By Jim Ryan | Senior Stock Analyst
With 2010 drawing to a close, we thought it would be interesting to take a deeper look at the holdings, purchases and sales of some of our best-performing managers over the last year. As we noted in our last article, the end of the third quarter and start of the fourth quarter of 2010 were exemplified by strong equity market performance, with the S&P 500 Index (SPX) posting one of its best returns for the month of September in the last 85 years. This compares to the seesaw of returns that were posted by equities during the five months prior to September, with the market dropping more than 8% in May, and another 6% in June of this year. The recent rebound in the markets was driven by solid second-quarter earnings results in the face of the European credit crisis, and its potential impact on the global economic recovery.
In a period marked by this kind of volatility, it was not too surprising to see only a handful of our Ultimate Stock-Pickers actually beating the market this year. Of the 22 fund managers we track, just four of them-- Wintergreen (WGRNX), Fairholme (FAIRX), Columbia Value & Restructuring EVRAX, and Amana Trust Growth (AMAGX)--are currently beating the S&P 500 Index. This compares to 15 out of 22 managers that outperformed the market in 2009. Of the four managers beating the market this year, three of them were on the list of top performers in 2009, with Columbia Value & Restructuring not making the list by virtue of it not being added to our Ultimate Stock-Pickers until the first quarter of 2010. For the record, Columbia Value & Restructuring did beat the market in 2009 with a 47% total return.
What is interesting to note, though, is that our best-performing manager last year, Yacktman (YACKX), which posted a 59% return in 2009, is trailing the market by more than 100 basis points this year. Most of this underperformance happened late in the third quarter, and continued through October and November, as the fund was beating the market by more than 200 basis points through the first two quarters of 2010. Yacktman remains one of the top three best-performing funds on our list over the last 3-, 5-, and 10-year timeframes, a testament to the success Donald and Stephen Yacktman have had picking winning stocks over the years.
Barring a strong run of performance this month (relative to the market that is), Yacktman will most likely close out 2010 trailing the total return of the S&P 500 Index. This is not unusual for the fund, which trailed the market by more than 200 basis points in 2007, and more than 600 basis points in 2005. The key to their success has been steering clear of investing methods aimed at mimicking benchmark returns, preferring to rely on bottom-up individual security analysis to purchase stocks, and hold them until better opportunities become available, or until they determine they've made a mistake.
Wintergreen Outperforming with Eclectic Mix of Stocks
With a total return of 19% year to date, Wintergreen is our best-performing fund manager this year. Portfolio manager David Winters has put together one of the more eclectic portfolios in our list of 26 top managers, with top five holdings Jardine Matheson Holdings (JMHLY), The Swatch Group (SWGAY), Schindler Holding (SHLAF), Anglo American (AAUKY), and British American Tobacco (BTI) accounting for more than one third of his portfolio. Winters has also made large sector bets in consumer goods (36% of total stock holdings) and financial services (34%). Within consumer goods, he has around half of his holdings in tobacco stocks, including British American Tobacco, Imperial Tobacco Group (ITYBY), Japan Tobacco, and Philip Morris International (PM). His financial services holdings, meanwhile, include a mix of the less well-known--like Jardine Matheson, Genting Malaysia, and Fairfax Financial (FRFHF)--and more commonly known firms--like Berkshire Hathaway (BRK.A) / (BRK.B), Franklin Resources (BEN), and Goldman Sachs (GS).
Wintergreen is also one of the few truly global funds on our list of top managers, with nearly three quarters of the fund's equity holdings in non-U.S. stocks. David Winters believes that the best opportunities in years ahead will be outside the U.S. and has more than doubled his fund's international exposure over the last five years. He feels that companies able to tap into growing affluence in developing and emerging markets will have a big advantage over those that are focused on mature economies like the U.S. and Europe, where he believes the deleveraging process we are currently undergoing will take a long time to work out. Winters has been a big proponent of Nestle (NSRGY) of late, making a meaningful addition to an existing position he has held in the stock. He also established a new stake in Heineken (HINKY) during the third quarter.
Columbia and Amana Run More Diverse Portfolios
Producing total returns of more than 14% this year, both Columbia Value & Restructuring and Amana Trust Growth have generated market-beating returns with far less concentrated portfolios. Columbia's top ten holdings accounted for 36% of the firm's total equity portfolio at the end of the most recent period, while Amana's top ten holdings made up just 25% of its stock portfolio. Whereas Columbia is a bit more concentrated in a few sectors, like industrial materials, energy, and financial services, Amana has been a bit more diversified, with seven sectors accounting for more than three quarters of the portfolio. Amana has, however, been more heavily invested in hardware, software and telecommunications than Columbia, which is understandable given its penchant for growth investing.
That said, Amana's most recent purchases-- Coach (COH), Hewlett-Packard (HPQ), Fastenal (FAST), Harris Corporation (HRS), Adobe Systems (ADBE), and Intel (INTC)--include a mixture of both cyclical firms and growth stories. What continues to amaze us about Amana, though, is that fund manager Nick Kaiser can generate market-beating returns by investing in accordance with Islamic law. This means that the fund cannot hold the stock of any firm that generates more than 5% of its revenue from alcohol, tobacco, pork processing, gambling, or from the borrowing or lending of money.
Columbia has no such constraints, but does target firms that manager David Williams believes are set to boost profits through restructurings, reorganizations, and/or mergers and acquisitions. Williams tends to stick with his winners long after they've overcome the challenges they faced when he purchased their shares, but only for as long as the underlying business generates solid returns on capital. The fund's largest purchase of late have included Xerox (XRX), AIA Group, and Methanex (MEOH).
The Strange Dichotomy of Fairholme and Yacktman
As you may recall from the first article we published this year, both Fairholme and Yacktman have been generating market-beating performance over much of the last ten years by running fairly concentrated portfolios. In fact, looking at their performance over the last 3-, 5-, and 10-year time periods, one could assume that their investment philosophies were highly correlated (especially over the last decade, where the two funds' returns are almost identical). And we could go even so far as to note that what we said earlier this article about Yacktman--that the key to their success has been steering clear of investing methods aimed at mimicking benchmark returns, preferring to rely on bottom-up individual security analysis to purchase stocks, and hold them until better opportunities become available or they determine they've made a mistake--could easily be said about Fairholme.
But a quick look at their holdings over the last two years demonstrates the different approaches these top managers have taken to generate market-beating returns. Bruce Berkowitz's Fairholme fund, for example, ran a fairly concentrated portfolio during 2009, with just two stocks-- Pfizer (PFE) and Sears Holdings (SHLD)--accounting for close to one third of the fund's equity holdings. Contrast that with 2010, where the fund's top four holdings American International Group (AIG), Sears, Goldman Sachs, and Citigroup (C)--accounted for about 35% of Fairholme's stock portfolio. In the interim, Berkowitz has made a highly publicized shift into financial services, which made up more than three quarters of the fund's stock portfolio at the end of the most recent period. Compare this to the end of 2009, when financial services accounted for just over one third of Fairholme's stock holdings, with health care (25%), business services (13%) and consumer services (13%) accounting for significant portions.
This is not too dissimilar from the bets Yacktman was making at the end of 2009, with close to one third of its stock holdings in consumer goods stocks, another quarter in media firms, and health care (14%) and financial services (10%) representing other major sector holdings. Whereas Fairholme went big on financial services, Yacktman cut its exposure even further (to less than 5% of its equity holdings). This may have cost the fund some outperformance earlier in the year, but certainly hasn't hurt it since the start of the European credit crisis. By the end of the third quarter, Yacktman had increased its stake in health care (22%), while trimming its commitment to consumer goods (27%), and media (20%). The fund's top ten holdings accounted for 62% of its total stock portfolio, in contrast to Fairholme, which had 73% of its stock portfolio committed to its top ten holdings at the end of the most recent period.
To Moat or Not to Moat (and Don't Forget about the Risk)
The stock concentration and sector bets made by these two funds have also had an impact on two of the most important factors we consider when evaluating stocks, moats and uncertainty. Looking at the top ten holdings of each fund, Yacktman has six wide-moat and four narrow-moat stocks in its top stock holdings, while Fairholme has two wide-moat, four narrow- and four no-moat stocks. Looking at their total holdings, Yacktman has 54% of its stock portfolio invested in wide-moat stocks, 42% in firms with narrow moats, and the remainder invested in companies with no moats or where Morningstar has no rating on the firm. Contrast this with Fairholme, where just 17% of the stock portfolio is invested in wide-moat names, 32% in companies with narrow moats, 38% in no-moat firms, and the remainder in companies where Morningstar has no rating on the firm.
Looking at our uncertainty ratings, which reflect how tightly our analysts feel they can bound the fair value estimate that they assign to any given company, further demonstrates the higher level of risk in Fairholme's portfolio relative to Yacktman. As you may recall, for stocks with low uncertainty ratings, we feel that the distribution of our fair value estimates is fairly tight, such that we demand a relatively small margin of safety before investing. High-uncertainty stocks, on the other hand, are much more difficult for our analysts to value and, therefore, require a much steeper discount to our fair value estimate before we would consider recommending them. With an overwhelming majority of its portfolio in stocks with high, very high, and extreme uncertainty ratings, Fairholme is much riskier than Yacktman, which has a significant portion of its portfolio invested in stocks with low (35%) and medium (55%) uncertainty.
Obviously, these two funds have had a much different style and approach to investing in the market (at least, that is, over the last couple of years). But given the long-term success that both Berkowitz and the Yacktmans have had this small exercise does demonstrate that there is more than one way to skin the proverbial cat. Based on their current allocations, we would be surprised if we didn't see vastly different results from these two Ultimate Stock-Pickers over the next year (especially considering Berkowitz's extremely heavy allocation in the financial services sector), but stranger things have happened. As always, Yacktman remains almost fully invested in stocks, with little exposure to bonds. Fairholme, on the other hand, holds close to 25% of the fund in cash, and another 10% in bonds, offsetting some of the risk it takes in its highly concentrated stock portfolio.
Yacktman (YACKX) Fund Top Holdings on 09/30/10
Stock price and Morningstar rating data as of 12-03-2010
Looking at Yacktman's top ten holdings at the end of the most recent period, News Corporation (NWSA) remains its top stock position, with the fund increasing the amount of shares it holds in the firm by 33%. Morningstar analyst Mike Corty thinks this media conglomerate rates a narrow moat due to its cable network business, which generates more than 50% of its overall operating profit. Led by Fox News Channel, which continues to gain share and is likely to garner even more over the next few years, and its regional sports networks, the firm should benefit from affiliate fee growth over the next five years. The company's filmed entertainment segment, which includes its television content, has a history of generating major box-office hits such as Avatar, and contributes another 20% of News Corporation's operating profit. He believes that shareholders will be best served if the company continues to reinvest in its more successful businesses (such as its recent bid to acquire the 61% of British Sky Broadcasting (BSYBY) it doesn't already own) and returns capital to investors through dividends and share repurchases (but only when the company's shares are undervalued).
Yacktman was also taking a much deeper dive into the health-care sector during the third quarter, with the managers noting additional purchases in Johnson & Johnson (JNJ), C.R. Bard BCR, Stryker (SYK), Becton Dickinson (BDX), and Covidien COV was part of a broader move to increase already established stakes in healthcare equipment firms. Yacktman made new money purchases as well in Patterson Companies (PDCO) and Medtronic (MDT), which we highlighted in a previous article. Medtronic is one of only a few 5-Star stocks in Yacktman's portfolio and our analyst Debbie Wang believes the stock may continue to be pressured as long as patients delay or forgo nonacute care in response to unemployment and higher out-of-pocket costs and deductibles for workers. That said, she believes that Medtronic should recover longer term, with the next two years of evolutionary upgrades to existing products helping it tread water until the firm can roll out is more revolutionary, emerging technologies in 2013-2015.
Fairholme (FAIRX) Fund Top Holdings on 08/31/10
Stock price and Morningstar rating data as of 12-03-2010. Top holdings for FAIRX have been adjusted to reflect acquisition of Americredit since the close of the company's last fiscal quarter.
In its most recent quarterly filing, Fairholme disclosed that it opted out of positions in Comcast CMCSK, Ensign Energy and CanWel Holdings, and cut its stake in Humana (HUM) by more than half, in favor of a brand new stake in General Electric (GE). Morningstar analyst Daniel Holland likes General Electric's synergistic approach to combining businesses, and thinks the firm has a wide moat with medium uncertainty, which is a rarity in the Fairholme Fund. He believes GE's ability to generate cash remains one of its best attributes, and expects the company to generate $14 billion to $15 billion in cash this year. Holland is further encouraged by recent moves by GE, including the Dresser acquisition, further share repurchases, and the announcement of a dividend increase. He feels these actions signal that the company is ready to exit the protective stance it needed to take during the downturn, which could mean that the worst is finally behind it.
More exposure was gained to the Financial Sector with Fairholme's additions to existing positions in Morgan Stanley (MS), Bank of America (BAC) and American International Group. While the two banks have narrow moats, our analysts believe that the uncertainty around them remains elevated, as they work their way through what looks to be the end of the financial crisis. Our analysts still feel that AIG carries extreme uncertainty, as the disposition of assets continues, and the U.S. government positions itself as the firm's primary shareholder in the near future. Since the last filing, Fairholme has also announced a well-publicized increase in its stake in St. Joe (JOE). Morningstar analyst Michael Gaiden thinks the most recent attack on the firm by short sellers is unwarranted on this wide-moat stock, and he has maintained his Consider Buy rating on the stock. In his view, St. Joe holds one of the largest, most attractive development opportunities in global real estate.
Clearly, the risk trade is on at Fairholme and if it works out it will likely produce far better returns in the short run. Fairholme made some timely buys earlier this year in firms such as AIG and MBIA (MBI) that have worked out so far, but other recent purchases like Bank of America, Morgan Stanley and Regions Financial (RF) have yet to show results. Fairholme is now about 75% vested in the financial sector, which could go either way in large proportions.
Disclosure: Jim Ryan does not own shares in any of the securities mentioned above.
The Morningstar Ultimate Stock-Pickers Team does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.