Ascent of the Fallen Stars: Barron’s looks at the comeback of funds run by star managers who had stellar runs and then imploded. They discuss their strategies

SATURDAY, JANUARY 4, 2014

Ascent of the Fallen Stars

By LESLIE P. NORTON | MORE ARTICLES BY AUTHOR

Barron’s looks at the comeback of funds run by star managers who had stellar runs and then imploded. They discuss their strategies.

A surprising byproduct of this year’s rally was the comeback of the star manager: investors with long spells of brilliant performance, whose funds then spectacularly imploded. Consider Bill Miller, whose Legg Mason Opportunity Trus t (ticker: LMOPX) is staging a revival. Finally approaching the levels of 2007, Miller’s fund is up 67%, more than double the S&P 500’s gain. Miller is by no means alone: The same could be said of Ken Heebner’s CGM Focus fund (CGMFX) fund and Bruce Berkowitz’sFairholme fund (FAIRX), both of which are outpacing the index.You can thank the Federal Reserve, which in May aired the topic of tapering back its purchases of Treasuries (on which it will follow through this month). Raising the issue suggested the recovery was durable, that conditions were normalizing at last. Previously, the prospect of unending liquidity had lifted speculative stocks, then high-yielders like REITs, and dividend plays. A more normal environment meant companies with strong growth prospects — the visible, not the risible, in other words — would be recognized. That would help the stockpickers, who for some years have been trounced by the indexes.

Conditions have improved for active managers. Stocks have a declining correlation to one another: Stockpicking skill goes out the window when stocks move together, says Joseph Mezrich, quantitative strategist at Instinet, the brokerage arm of Nomura. But over the past six months, more active managers have been besting their benchmarks. The flight of funds has stabilized. At the same time, dispersion in valuations has narrowed even as stocks have stopped moving together: That means prospects are more visible. That will benefit investors with an unusually high level of conviction — those who run concentrated portfolios, says Adam Parker, a strategist at Morgan Stanley. As a result, Parker recently cut the number of names in his recommended portfolio from 54 to 45.

Does that mean it’s time to invest again with the star managers? Depends. Miller hasn’t beaten his peers in more than 10 years. He’s also about to start a new fund with his son, though Legg Mason will own half of the new company. Heebner has built returns for investors, but his fund is wildly volatile. Berkowitz’s fund is overly concentrated — insurer American International Group (AIG) is 40% of assets — and anyhow is closed to new investors.

Use your common sense. “Experience tells us that funds that post extraordinary gains in a short period are more likely to lag by extraordinary amounts and tend to be more volatile,” says Daniel Culloton, associate director of fund analysis at Morningstar. Buy because the manager has a good record, because their interests are aligned with your own, because the fund represents an asset class you don’t own, because managers pay attention to costs. Heebner, for example, had turnover of nearly 500% in 2011, meaning commissions were 1% of assets.

Culloton ran a screen for Barron’s of managers with tenures of at least a decade, with above-average returns over the long haul and below-average returns over five years. Then he assembled those with above-average gains as of mid-December. We picked a handful that covered different styles and seem to have promising prospects. All have a Morningstar analyst rating of Bronze or higher. Many have been profiled by Barron’s in the past.

Christopher Davis

Davis New York Venture fund (NYVTX) and Selected American Shares (SLASX)

Davis comes from a long line of accomplished investors: His late grandfather, Shelby, famously turned his wife’s $100,000 into $850 million over not quite 50 years, and his father, also called Shelby, started the firm that Davis heads today. They look for well-managed businesses at value prices and hold them over the long haul. Turnover at both funds (one has a sales charge, one doesn’t) is negligible, suggesting they hold stocks for 10 years. That inevitably leads to periods of underperformance, like the past couple of years. Redemptions have climbed, but the firm has cut fees to make itself more shareholder-friendly; the Davis family and employees have nearly $2 billion invested in the funds. This year, the funds surged on gains in Bank of New York Mellon (BK), Wells Fargo(WFC), and Berkshire Hathaway(BRK.A). Just like banks after the savings-and-loan crisis, when Davis entered the business, banks today have “fewer competitors, better pricing power, higher capital ratios, and higher reserves.”

Davis is also a fan of Google (GOOG) and Costco Wholesale (COST), companies that tread “the funny line between growth and value…with extraordinary competitive advantages that sometimes look expensive only because people aren’t looking out far enough.” He thinks circumstances favoring stockpickers will continue, as people keep plowing money into ETFs, which, in turn, plow money into the largest companies. If his bets are successful, shareholders will win proportionally — the largest 10 positions account for more than 40% of the fund, sharply above the 28% or so held by the typical stock fund. Davis’ longtime co-manager, Kenneth Feinberg, stepped down late last month. He was succeeded by Danton Goei, who has been with the firm since 1998 and runs the firm’s large-company value portfolios.

Daniel Becker

Waddell & Reed Vanguard fund (UNVGX) and Ivy Large Cap Growth fund (WLGAX)

“Long-term track records are part skill and part luck,” says Becker. The 24-year Waddell & Reed veteran is kicking himself for not using the four or five recent “systemic collapses” triggered by the euro crisis and Capitol Hill to “widen the fishing net.” Ordinarily Becker and his co-manager, Philip Sanders, who also serves as Waddell’s chief investment officer, buy highly profitable growth stocks with strong brands and sustainable strategies. That didn’t work in the past when the market preferred dodgier stocks. Nor did he double down. And he reflects that he shouldn’t have sold some software stocks just because of cyclical pressures at IBM (IBM) and Oracle (ORCL). Today, Becker has learned a thing or two about downturns: Last summer, after a scare about the Chinese banking system hurt casino stocks like Las Vegas Sands (LVS), he bought more. He likes companies that are buying back shares and boosting dividends because that signals that “margins and returns are sustainable.” Growth stocks are now following this playbook. His winners this past year included Las Vegas Sands, Wynn Resorts (WYNN), Gilead Sciences (GILD), and Starbucks (SBUX).

Today, Becker maintains, we are in the early innings of a bull market for companies with $8 billion or more in market value. “These have the highest returns, the highest returns on equity,” he says. He expects the S&P 500 to rise 10% to 15% in 2014 and stocks to gain as investors become more confident in future earnings and price/earnings multiples expand. Becker’s fund is also slightly more concentrated: The top 10 holdings account for more than 30% of the fund.

Judith Vale

Neuberger Berman Genesis (NBGNX)

Vale is a master of narrative: someone who knows her companies intimately and understands what will drive them higher. Vale has run the fund since 1994 (co-manager Bob D’Alelio joined three years later). She looks for small companies, with market values below $1.5 billion, boasting strong free-cash flows, nice balance sheets, reasonable valuations. The fund owns 140 of them, though many have grown so big that Vale’s $15 billion fund is now considered a mid-cap fund. “We actively shop for nonvolatile business models and like to have some degree of visibility,” she says. Coming off the bottom of 2009, when the best stocks to own were heavily levered and troubled businesses had to be bailed out by declining rates, “we looked like morons. We lagged with a vengeance,” she recalls. “Cash was trash, debt was free.” That hurt last year, too, when high-yield investments like REITs, which make up a big portion of the Russell 2000 Index, were ascendant.

That all changed with taper talk. Vale expects any tick up in rates to help her holdings, including small-cap banks struggling with a flat yield curve. One pick that contributed to performance and remains a Vale favorite is Altisource Portfolio Solutions (ASPS), which services the real-estate and mortgage markets with an online brokerage, renovation and property management services, and title and escrow services. She sees earnings growing 15% to 30% annually over the next five years. “They are free-cash-flow generating monsters.” Now at 15 times 2014 earnings estimates, Altisource’s multiple should widen even more as people view it as a “business process outsourcing firm.”

Conrad Herrmann

Franklin Flexible Capital Growth (FKCGX)

Herrmann has steered this fund for 20 years, since it was named Franklin California Growth fund, owning Silicon Valley names; today he runs it with two other managers. Herrmann tries to invest in “disruptive innovators,” and companies growing swiftly through market-share gains or leverage; the $3.4 billion fund owns 140 of them. He fared well — comparatively speaking — in 2008 as the fund avoided financials, but trailed in 2009 and again in 2011 and 2012 (that year, Apple climbed to 700 from 400, just after Steve Jobs died and Herrmann decided to chop down his Apple holding). This past year, he’s benefited from a technology resurgence, which accounts for 20%-plus of the fund. His winners included LinkedIn (LNKD), MasterCard (MA), and Apple (AAPL). Now that the economy is becoming normal, he thinks multiple expansion lies ahead.

Among his favorites for 2014 are healthcare and biotechnology firms like Gilead, with its popular hepatitis C treatment, and Facebook (FB), which “continues to monetize their active consumer base.” He’s willing to hold on: Herrmann’s turnover is just 63%. He also grew up with investing in his blood: His late father, Lacy Herrmann, founded Aquila Group and was a money-market and muni-fund pioneer.