Consistency: An Overrated Virtue in Mutual Funds?

When  Legg Mason Value (LMVTX) manager Bill Miller visited our offices a couple of months ago, we asked him to name the most overrated, overvalued stocks in the market right now.

Without skipping a beat, Miller shot back: "Companies with consistent earnings." He went on to argue that stock investors lavish too much attention on firms that meet or beat their earnings targets quarter in and quarter out, while short-shrifting those companies with more-erratic earnings patterns but better long-term growth trajectories.

Miller was talking about stock investing, of course, but his message could have just as easily applied to investing in mutual funds.

Many consultants and investment advisors urge investors to seek funds whose returns land in the top half, third, or quartile of their peer groups in every calendar year and consider giving the heave-ho to those with less predictable annual returns. But if you limit yourself to such funds, you're likely to miss out on a large number of gems that are very worthy of your attention.

A Short and Arbitrary Time Period
Miller's own charge provides a vivid illustration of why it's a mistake to get hung up on the consistency of calendar-year returns when evaluating a fund's worthiness.

He gained acclaim for thumping his benchmark, the S&P 500, for 15 consecutive years, from 1991 through 2005. In 2006, however, he fell behind his bogy in dramatic fashion, ending the year 10 percentage points behind the index and prompting much hand-wringing over whether he had lost his touch.

But as analyst Greg Carlson wrote last year, it would be a mistake to let one weak year overshadow the whole of Miller's remarkable tenure here: Even after his fund's 2006 performance slump, it still outpaces the S&P 500 by an annualized 4 percentage points over the past decade.

More important, gauging performance in a calendar-year period is an extremely arbitrary exercise that informed investors should avoid. As Miller was quick to point out even when his S&P 500-beating streak was still fully intact, the fund had underperformed the S&P 500 in many rolling non-calendar-year periods during his tenure.

When Inconsistency Is Consistent
But the key reason you shouldn't get bogged down in consistency of annual returns is that a great manager's year-by-year performance will generally be a lot less consistent than his strategy. It's also worth noting that the best managers often follow up weak performance periods with stellar returns.

A peek beneath the hood of Miller's recent underperformance demonstrates why this is so. Unlike many rival fund managers working today, he has always understood that beating the benchmark requires a willingness to differ significantly from his bogy, the S&P 500. In 2006, as in years past, that meant underweighting energy and commodity-related stocks that led the S&P 500's gains, to the detriment of near-term returns. Moreover, he's not inclined to waver from his strategy and his basket of securities amid bouts of short-term performance. Just the opposite, in fact: He's often adding to his holdings as their share prices are slumping, arguing that if he liked the company in the first place, he should like it even more when it's on sale. In 2006, many of Miller's Internet-related companies came in for some pain, but he stood by them and even added in some cases.

The conviction Miller shows in his approach, as well as his willingness to diverge meaningfully from the consensus view, is the hallmark of all great investors, ranging from  Third Avenue Value's (TAVFX) Marty Whitman to  Fidelity Contrafund's (FCNTX) Will Danoff to all three of our Managers of the Year for 2006. All of these skippers, like Miller, have seen their performances slump at various points in time but have rewarded their shareholders by not wavering from their strategies amid times of trouble. In some cases, these managers' near-term performance has drifted downward because they saw a market sell-off as an opportunity to buy stocks while they were dropping. In other cases, short-term performance has suffered because managers refused to drink the Kool-Aid amid market manias. In 1999, for example, Danoff's Contrafund badly lagged the typical large-growth fund's scorching gain because he hadn't feasted on tech stocks to the extent his rivals had. Amid the ensuing sell-off, however, his prudence was rewarded.

Takeaways
None of this is to suggest that consistency isn't a virtue. Consistent positive returns and capital preservation--the goals of cautious managers such as  FPA New Income's (FPNIX) Bob Rodriguez and former First Eagle manager Jean-Marie Eveillard--are obviously important to risk-averse investors. But that kind of consistency reveals itself in absolute returns and volatility-related statistics like standard deviation--not by looking at how a fund has performed relative to a peer group or a benchmark.

If you're a long-term investor in equities, you've got to brace yourself for the inevitable weak patch and, indeed, real losses. When that occurs, turn your attention to whether your fund is consistent where it counts--in its management and strategy. And if it is, do what Miller does: Hang on and consider buying more shares.