The Best Go-Anywhere Core Funds

Last week, we argued in favor of large-cap funds as core holdings worthy of the bulk of your long-term assets. As 70% of the stock market is composed of large-cap stocks, we suggested that most of the stock portion of your portfolio should be as well. We argued that exposure to large-cap stocks will offer you a significant portion of the market's return over time; that large-caps tend to be more stable than small, helping investors to stay the course; and that now, in the sixth year of a small-cap rally, might be a particularly good time to check if your large-cap exposure is beefed up enough.

There are, however, alternative methods to portfolio construction. Interestingly enough, these alternative methods correspond more closely to what many novice investors envision when they contemplate investing in a mutual fund. Many beginners assume that the whole point of a mutual fund is to hire a manager who is free to roam in all parts of the market, finding values wherever he thinks the markets present them, without being tied to a certain type of stock. Having to build a portfolio of "core" and "supporting" mutual funds strikes many novice investors as alien and difficult, even defeating the purpose of choosing funds over stocks in the first place. The point of owning a mutual fund is to put portfolio construction in the hands of a professional, isn't it?

It is true that there are funds that aren't limited to certain market caps or to certain countries by their prospectuses and whose managers don't think of their potential investment universe as being demarcated by part of the style box. When the famed Peter Lynch ran Fidelity Magellan (FMAGX), for example, he bought everything from multinational large caps to small banks. No publicly traded business was off-limits to Lynch; the entire investment world was his oyster. Ditto Warren Buffett, whose company Berkshire Hathaway (BRK.B) owns everything from behemoths like Coca-Cola (KO) and American Express (AXP) to small, private outfits like See's Candy and the Pampered Chef. Investors who share Lynch and Buffett's expansive views are rare, however, because it's difficult for even a professional investor to expand what Buffett calls his "circle of competence" or area of expertise.

Still, some investors are able to pull it off, and their funds may serve as worthy core holdings. If you do bring such a fund into your portfolio, however, you should first understand the drawbacks it may present. Very often (though not always), the managers of these funds are quite value-oriented. They may buy everything from small to large caps, and even venture overseas; invariably they end up decidedly on the value side of the style box and, more often than not, in the mid-value box. In addition, these managers often short-shrift entire sectors of the economy, such as technology. Their value disciplines attract them to boring businesses that have low expectations attached to them. Even when they do snag technology shares, it's typically when those stocks are beaten down dramatically and given up for dead by other investors. This bias has helped them deliver stellar returns relative to the S&P 500 in recent years, but investors should also be prepared to see these funds lag in periods when growth stocks and/or small caps lead the way.

Another characteristic of go-anywhere funds is that they tend to hold considerable amounts of cash at times and adopt as their first rule of investing "don't lose money." From the standpoint of capital preservation, this will make these funds safer than the index funds we discussed in our last piece. However, the tendency to hold cash means that investors who choose one or two go-anywhere funds as the repositories for the bulk of their assets will have to tolerate times when they lag the broader markets. This may sound easy to put up with, but it was difficult to attend a cocktail party in 1999, having to admit that your core holding was a value-oriented go-anywhere fund that avoided tech stocks like the plague and held large amounts of cash in anticipation of the next market downturn. Additionally, some investors resent having to pay an expense ratio on assets that the fund manager is holding in low-return cash investments. You'll have to decide whether the manager is talented enough to be trusted with shifting the asset allocation of the fund.

Finally, managers of go-anywhere funds may use some exotic techniques such as investing in the bonds of bankrupt companies. Managers who have a special talent for unearthing bargains amid distressed securities can often make a lot of money, but individual investors must be satisfied that a manager who engages in this activity has a long track record of doing it successfully. They also must be willing to tolerate opening up their shareholder reports and seeing the names of businesses that are associated with problems.

These are some of the better go-anywhere funds that investors can use as core holdings. Their managers are among Morningstar analysts' favorites, but investing in them requires patience for the reasons we've just discussed:

 Fairholme Fund (FAIRX)
Managers Bruce Berkowitz and Larry Pitkowsky are devotees of legendary value investor Benjamin Graham. They buy good businesses run by great managers and load up when they find something they like. They own a huge stake in Warren Buffett's Berkshire Hathaway. The managers also display a penchant for buying turnaround stories when they see a big opportunity. These "special situations," limited to 25% of the portfolio, included a big success with the bonds of Worldcom as it went through bankruptcy. They tend to hold big cash stakes, which they view as a source of funds for new opportunities as they arise.

 Third Avenue Value (TAVFX)
Legendary value hound Marty Whitman runs this fund in an inimitable style. He buys everything from Florida land companies such as St. Joe (JOE) to foreign steel companies like Posco (PKX) to the bonds of Kmart when it went through bankruptcy. He'll even scoop up technology stocks when they're having problems. His two most recent shareholder letters--and he writes arguably the best, most detailed letter in the mutual fund business--discuss his purchase of General Motors (GM) bonds and the common stock of struggling chip-maker Intel (INTC), respectively.

 FPA Capital 
Bob Rodriguez has run this fund since 1984 and has the distinction of having earned Morningstar Manager of the Year honors in both equities and fixed income. His guiding principle is "don't lose money." This has caused him to run with large amounts of cash when he thinks the market is frothy. Currently, the fund holds a whopping 40% cash stake. The current equity holdings are concentrated in the energy sector, which Rodriguez thinks can benefit from supply/demand imbalances in oil and natural gas. Although this may not seem very contrarian, Rodriguez was buying energy names as early as 2003 and hasn't given up his value criteria. Rodriguez also writes excellent, candid shareholder letters.

 Mutual Discovery (TEDIX)
The once-sleepy value shop run by Max Heine hit the big time when Heine's prot�g� Michael Price took it over in the mid-1980s. Price employed a three-pronged method of finding cheap stocks, engaging in merger arbitrage, and delving into companies involved in bankruptcy. In so doing, he managed to guide the Mutual Series funds to top returns during his tenure. Although Heine is deceased and Price is retired, that style continues today and also includes investor "activism," whereby Mutual Series will take a large position in a business that it thinks is being mismanaged and push for change. Mutual Discovery is the most wide-ranging of the funds, and includes a large number of foreign stocks. Although there's been a fair amount of manager turnover since Price sold the shop to Franklin Templeton in the late 1990s, talented investors trained specifically in the style have stepped in seamlessly. Peter Langerman, who worked with both Heine and Price, runs the show now.

Wintergreen 
David Winters spent 18 years at Mutual Series (parent of Mutual Discovery listed above), and started this fund in October 2005. He put up market-beating performances during his five-year tenure as manager of the Mutual Series funds with low volatility. He brings with him the strategy he used at Mutual Discovery specifically, including the abilities to engage in merger arbitrage, buy distressed securities, and roam anywhere in the world searching for stocks priced below his estimates of their intrinsic value. According to filings, he has recently been picking up shares of land company Consolidated-Tomoka Land  (CTO), which has declined dramatically on fears of a real estate slowdown. One caveat is that Wintergreen's expense ratio looks quite high now at 1.95%.

 Muhlenkamp (MUHLX)
Manager of his eponymous fund, Ron Muhlenkamp combines macroeconomic forecasts with traditional fundamental stock analysis in putting together his portfolio. Currently, out-of-favor large caps such as insurer American International Group (AIG) and pharmaceuticals Pfizer (PFE) and Johnson & Johnson (JNJ) sit next to mid-caps such as homebuilders Centex  and NVR (NVR) and title insurer Fidelity National Financial (FNF) and small-cap case-goods maker Stanley Furniture (STLY). Muhlenkamp also sports a sizeable energy bet, which, though it may not seem very contrarian, he has built over a number of years. The energy and housing bets are hurting the fund badly in 2006, indicating why patience is required with many go-anywhere funds, whose managers tend to have their own rhythms.