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Fund Spy

What Two Great Managers Are Buying

Inside Clipper Fund's makeover.

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Ever since Chris Davis and Ken Feinberg were hired to run  Clipper Fund (CFIMX), I've been eager to see what they would do with this concentrated portfolio. Davis and Feinberg don't typically trade much so I figured the new portfolio would be a good indicator of what appeared attractive to them now. Likewise, I was interested to see which of the old Clipper team's holdings they would sell.

Davis and Feinberg's past takeover of  Selected Special (SLSSX) shows that they don't automatically toss out all the old holdings. Rather, they seem to treat legacy positions a little like they treat mistakes in their own portfolio. If they make a mistake and a stock gets hammered, they reassess their fair value estimate and will continue holding if they think the stock is significantly undervalued. In a similar vein, they'll hold on to inherited positions if they believe there's real value there--even if they wouldn't have bought the stock in the first place. That's rather different from most managers who toss out their inherited holdings--as well as their mistakes--as soon as possible no matter the price.

Now, the wait is over, and it turns out that Davis and Feinberg have made quite a few changes to Clipper Fund. In a recent shareholder letter, Davis and Feinberg say the transition is now largely complete.

Financials
The most dramatic action took place in this sector. It's a favorite area of both Clipper's former managers and its current managers, yet their approaches are quite different. The old Clipper managers loved a fire sale and wouldn't hesitate to buy a controversial beaten-down stock. Davis and Feinberg, by contrast, want good managers who have generated strong returns on invested capital. (Click here for a little more on what they look for.) Davis and Feinberg care about price, too, but they're willing to pay a fair price for a good company rather than wait for something to be supercheap.

With that preamble, you shouldn't be surprised that Davis and Feinberg dumped  Fannie Mae (FNM) and  Freddie Mac (FRE), the controversial and battered quasi-federal mortgage lenders. Both got in trouble for manipulating accounting and face an uncertain future with regulators.

That's not to say that controversy always scares off Davis and Feinberg. They've made  American International Group (AIG) their top holding. That firm's role in bid-rigging and its Byzantine structure, including having executives paid by the separate Starr companies, have scared some away. Yet, the company seems to be putting those issues behind it, and it's still very profitable and well positioned in markets across the world. Indeed, our stock analysts rate it 4 stars. From a recent report: "Although it has increased the value of its shares more than 100-fold during this analyst's lifetime, AIG is likely to sustain its record as one of the market's great wealth-compounding machines, in our view. The insurance conglomerate's enduring--if narrow--moat, rapidly growing marketplace, and freedom from obsolescence risk endow some competitive insulation and abundant opportunity to grow."

The other financial additions are longtime holdings of Davis and Feinberg where they like management and the company's position:  Golden West Financial  (GDW), Berkshire Hathaway (BRK.A), and  J.P. Morgan Chase (JPM).

Health Care
Davis/Selected has a dedicated health-care analyst, and the firm is not the sort of value shop that shies away from tech or health care, so it's interesting that they really cleaned house here. They only held on to one Clipper pick,  Johnson & Johnson (JNJ), and sold the rest. That includes  Pfizer (PFE), formerly one of Clipper's largest holdings,  Tenet Healthcare (THC) (speaking of controversy), and  Wyeth (WYE). Although they haven't discussed the latest round of changes in a letter to Clipper shareholders yet, they have said in the past that they were wary of the diminished prospects for earnings growth at many pharmaceutical companies.

Still, J&J sounds like a classic Davis/Selected holding. It's a well-run company with consistent profits whose share price has lately been depressed. Our stock analysts like the stock, too. In a March 21 analysis, Tom D'Amore wrote: "J&J boasts superb financial returns; its average five-year return on capital exceeds 30%. We forecast $10 billion in free cash flow this year--an impressive 20% of sales and 4% of our fair value estimate."

Retail
The new team has invested about as much in retail as did the previous team, but Davis and Feinberg chucked supermarket stocks  Kroger (KR) and  Safeway (SWY) and bought  Costco (COST). This is another Davis/Selected favorite. They first bought Costco back in 2000 when the stock got whacked over an earnings disappointment.

Food & Tobacco
They held on to  Altria (MO), which has been a big holding in  Selected American (SLASX). In the past they've said that they think the legal environment is improving for tobacco companies.

On the other hand, they chucked  Kraft Foods  (KFT). I'd imagine tepid growth and tight margins made them wary.

Energy
Davis and Feinberg dumped natural-gas pipeline company  El Paso (EP) and added integrated giant  ConocoPhillips (COP), which has benefited from its strong position in refining.

The Rest
The new Clipper managers also kicked former top-five holding  Electronic Data Systems (EDS) to the curb. I would guess the firm's declining IT business and the fact that  General Motors (GM) is a big customer had some role in scaring away Davis and Feinberg.

Meanwhile, I'm intrigued by the addition of  Harley-Davidson (HDI) as the 10th-largest holding in the portfolio. It's smaller than most of the companies in the portfolio, and it's outside of the typical favorite industries for Davis and Feinberg. However, it does have a tremendous brand, decent growth, and modest valuations.

Finally, Davis and Feinberg made wireless giant  Sprint Nextel (S) a modest-size position. Morningstar stock analyst Michael Hodel notes that the company has some appealing qualities. "Nextel's customer base is composed primarily of high-spending, loyal business customers, which should complement Sprint's ability to offer corporate data services via its long-distance unit. Sprint has done a good job of attracting consumers with innovative data services. As the only major wireless carrier not affiliated with a large local phone company, Sprint Nextel is well positioned to partner with cable firms looking to add wireless services to their offerings. This could prove a valuable distribution channel in the battle for customers."

Conclusion
Not surprisingly, all those trades will cause some distributions. Clipper is distributing capital gains of $4.50 per share, or roughly 5% of net asset value per share, on April 25, 2006, to shareholders of record as of April 21, 2006. With that distribution out of the way and a recent expense ratio cut added in, the fund now looks mighty attractive.

Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.