May's Mutual Fund Red Flags

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

The biggest stock story of 2007 has been the meltdown of subprime mortgage outfits. Most experts seem to think that a protracted, severe housing downturn is unlikely and that a domino effect that causes many high-quality mortgage defaults is similarly improbable. But experts sometimes are wrong, and some economists who lean heavily on demographics think housing values could take a long, painful downhill slide.

Besides, it's clear that credit standards eroded dramatically the past few years and a broad slowdown in the housing market is continuing. So even if disaster isn't looming, funds with heavy exposure to housingrelated stocks could have a bad short-term indeed. That is something that all three of the managers discussed here realize, but they believe they'll be vindicated in the long run.

Weitz Value WVALX
Actually, all of Wally Weitz's funds have big housing stakes, but this one looks to have the largest. As of Dec. 31, 2006, nearly 24% of assets are devoted to housing-linked stocks--mainly those in various segments of the mortgage industry. The biggest individual stakes are in Redwood Trust RWT, a mortgage REIT, and thrift Countrywide Financial CFC, the latter of which has fallen 12% in 2007.

Weitz, a seasoned contrarian, has hardly been shaken by the troubles. Indeed, when we spoke to him a few days after subprime lenders Novastar Financial NFI and New Century Financial NEWC went into free fall, he said that he was examining "anything housing-related," including subprime outfits for value among the wreckage. Weitz is certainly willing to allow a bad year or two if he thinks he'll ultimately be proved right.

Muhlenkamp MUHLX
Ron Muhlenkamp's eponymous fund has the second-worst returns from Jan. 1, 2006, through April 30, 2007, of any large-value fund in Morningstar's database. That's in large part because Muhlenkamp has remained true to his long-term practice of holding for extremely long periods of time; the economically sensitive fare that boosted the fund from 2003 through 2005 remains in the fund. A big part of that bet is housing-related firms, which we tally up as 27% of assets on Dec. 31, 2006.

While Muhlenkamp has since sold a couple of homebuilders--Centex CTX and Beazer Homes USA BZH--it's unlikely that he's fully unloaded the other four that recently held more than 7% of assets in total. Plus, at the end of last year the fund's top holding was Cemex CX, a Mexican producer of cement and aggregate, and the fourth-largest holding was Countrywide.