Get 'Em While They're Cheap

The following commentary originally appeared in the Oct. 6, 2007, issue of Morningstar Mutual Funds, Morningstar's flagship resource for serious fund investors. Click here to learn more about Morningstar Mutual Funds.

Trying to time your purchases and sales of mutual funds is often a fool's errand. For one thing, it may not be necessary. That's because investors don't need to worry about buying or selling following a run of good performance, at least in theory; after all, the fund manager should be selling securities that are overvalued and replacing them with ones that are undervalued. That's an oversimplification, of course, but it gets to the appeal of actively managed mutual funds. Further, the delayed reporting of a fund's portfolio and a high level of trading actively make it tricky to say with much conviction whether a fund's portfolio is undervalued or overvalued at any one point in time.

Nonetheless, anyone who is investing a big lump sum in a fund might rightly consider whether a fund's holdings are reasonably or richly valued, and an investor who's about to sell would do well to do the same. It's not impossible to assess whether a fund portfolio is over- or undervalued, presuming a fund has consistently low portfolio turnover, using Morningstar's estimates of each holding's fair value. The exercise can also be employed when analyzing exchange-traded funds and index funds, which have largely static portfolios. But we'll save those for another day.

To start, I simply compared the stock prices of different fund portfolio holdings with Morningstar's fair value estimates. The portfolios typically had a June 30, 2007, date, but by focusing on low-turnover funds I could assume that most of those holdings were still present in mid-September, when I ran the numbers. Not all stocks are assigned a fair value by Morningstar, so this is not a perfect study. Still, I was able to find four low-turnover funds that I think offer investors some good return potential based on their securities' current valuations. Skilled and experienced managers also argue in favor of each fund.

 Weitz Value (WVALX)
Of the 22 holdings in Weitz Value that have fair value estimates (the fund holds 31 stocks), just one would be considered overvalued by Morningstar. And as a group, the 22 are trading at a discount of roughly 33% to Morningstar analysts' fair value estimates. The discounts are spread across a number of sectors. For example, the fund holds troubled financial-services provider  Countrywide Financial , which has been crushed by concerns about its mortgage origination business. Countrywide stock trades at less than half of Morningstar's fair value estimate. But the fund also owns  Wal-Mart (WMT),  Tyco International  , and  American International Group (AIG), all of which are on firmer ground and also earn 5-star ratings from Morningstar. That rating is a risk-adjusted measure of whether a stock is over- or undervalued based on a discounted cash-flow formula.

My confidence in this fund stems not just from its undervalued holdings, but from manager Wally Weitz's track record and experience. He's been with this fund since its inception in 1986 and his 10- and 15-year records are among the best in the business. Weitz likes to go against the grain, so I'd expect his holdings to make investors nervous on occasion. In 1999, for example, he plowed into the financial and real estate sectors, while others were chasing returns in technology. Weitz's approach can leave the fund dramatically out of step with its peers and the market, as we've seen recently, but his eye for value has paid off in the past, and I expect it to pay off in the future as well.

 Oakmark Select (OAKLX)
Oakmark Select provides a similar opportunity. Of the fund's 22 holdings, 18 receive fair value estimates from Morningstar. Those 18 trade at an average discount of 33% to our analysts' estimates of fair value. A few of the fund's holdings, including  Pulte Homes (PHM) and  Washington Mutual  (WM), have been stung by housing and mortgage concerns, but the undervalued holdings here cover a lot of ground. Indeed, industry leaders  Time Warner  ,  Sprint Nextel ,  Dell , and  Home Depot (HD) all trade at significant discounts to their fair value estimates. And as with the Weitz fund, only one of the fund's holdings is considered overvalued by Morningstar.

I also like the management here. Bill Nygren has led this fund since its inception in 1996 and boasts an excellent long-term record, despite the fund's recent struggles. His approach centers on the belief that short-term disconnects can occur between business performance and stock-price performance but that the two converge in the long run. That approach takes patience, but Nygren has shown just that over the years, holding Washington Mutual through a terrible year in 1999 in order to profit from it in 2000, for example. Nygren is also very shareholder-friendly. Recognizing that fund owners may have some concern over the fund's recent performance, he penned a letter to shareholders in which he described the fund's performance as "dreadful." He detailed some of the issues facing the fund but reassured shareholders that he is not changing his stripes and that he is investing more of his own money in the fund. I like a chef who eats his own cooking.

 Legg Mason Value (LMVTX)
Manager Bill Miller's current situation reminds me a bit of Warren Buffett's in the late 1990s. As Buffett's  Berkshire Hathaway (BRK.B) fell off the pace of many hard-charging, tech-stock-laden mutual funds, investors started actually questioning whether Buffett had lost his touch. With Miller's fund now underperforming the S&P 500 over the trailing three- and five-year periods--the same index he topped 15 years in a row--investors may have similar concerns. I don't. Buffett showed that his eye for value had never left him, and I expect Miller will do the same.

Morningstar has estimated fair values for each of this fund's top-25 holdings, which account for more than 85% of the fund's net assets, and the average discount is 25%. And based on those estimates, 17 of the fund's top holdings, which read like a who's who of blue-chip companies, are undervalued, with half of those undervalued by at least 40%. Finance stocks have slumped on mortgage concerns, but  eBay (EBAY), Sprint Nextel, and others have also fallen out of favor. But like Weitz and Nygren, Miller is patient.  Amazon.com (AMZN) was a drag on returns in 2004 and 2006, for example, but has soared about 100% since the first of the year. If shareholders show the same patience with Miller, we expect they, too, will be rewarded.

 Jensen (JENSX)
This fund shows that cheap funds aren't limited to value investors. Morningstar assigns fair value estimates to all 26 of this fund's stock holdings, and Jensen's turnover is a low 14%, so it's a perfect candidate for this study. Its portfolio isn't as undervalued as those above, but a 14% discount for a fund with strong management, a sound approach, reasonable costs, and a strong long-term record is nothing to sniff at. And it seems particularly reasonable, considering the high-profitability, high-quality businesses in the portfolio.

The fund's success is driven by management's ability to analyze businesses and accurately project the future cash flows that they'll generate for years to come; for them, short-term price fluctuations are more of an opportunity than a concern. I like that approach, and it jibes with Morningstar's approach to stock analysis. A look at the portfolio shows that only four of 26 holdings are overvalued and none are dramatically so. And among those holdings that are trading at a discount of at least 15% are industry leaders like  General Electric  (GE) and  McGraw-Hill (MHP).

Takeaway
Funds with poor short-term performance--as is the case with all four of the funds listed above--often get dumped by shareholders. This exercise illustrates that poor short-term performance can actually present a buying opportunity for investors. It may be more tempting to buy a fund that sits near the top of the pack, but it may be more rewarding to buy a fund that's closer to the bottom.