"I'd like to think that I'm a good stock picker, but if you told me that I had to manage my fund as the average mutual fund manager does -- 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund -- then I would give my investors their money back and find a different career because I don't think I could beat the market over a long period of time, after all taxes and costs are considered, no matter how good a stock picker I was."
There's another big disadvantage that most mutual funds suffer from: They generally have investment restrictions that limit them to a particular industry, investment style (typically value or growth), or market capitalization of stock they can own. These limitations have pernicious effects that work to the detriment of the funds and their investors.
Buying a small-cap value stock and then watching it grow into a large-cap growth stock pretty much defines investing nirvana. But how many mutual funds could ever do this? For example, consider a small-cap value fund that might have owned Dell in 1990 when its market capitalization was less than $1 billion and the stock was trading at less than 10x earnings. That fund would have been forced to sell the stock as its market cap and P/E grew, thereby triggering significant capital gains taxes and, even worse, missing out on a subsequent 100-bagger or so. That's a painful double whammy!
One of the reasons that Legg Mason Value Trust mutual fund has been able to beat the S&P 500 Index for a remarkable nine consecutive years is that its manager, Bill Miller, bought America Online and Dell when they were mid-cap value stocks, and then had the courage and good sense to hold onto them as they grew into large-cap growth stocks. (You see! I can write something nice about a mutual fund.) It doesn't take very many grand slam investments like these to build a fabulous track record.
Or consider a large-cap growth fund today. This type of stock has done extremely well over the past few years, as have the funds in this sector. I've made a great deal of money in this space, too. But with the enormous valuation gap that has developed between today's Nifty Fifty and the rest of the market, I'm investing new cash almost exclusively in value stocks or smaller capitalization companies -- something large-cap growth funds can't do.
Speaking of growth and value investing, I completely reject this distinction as commonly defined. All investing should be value investing, which I think of as buying something for less than it is worth. The common definition of a value stock -- one that has a low price-to-book or price-to-earnings ratio -- means little to me. I believe that some stocks trading at 50x earnings or more -- or which have no earnings whatsoever today -- are value stocks. And many stocks trading at single-digit earnings multiples do not represent value at all.
Having industry-specific funds makes a bit more sense because it allows fund managers to develop deep knowledge in a particular sector. However, these funds are vulnerable to the market's tremendous sector-based herding tendencies. For example, I bought several of my favorite technology stocks last June, when many were out of favor, but as this sector has become enormously popular and prices have soared, I am now making new investments elsewhere. In contrast, managers of technology-focused mutual funds have no choice but to continue to invest in this sector, even if they share my view that there are few attractively priced stocks to buy. (By the way, I'm not advocating that anyone invest outside their areas of expertise, but I think every investor should understand at least a few industries well enough to invest in them should an attractive opportunity present itself.)
The investment restrictions of most mutual funds helps explain why their past performance has proven to be no predictor of future results. Numerous studies have shown that the performance of top funds tends to be driven by the sector they're in rather than any unique stock-picking talent of the fund manager. Given that hot sectors rarely remain hot for very long, so too does the performance of top funds tend to wane.
Finally, almost no mutual funds invest in privately held businesses due to the risk and lack of liquidity (not to mention SEC regulations). But in a sector like the Internet, where it's entirely possible that there is a "greater fool" game going on, buying the extraordinarily richly valued public stocks is far less appealing than investing in companies before their IPOs.
To summarize, I seek to invest in high-quality businesses that I understand well at attractive prices. Companies like these don't consistently fall neatly into certain categories. Depending on the market's moods at any given time, the best investments can be anywhere, so I pursue these opportunities wherever they may lie. You have this flexibility as well. I urge you to use it.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here
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