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Fool On The Hill

Tuesday, December 8, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Profit From Funds!

The Motley Fool has spent a great deal of time discouraging you from investing in most mutual funds. We believe it makes sense for most investors who don't want to pick stocks to put their money in index mutual funds, which have much lower turnover and expenses than their actively managed brethren. This is no doubt very sound advice that I'm not going to contradict. There are few compelling reasons to pay 1% (and oftentimes significantly more) annually to managers who give you sub-par results. Nonetheless, billions upon billions of dollars have flowed into these funds. Why not take a free piggyback ride off those folks who are paying fees?

You can do this by using good-performing mutual funds for stock ideas. The overall disadvantage of mutual funds is not that portfolio managers are poor stock pickers (although that is certainly an issue for many funds). The larger problem arises from trading fees, operating expenses, and management expenses that are incurred year after year. This puts funds at a disadvantage to index funds, which minimize these fees. For example, let's compare the imaginary small-cap GumpFund (1.25% annual expense ratio) to an efficient Russell 2000 index fund (0.25% annual expense ratio).

Every year, the GumpFund has a one percentage point disadvantage to the Russell 2000. In a year when the Russell 2000 returns 10%, the GumpFund will need to post a gross return of 11% for fundholders to achieve the same 9.75% net return (10%-0.25% for the index fund, 11%-1.25% for GumpFund). Funds with higher fees simply have the odds stacked against them. The magnitude of this disadvantage is directly proportional to the size of fees charged to fundholders. Very few portfolio managers are able to overcome this handicap over long periods of time, hence their historical underperformance.

Knowing that the historical underperformance of funds is not always attributable to stock picking, let's consider how we can take advantage of the money the funds spend researching stocks. Fund managers (and their research analysts) spend lots of time determining the best stocks to pick. For the most part, these folks don't face the conflicts-of-interest held by brokerage firm research analysts (or as Tom Gardner would call them, sales analysts) who push stocks. People working at funds are almost always compensated based on the performance of their investment results (okay, the effectiveness of their marketing department is also important). Since funds periodically make lists of their holdings publicly available, there is no reason for you not to capitalize on this research. I believe a terrific source for new stock ideas is the top holdings and/or new buys of funds I respect.

Thousands of funds are now being sold. How should you decide which ones to look at? Many people will probably be tempted to find the hottest performer over the past year. That's fine, but remember that funds often outperform over the shorter periods of time because a specific segment of the market is in favor. That fund may go out of favor just as fast. Instead of looking at recent superstars, I prefer using mutual funds that have strong long-term returns and specialize in certain areas. This specialization may be in either a specific sector of the market (i.e., technology, real estate, pharmaceuticals, etc.) or an investment strategy (i.e., value or growth). Using these funds, individual investors can learn from managers who may have decades of experience and/or specialized knowledge.

Here's an example. I believe one of the best value investing investment firms is Memphis-based Southeastern Asset Management (SAM), which runs the Longleaf Partners Funds. These folks are very patient and have amassed an impressive track record, particularly considering the market's recent preference for growth stocks over value stocks. Earlier this year, I noticed that SAM had amassed a large position in FDX Corp. (NYSE: FDX), the owner of FedEx and RPS, in two of the funds it manages. I normally would have overlooked that holding (I generally don't invest in transportation stocks) except for the fact that the Longleaf funds took such a big position and I knew that both SAM and FDX were based in Memphis. Did SAM know something I didn't?

I pondered the question for a while. I even talked to an analyst who follows transportation stocks who told me to stay away from FDX. Still, the Longleaf purchase had piqued my interest. About a month after seeing Longleaf's FDX purchase, I received a plane ticket ordered over the Internet via FedEx. It finally dawned on me that if the Internet explodes, FedEx could be a prime beneficiary (along with privately owned UPS and everybody-owned U.S. Postal Service). I decided to tip my toes in the water of FDX stock upon that realization. Lo and behold, last weekend Barrons comes out with an article touting FDX as the next big Internet stock and the stock jumps several dollars. I don't know the exact reasons SAM purchased FDX stock. Perhaps it was the prospects of an Internet boom, perhaps it is the amazing employee loyalty that helped the company avoid a pilots strike this Christmas. It may have been something else. Regardless of why the Longleaf funds purchased FDX, I wouldn't have looked at the stock if the fund hadn't put FDX on my radar screen.

There are numerous places to get information on fund holdings. One of the easiest is Morningstar, where you simply type in the fund symbol or name. (Once a "Quicktake" pops up, click on Portfolio to get the fund's top-10 holdings.) In addition to the top-10, Morningstar also indicates whether the position has been increased or decreased in the latest reporting period. You will unfortunately have to become a "premium" member to get a list of the fund's entire portfolio. Have no fear, though. If you want more details (or don't want to use Morningstar), you can check out the fund company's Web page or call it's toll-free number to get the most recent quarterly or semi-annual report.

Another option is to check out a fund's EDGAR filings. I've been able to find semiannual N-30D and/or quarterly N-30B-2 for most funds. These documents not only include the listing of an entire portfolio, but also a letter to fundholders and other information regarding a fund's strategy. The biggest drawback to using EDGAR is that you'll have to enter a fund name (i.e., Fidelity Magellan) in the search field rather than a fund symbol (which invariable leads to a message indicating no documents are available). If that search brings up no documents, try just entering the fund family's name (i.e., Fidelity). You may have to search through a bunch of items, but you can eventually find information on most funds.

Don't invest in a stock blindly because it is purchased by a fund manager you like. Even the best portfolio managers regularly make bad decisions. The thing that makes them better is that the returns from good decisions overwhelm the losses from bad ones. Our own Fool Portfolio (soon to be renamed the Rule Breaker Portfolio) has experienced phenomenal growth because the astounding returns from good ideas such as Amazon.com (NASDAQ: AMZN) and America Online (NYSE: AOL) made the losses from clunkers like KLA-Tencor (Nasdaq: KLAC), 3Com (Nasdaq: COMS), and Innovex (Nasdaq: INVX) virtually meaningless. Portfolio managers are making their investment decisions in the context of other stocks they own. You should do the same. Use the buy and sell decisions of mutual funds as a starting point for evaluation. Then do your own research to determine whether the stock is something you want to own.

A major drawback you will find using publicly available fund reports is that they may not be too timely. Portfolio updates are usually only released on a quarterly or semi-annual basis. A portfolio manager's perspective could change during the time lag between when the transaction occurs and when you find out about it. Of course, the stock price has probably moved as well (particularly in today's volatile market). This is another reason that you can't blindly follow the moves of professionals. As with any investment, you should learn about the prospective candidate and determine your own reasons for investing. Combining the stock ideas of some pros with your own investigative skills could prove to be a very profitable endeavor.


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