Tough Times for Buffettology

The following commentary originally appeared in the Dec. 6, 2006, issue of Morningstar Mutual Funds, Morningstar's flagship resource for serious fund investors. Click here to learn more about Morningstar Mutual Funds.

We all know that no fund or manager can outperform the market or its peers in every time period. Still, after a once-successful fund has lagged for a certain amount of time, it's only human to begin wondering whether something has gone awry. We'd be very quick to say that one year is too short a time period for poor returns to mean anything, but what about three years? What about five?

Take, for instance, the following five funds: large-value fund  Weitz Value  (WVALX), large-blend funds  Torray (TORYX) and  Oak Value , large-growth fund  Legg Mason Growth (LMGTX), and mid-blend fund  Ariel Appreciation  (CAAPX). Over the trailing 10 years ended Oct. 31, 2006, their returns finish in the top quartile of their respective categories. Yet each dwells in the bottom 15% of its category over the trailing three-year period, and some look pretty wretched over the past five years. Have they gone astray? Have their managers lost their touch?

We'll go ahead and end any suspense now. We think they're all intact. Because their long-term fundamental strengths and short-term performance issues are quite similar--despite their seemingly different style profiles--they provide great examples of why you must look beyond short-term performance and other shallow metrics to determine if a lagging fund remains a sound investment.

In different ways and to different degrees, the managers of all these funds emulate the great Warren Buffett's investment discipline. Most people think of Buffett as a value investor, but his investment philosophy is a detailed version of value investing--and also more than just value investing.

Buffettology Boiled Down
The first big idea underlying Warren Buffett's approach is understanding value. His mentor, legendary value investor Ben Graham, believed that an investment's market price didn't necessarily reflect its intrinsic value, which he saw as a combination of its current assets and its future earnings power. If you purchase an investment that trades below its real worth, a "margin of safety" protects capital and drives a solid rate of return. This philosophy of measuring intrinsic value and buying at a discount is a firm foundation for all the managers here. For instance, Wally Weitz uses discounted cash-flow analysis, while John Rogers of Ariel Appreciation does the same and adds a merger and acquisition metric.

The second big key to being a Buffetthead is focusing on a rather small number of firms. Buffett learned this technique from Phil Fisher, an outstanding growth investor, who felt that by concentrating on firms growing faster than the economy and holding for long periods of time, one would trounce the market. And the funds we're looking at definitely follow those models: Turnover ranged in 2005 from a low of 20% at Legg Mason Growth to a high of 42% at Weitz Value, while the number of holdings ranged from 29 at Legg Mason Growth to a high of 40 at Torray. As long-term readers know, Morningstar's study of funds that invest with conviction--meaning low turnover, focused portfolios--has shown that such funds have a greater chance to outperform over very long periods of time.

Still, a compact portfolio, however constructed, drives short-term volatility. Plus, discounts to an investment's true value can persist for some time--years, in fact, as recent history suggests. The key for investors is to know when they're seeing a time period when such a fund is likely to lag and then to consider whether the strategy remains valid.

High-Quality Funds in a Low-Quality World
The environment since late 2002 hasn't been conducive to a Buffett-like strategy. Many investors have throughout the current bull market described it as a "low-quality" rally. That means investors have sought out riskier businesses rather than steady ones, and firms that use debt to juice returns rather than those that grow organically. As many readers likely know, commodity-based businesses connected to oil, metals, and so forth, which are not generally core holdings for investors who prefer predictable cash flows, have delivered superior returns.

Meanwhile, the managers here have stayed very true to their discipline. For instance, the five funds' collective exposure to the energy area is zero percent, right where it's been throughout its multiyear rally. Simultaneously, statistical measurements of quality abound. At Oak Value and Legg Mason Growth, for instance, the overall return on equity (which measures how well firms plow earnings back into their businesses to fuel more earnings) are 12% and 24% higher than the S&P 500 Index's. And compared with other large-value funds, Weitz Value's portfolio has 70% higher free cash-flow growth but pays only about half for each dollar of cash flow than the typical rival.

It's very unlikely that the way the world looks lately can last forever. Ultimately, the firms that can generate their own organic growth through high profit margins and niche businesses over which they have control--a hallmark of Buffettology--thrive. Meanwhile, firms that can't finance their own growth--those that overly depend on debt--fail. And businesses whose products are no different from competitors', as is widely true in the energy sector, remain at the mercy of those commodified product prices.

No Reward Without Risk
That doesn't mean that there's no danger zones for the five funds we're examining as a group. One sits front and center: Just as Buffett's discipline led him to invest in the  Washington Post (WPO), so have his compatriots been attracted to media firms. Radio stations, television companies, and newspapers all have dependable cash flows and fairly low fixed costs, making them likely targets of a strategy that seeks enduring profits. Indeed, all of the managers here have outsized bets on media stocks. While the S&P 500 Index's media weighting is currently about 3.5%, the funds here range from a low of 10% at Legg Mason Growth to a whopping 27% at Weitz Value.

While the rules of investing may not have changed, the world can change. It's undoubtedly true that Internet news and video and satellite radio are diverting people's attention from traditional media. That doesn't necessarily mean that old media's cash flows will simply disappear, but many firms' profits are shrinking, and almost all these funds' managers acknowledge that the old guard in which they invest need to find new and improved ways of running their businesses. We're inclined to agree that the rampant pessimism has become overblown, that the cash flows currently justify the investments, and that management teams will find ways to improve the businesses.

We'd also note that there's a specific and, indeed, intriguing cause for caution with regard to Legg Mason Growth. Manager Robert Hagstrom has as good a grounding in Buffett's specific craft as almost anyone. That said, in 1997, he made a conscious, conspicuous shift toward different kinds of firms, including many of those new media names just mentioned as well as technology firms that most Buffett devotees avoid. So, five of its top six holdings, which include  Google (GOOG) and  Amazon.com  (AMZN), trade at P/E ratios north of 30. There's no reason that a Buffett-like approach won't translate to such firms, but clearly Hagstrom is exploring new ground, and if his estimates of future cash flows at such firms are too high, the fund's current woes could lengthen.

As we've said from the beginning, however, we still have a high degree of confidence in all five funds. That's because their strategies are highly sensible and definitely repeatable. Moreover, the managers have proved their ability to execute their approaches. When those core fundamentals remain in place, it should take more than a few years to shake an investor's confidence.