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Have You Hugged Your Struggling Fund Today?

Poor performance can indicate that stocks are on sale.

Christine Benz, 11/06/2007

As a junior analyst covering Legg Mason Value LMVTX more than a decade ago (!), I quizzed manager Bill Miller on his rationale for adding to his position in a company that had been badly beaten down. Miller's response was so common-sense and unequivocal that I can still recall it almost verbatim. "I almost always do that," he replied. "If I liked a suit at Nordstrom when it was full price, I should like it when it's on sale, right?"

"Doubling down"--upping the ante on a bet--is a common tactic among value-minded mutual fund managers. If they've done their homework on a stock, these managers figure that lowering their funds' average purchase price of that name should be a no-brainer.

So, is doubling down a good idea when it comes to your mutual fund holdings, too? It's certainly not foolproof. A performance slump in a fund can be an indication of numerous "fundamental" ills, including personnel and strategy shifts, asset bloat, and upheaval at the fund-company level. And if the fund manager trades frequently or isn't particularly concerned about valuation, you won't get any sort of "pop" from buying the fund when it's in a trough because the slumping holdings may already be gone.

At other times, however, adding to funds on weakness can be an effective strategy. You can lower your own average cost basis in the fund, and you can give the manager money to put to work in the market when he or she is presumably finding a fair amount to buy. Contrarian fund buyers can also help the fund keep its overall trading costs down. If there's enough new cash coming in, the manager may be able to avoid selling stocks to meet redemptions, and he or she may also be able to obtain an advantageous price on new purchases because there are fewer buyers than sellers.

With some of our favorite funds slumping amid weakness in the financials and housing sectors, we decided to take a look at whether they represent a good buying opportunity. Here are a few that fit the bill. Not only do they have talented managers and good fundamentals, but their holdings look fairly cheap right now based on Morningstar's equity analysts' estimates of their holdings' fair values.

There are a few caveats, however: Some of these funds have indicated that they will likely make sizable capital gains payouts later this year, so check the Web sites for distribution information for these offerings (or for any other funds you're considering purchasing for your taxable account before year-end). Moreover, we're not promising that all of these funds will outperform their peers or the market in the very near term. Rather, we wanted to call attention to them because we think they're superior long-term holdings and it's better to buy them when they're in a trough than when they're riding high on the performance charts.

Legg Mason Value LMVTX
This is shaping up as a year to forget for the world's most storied working mutual fund manager, and investors are demanding their money back. But as Greg Carlson noted in his analysis last month, we think shareholders cashing out of this fund are making a mistake. True, Miller's timing of his purchases of homebuilders was off, and Countrywide Financial CFC has also cratered this year. But no, we don't think Miller has lost his touch, and redemptions have also made the fund more nimble than it has been in the past few years. While Miller's portfolio contains names that few would consider cheap, such as Amazon.com AMZN and Google GOOG, it also contains a large share of names that appear to be trading cheaply, ranging from Tyco International TYC to J.P. Morgan Chase JPM.

Muhlenkamp Fund MUHLX
Good managers don't always use weakness in their holdings as a reason to double down, as evidenced by manager Ron Muhlenkamp's decision to dramatically scale back this portfolio's stake in homebuilders amid recent housing-market weakness. (Muhlenkamp had held the stocks for several years and had made huge gains in them.) Even so, he appears to be sticking with many of his unloved holdings, and we think investors would do well to stick with--and even add to--the fund on weakness. True, the fund's near-term returns look ugly, Muhlenkamp's bold approach means the fund will remain quite volatile, and the firm has said the usually tax-efficient fund will make a capital gains distribution later this year. However, we think Muhlenkamp is a talented investor, and the majority of his holdings, ranging from Citigroup C to oil driller Nabors Industries NBR, look cheap right now based on Morningstar analysts' fair-value estimates.

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