recently the growth funds led the market, but then they lost their advantage in 1992.

Here we get into the increasingly complex universe of types of funds. For the purposes of this discussion, the most important basic types are as follows:

1. Capital appreciation funds, in which the managers have leeway to buy any and all kinds of stocks and are not forced to adhere to any particular philosophy. Magellan is one of these.

2. Value funds, in which the managers invest in companies whose assets, not their current earnings, are the main attraction. These include natural resource companies, companies that own real estate, cable TV companies, pipeline companies, and bottling companies. Many of these so-called value companies have gone deep into debt to buy assets. They plan to reap the benefits later as the debts are paid off.

3. Quality growth funds, in which the managers invest in medium-sized
and large companies that are well established, expanding at a respectable and steady rate, and increasing their earnings 15 percent a year or better. This cuts out the cyclicals, the slower-growing blue chips, and the utilities.

4. Emerging growth funds, in which managers invest mostly in small companies. These small-cap stocks lagged the market for several years and suddenly came into their own in 1991.

5. Special situations funds, in which managers invest in stocks of companies that have nothing in particular in common except that something unique has occurred to change their prospects.

Knowing what kind of fund you have helps you make an informed judgment as to whether or not you should keep it. That Mario Gabelli's value fund has lagged the market for four years is not in itself a good reason for abandoning Gabelli. (In fact, Gabelli's fund rebounded in 1992). When value stocks are out of favor, there is no way Gabelli or Kurt Lindner or Michael Price can be expected to perform as well as the manager of a growth fund that is in favor.

The only fair point of comparison is one value fund versus another. Over many years, if Gabelli has achieved a better result than Lindner, that's an argument for sticking with Gabelli. But if Gabelli has been outperformed by John Templeton, the well-known growth-fund manager, it's no reflection on Gabelli. It's a reflection on the value style of investing.

Likewise, it would be silly to blame the manager of a gold fund that was down 10 percent last year, when gold stocks in general were down by the same 10 percent. When any fund does poorly, the natural temptation is to want to switch to a better fund. People who succumb to this temptation without considering the kind of fund that failed them are making a mistake. They tend to lose patience at precisely the wrong moment, jumping from the value fund to a growth fund just as value is starting to wax and growth is starting to wane.

In fact, when a value fund does better than its rivals in a lousy year for value funds, it's not necessarily any cause for celebration. (This also applies to growth funds or any other kind of fund.) It may be that the manager has gotten disenchanted with value stocks and has invested some of the money in blue chips or utilities. He or she has gotten frustrated with the value style, especially when it hasn't been working.

The manager's lack of discipline may produce good results in the short run, but the benefits may be fleeting. When value stocks come back, this manager won't be fully invested in them, and his or her shareholders won't be getting what they paid for.

The sophisticated investor can check up on a fund by reading the semiannual and annual reports to determine whether the manager is buying the kinds of stocks he or she is supposed to be buying. For instance, you wouldn't want to find Microsoft in the portfolio of your value fund. Second-guessing the fund manager, I realize, is beyond the scope of the average investor, but it's the kind of thing we stockaholics have fun doing.

To increase the odds that at least some of the assets would be invested in the right place at the right time, we ended up picking 13 different funds and managers for our nonprofit organization. These included one value manager, two quality growth managers, two special situations funds, three capital appreciation funds, one emerging growth fund, a fund that invests only in companies that have consistently raised their dividends, and three convertible securities funds (as described on page 72).

Out of this team of funds and managers, we expect to produce a different all-star to outperform the market every year, and with enough all-stars to counteract the mediocre performers, we hope to beat the dreaded market averages.

If you are an average investor, you can duplicate this strategy in a simpler way by dividing your portfolio into, say, six parts and investing in one fund from each of the five fund types mentioned above, plus a utility fund or an equity-and-income fund for ballast in a stormy market.

Since 1926, emerging growth stocks have outperformed the S&P 500 by a substantial margin, so it's always a good idea to keep something invested here. You could throw in a couple of index funds to go along with the managed funds. You might, for instance, buy an S&P 500 index fund to cover the quality growth segment; the Russell 2000 index fund to cover the emerging growth stocks; Gabelli Asset, the Lindner Fund, or Michael Price's Mutual Beacon for the value stocks; and Magellan (is one plug allowed here?) for capital appreciation.

The easiest approach is to divide up your money into six equal parts, buy six funds, and be done with the exercise. With new money to invest, repeat the process. The more sophisticated approach is to adjust the weighting of the various funds, putting new money into sectors that have lagged the market. This you should do
only
with new money. Since individuals have to worry about tax consequences (which charities don't), it's probably not a good idea to do a lot of buying and selling and switching around among funds.

So how do you know which sectors have lagged the market? We looked at this issue in our planning for our nonprofit organization in the fall of 1990. At the time, I was convinced that some of the major growth stocks, such as Bristol-Myers, Philip Morris, and Abbott Labs, which Wall Street had taken on a giddy scramble to new highs, were overpriced and due for a comeuppance, or at least a decent rest. How I divined this is explained in more detail on page 142.

These are typical corporate giants in the drug and food businesses that make up the S&P 500 index. The Dow Jones average, on the other hand, is heavily weighted in cyclicals, while the NASDAQ and the Russell 2000 represent smaller emerging growth enterprises—restaurant chains, technology companies, etc.

By comparing the S&P 500 index with the performance of the Russell 2000 Index going back 10 years, you can begin to see a pattern. First of all, emerging growth stocks are much more volatile than their larger counterparts, dropping and soaring like sparrow hawks around the stable flight path of buzzards. Also, after small stocks have taken one of these extended dives, they eventually catch up to the buzzards.

In the five years prior to 1990, the emerging growth stocks turned in a dismal performance relative to the S&P 500, with the S&P up 114.58 percent, while the Russell 2000 was up only 47.65 percent. But emerging growth caught up with a vengeance in 1991, when the Russell index gained 62.4 percent in 12 months. Some emerging growth funds did better, even, than the Russell 2,000, posting 70 or even 80 percent gains.

Obviously, 1990 would have been a good year to add money to the emerging growth sector of your portfolio. You would have been inclined to do just that had you paid attention to the progress of the various indexes, as reported in
Barron's, The Wall Street Journal
, and elsewhere.

Another useful way to decide whether to put more money into the emerging growth sector or to invest in a larger, S&P-type fund
is to follow the progress of T. Rowe Price New Horizons. New Horizons is a popular fund created in 1961 to invest in small companies. In fact, whenever a company gets too big, the managers at New Horizons remove it from the portfolio. This is as close as you'll get to a barometer of what is happening to emerging growth stocks.

Figure 3-1
, published with periodic updates by T. Rowe Price, is a comparison of the p/e ratio of the stocks in the New Horizons fund and the p/e ratio of the S&P 500 overall. Since small companies are expected to grow at a faster rate than the big companies, small stocks generally sell at a higher p/e ratio than big stocks. Theoretically, you would expect the p/e ratio of the New Horizons fund to be higher than the p/e ratio of the S&P at all times.

Relative Price/Earnings Ratio

FIGURE 3-1

In practice, this is not always the case, which is what makes this table so useful. During certain periods when emerging growth sector
is unpopular with investors, these small stocks get so cheap that the p/e ratio of New Horizons falls to the same level as that of the S&P. (This rare condition is indicated here by the number 1.0.)

In other periods, when small stocks are wildly popular and bid up to unreasonably high levels, the p/e ratio of New Horizons will rise to double that of the S&P 500 (shown here by the number 2.0).

As you can see, only twice in the past 20 years (1972 and 1983) has this lofty 2.0 level been reached. In both cases, small stocks got clobbered for several years afterward. In fact, small stocks missed most of the bull market from 1983 to 1987. When the New Horizons indicator approaches the dreaded 2.0, this is a huge hint that it's time to avoid the emerging growth sector and concentrate on the S&P.

Clearly, the best time to buy emerging growth stocks is when the indicator falls to below 1.2. Once again, to reap the reward from this strategy you have to be patient. The rallies in small stocks can take a couple of years to gather steam, and then several more years to fully develop. For example, in 1977, after the emerging growth sector had had a year or two of good performance, the prevailing opinion on Wall Street was that this sector had played itself out, and it was time to abandon small stocks in favor of big stocks. As a young fund manager, I ignored that opinion and stuck with small stocks, a decision that helped Magellan outperform the market for five years after that.

The same sort of comparison can be applied to growth funds versus value funds. Lipper Analytical Services publishes an index of 30 value funds and an index of 30 growth funds that appears in every issue of
Barron's.
Between 1989 and 1991, the Lipper growth-fund index soared by 98 percent while the value-fund index managed to gain only 36 percent. When value underperforms growth for several years, you might want to add money to the value pot.

How do you choose a value fund, growth fund, or capital appreciation fund that will outdo its rivals? Most people look at past performance. They study the Lipper guide published in
Barron's
or any one of a number of similar sources that track fund performance. They look at the record for 1 year, 3 years, 5 years, and beyond.
This is another national pastime, reviewing the past performance of funds. Thousands of hours are devoted to it. Books and articles are written about it. Yet with few exceptions, this turns out to be a waste of time.

Some people take last year's biggest winner, the one at the top of the Lipper list of 1-year achievers, and buy that fund. This is particularly foolish. The 1-year winner tends to be a fund managed by someone who bet on one industry or one kind of company in a hot sector and got lucky. Why else would he or she have been able to run so far ahead of the pack? Next year, when this fund manager is not so lucky, his or her fund will be on the bottom of the Lipper list.

Alas, this picking future winners from past performance doesn't seem to work even when you use a 3-year or 5-year record. A study done by
Investment Vision
magazine (now
Worth)
shows the following: if every year between 1981 and 1990 you invested in the fund that had performed the best over the prior 3 years, in the end you would have lagged the S&P 500 by 2.05 percent. If you invested in similar fashion in the funds with the best 5- and 10-year records, you would have beaten the S&P by .88 and 1.02 percent respectively. This would not have made up for the cost of getting in and out of these funds.