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A Tale of Two Chart-Toppers

From worst to first ... what's next for these notable funds?

Bridget B. Hughes, CFA, 09/04/2012

A few weeks ago my colleague Russ Kinnel checked in on a handful of once-strong performers that had hit the skids to see if they had begun to turn things around so far in 2012. Most of the funds he highlighted, with the exception of soaring Fairholme FAIRX, are still in the tank for the year to date (admittedly a short period). Below I'll highlight two more notable funds that, like Fairholme, are topping the year-to-date charts after a marked weak period. Each has an interesting story to share.

Third Avenue Value TAVFX
Through the end of 2011, Third Avenue Value's 5.57% five-year annualized loss landed in the world-stock category's worst decile. For the most part, its weakness could be blamed on two years: 2008 and 2011. Its bottom-quartile showing in 2008, when it lost more than 45%, came as a surprise for the value-oriented fund. After all, the fund had long prized balance-sheet strength, and in 2008's rough-and-tumble fourth quarter, the financially weakest companies were punished the most. Further, the fund had often held up better than indexes and peers in times of previous market stress.

There were a couple of explanations, though. Manager Marty Whitman (later teaming with comanager Ian Lapey) had always run a very concentrated portfolio, a sign of conviction in Third Avenue's bottom-up, research-intensive process. But redemptions plagued the fund, and without much of a cash hoard (sometimes less than 2% of assets), another of Whitman's and Lapey's characteristics came into play--their absolute-value mentality. This forced Whitman and Lapey to sell off noncore holdings rather than touch their favorites, a handful of Hong Kong property companies, which they considered too cheap too sell. As long as these firms weren't disappointing them on a fundamental basis--and in fact, they continued to get better--Whitman and Lapey were hooked. As a result, the fund grew more concentrated in Hong Kong real estate stocks, which ranged between 40% and 50% of assets between late 2008 and early 2012. But while Whitman and Lapey could argue that the fundamentals of the companies were strong and that their businesses extended beyond Hong Kong real estate, they still traded as Hong Kong property companies and proved to be quite volatile.

With Whitman's March 2012 retirement from the fund (but not from the firm or from investment management), Lapey set out to make some changes, noting that redemptions had continued. (Third Avenue had also heard from its shareholders that the recent volatility had been unsettling.) And although Lapey still loves the Hong Kong firms, he has found opportunities in other areas, including insurance companies, regional banks, technology, and energy firms. Between the end of January and the end of July 2012, Lapey has added seven new companies, eliminated eight older holdings, and made other portfolio moves, including trimming his Hong Kong darlings so that none of them (or in fact, any other stock) consumes more than 10% of assets. Meanwhile, he has maintained an 8% cash position.

Even with the moderating tactics, the fund remains highly exposed to Hong Kong property, now roughly 35% of assets. Ironically, that still-big bet has been beneficial in 2012 and largely explains the fund's superior performance for the year to date. Through Aug. 29, the fund's near-17% gain lands in the world-stock group's best decile. And a closer look shows that while the fund outperformed its index during the early part of the year and the more recent uptrend, it also held up better than its bogy during the decline between early April and early July--reversing a pattern that had characterized the fund in the previous five years.

Whether such resiliency will continue remains to be seen of course, but the odds are moving more in the fund's favor based on Lapey's moves toward a more-diffuse portfolio. Investors who are selling the fund ought to reconsider. Even with its struggles since 2008, the fund's process is proven long term and its investment team is experienced and patient. These latest moves seem to improve the fund's risk/reward proposition.

Legg Mason Capital Management Opportunity Trust LMOPX
In some respects, Bill Miller's Legg Mason Capital Management Opportunity Trust has borne a similar burden as Third Avenue Value--in that shareholders have been leaving the fund for years, and concentrated funds with limited cash positions, like this one, are then forced to make choices about what to sell to meet those redemptions.

But here, the fund's weak overall performance from 2007 through 2011 had less to do with circumstance (though Third Avenue doesn't claim it was a victim either), and more to do with Miller's aggressive approach to investing. Miller has long used behavioral analysis to take advantage of broad market, sector, or industry trends; and when he perceives an opportunity, he is often "all in." In 2008, his early bullishness on financials, housing stocks, and other troubled companies led to a 65% pummeling that year. In 2011, the fund lost nearly 35%. Overall, the fund's annualized five-year return through Dec. 31, 2011, was a staggering 13.64% loss, landing dead-last among mid-value funds and much worse than the fund's S&P 500 Index benchmark, which reported a 0.25% annualized setback. That came even though the fund bounced high in 2009, with an 83% advance--thanks to the same portfolio that had crushed it the year before.

Bridget B. Hughes, CFA, is an associate director of fund analysis with Morningstar and is also happy to chat with you.
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