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Concentrated Funds Going Against the Grain

A closer look at these funds' favorites.

Greg Carlson, 11/10/2011

Our favorite focused funds have added value over the very long haul through stock selection, but the funds' managers typically haven't done that by simply making outsized bets on the largest constituents of their benchmarks. They've often gone against the grain, buying unpopular stocks and those that take up only a small slice of their funds' benchmark. A close look at some of those funds' most recent portfolios and the most commonly held positions among them demonstrates these managers' willingness to deviate from the norm.

We combined 10 of these funds-- Brown Capital Management Small Cap BCSIX, Clipper CFIMX, Fairholme FAIRX, FMI Large Cap FMIHX, Jensen Quality Growth JENSX, Longleaf Partners LLPFX, Mairs & Power Growth MPGFX, Matrix Advisors Value MAVFX, Oakmark Select OAKLX, and Sequoia SEQUX--to create a portfolio, and the results were telling. Only three of the portfolio's top 25 holdings are among the S&P 500 Index's 25 largest constituents ( Berkshire Hathaway BRK.B, Microsoft MSFT, and Procter & Gamble PG), despite the fact that all but one of the 10 funds reside in Morningstar's U.S. large-cap equity fund categories. Conspicuous by their absence from the funds' favorites list are growth darlings such as Apple AAPL and Google GOOG; behemoths in the popular energy sector ( ExxonMobil XOM and Chevron CVX); and big, slow growers (other than Procter & Gamble), which many think are poised to outperform.

It's telling that, instead, four of the five largest positions in this portfolio are in the unloved financials sector. True, Berkshire Hathaway, the biggest holding, isn't a typical financial firm and thus hasn't suffered as much from the credit crisis or the financial regulations implemented in 2010. But American International Group AIG surely has (and investors continue to be wary of it), American Express AXP was punished by the moribund credit market and Bank of New York Mellon BK has simply been quite sluggish over the past several years. Below we highlight some of the concentrated funds' favorites.

A Bet on Buffett
Berkshire Hathaway isn't exactly an obscure name nor is it in shaky condition, but controversy around now-departed David Sokol (who'd been appointed as Warren Buffett's successor) weighed on the stock. It's owned by three prominent focused funds, and none of them should be a surprise: Clipper (run by Chris Davis and Ken Feinberg of Selected American Shares SLADX, which has long held the stock); Sequoia (another longtime holder); and Fairholme (which previously had a large position in the stock and now has a much more modest stake). Feinberg said in a recent interview with Morningstar that Clipper and the other funds he comanages are trimming their stakes in Berkshire, though it was still a 7% position at the end of June. “There is still good value there,” he said. “[But] I think that there are other companies that are easier to run and that are smaller in size.” The managers of Sequoia, too, have gradually reduced the fund's stake in Berkshire--from 23% of assets in March 2009 to 9% two years later. They argue that while the stock is still selling at a discount to their estimate of fair value, it's not as cheap as it once was. And they take Buffett at his word that the company's book value will grow more slowly than it has in the past.

Can This Sluggish Service Provider Rebound?
Bank of New York Mellon (0.23% of the S&P 500 at the end of October) is a different animal. It does little traditional banking, focusing instead on providing services such as asset administration and trust services to money management firms (including mutual fund companies). Clipper, FMI Large Cap, and Longleaf Partners each have 3%–5% of their assets stashed in the firm. While the firm is market-sensitive to a degree because asset levels will fluctuate along with stock and bond prices, its fee-driven revenues give it a steady-Eddie profile, which stifled the stock's returns in 2009 and 2010 as cyclical fare ruled the day. However, while the stock might typically hold up better in a choppy market like 2011's, it's been hit because of expenses from integrating acquisitions and controversy over currency trades it made for custody clients to settle foreign securities transactions. Longleaf Partners' comanager Mason Hawkins argued in the fund's August 2011 shareholder letter that concerns about the latter are overblown and the stock is cheap. "The currency settlement business represents a small portion of [Bank of New York Mellon's] value, and our appraisal assumes lower revenues" as clients move away from that type of trading. "The controversy allowed us to add to our position at more discounted prices."

A Steady Grower
Manufacturing giant 3M MMM (0.49% of the S&P) is another favorite among focused funds. FMI Large Cap, Jensen, and Mairs & Power Growth each invest 4.3%-4.6% of their assets in the company. The stock isn't exactly beaten down: It held up substantially better than the market in 2008, posted a big gain in 2009 and a very modest one in 2010 and has registered a modest loss in this year's tumultuous market.

Although the firm is classified as an industrial, it's far less cyclical than most of its peers in the sector. Its wide range of products, history of innovation, and geographic diversification have translated into dependable profits. Indeed, Jensen can invest only in companies that have generated returns on equity of at least 15% for a minimum of 10 consecutive calendar years. Comanager Robert Zagunis says 3M is the fund's ninth-largest holding in part because "it gets two thirds of its sales from abroad, and that's an important part of the growth story because margins tend to be higher in other parts of the world, especially emerging countries." On a related note, Zagunis says 3M should thrive because of the need to build out infrastructure in many parts of the globe.

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Greg Carlson is a fund analyst with Morningstar.

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