The Stock Stinks, but the Fund's Fine

 Longleaf Partners Fund (LLPFX) made some waves recently. In its first-quarter shareholder letter, the managers of this highly regarded value fund made a frank admission of failure. It was the sort of clear and unambiguous confession that one tends to hear only from outstanding, experienced managers who are confident in their skills yet humble enough to recognize their human failings.

The admission centered on the first quarter's worst performer in the portfolio:  UBS (UBS). Longleaf had bought the Swiss bank in late 2007, after its stock price had already fallen. Managers Mason Hawkins and Staley Cates thought that new management could restore the firm's focus without incurring much cost. Wrong. "The cost . . . far exceeded our worst-case estimates of how much the historically prudent and conservative Swiss bank's board permitted the investment bank to over-leverage its balance sheet with questionable assets." Buying this stock last year, they concede, "was a mistake." Elsewhere they borrow a tennis phrase, calling the move an "unforced error."

This isn't a case of false modesty. Through June 27, UBS' stock had plunged 52% this year.

That's not the only deep-diver in the portfolio. Jockeying for a position in the financial headlines about the year's major disasters has been  General Motors (GM), and Longleaf owns that one, too. GM is down 53% this year. It's worth noting that the fund typically owns just 20 to 25 holdings, so these aren't merely tiny stakes in a sprawling portfolio. Longleaf makes a meaningful commitment to every company it buys: It entered this year with 4.5% of assets in UBS and 3.2% in GM.

So the fund must be getting crushed this year, right? And this column will focus on why investors should stick with talented managers even when their fund is struggling?

No. Longleaf Partners Fund is ahead of the S&P 500 by more than 4 percentage points this year. It's ahead of 90% of its rivals in the large-blend category (and would be in almost the identical spot in the large-value group). Shareholders might not be thrilled with the absolute performance, for the fund is down more than 7% this year. The managers aren't happy, either--they aim to post positive returns regardless of the market climate. But the fund is certainly not suffering to the extent one might expect knowing that two substantial holdings have lost more than half their value. Most other value or blend stock funds would love to have Longleaf Partners' year-to-date performance.

Similar examples can be found among less-prominent funds. Last August, Brian Posner, then comanager of  Legg Mason Partners Capital  and CEO of ClearBridge Advisors, discussed with me at length why he had confidence in  Lehman Brothers . Among other things, he said the market thought the firm was still purely a bond house when in reality it had much more going for it. We returned to that topic in a late-January interview, and he reiterated his confidence. The stock still played a significant role in the portfolio.

As you may know, when Bear Stearns ran into trouble earlier this year, investors turned their attention to other Wall Street institutions, with Lehman Brothers a main target. It's now down 66% for the year. In August Posner also talked about another portfolio holding,  American International Group (AIG). That one's down more than 50% this year. But as with Longleaf, Legg Mason Partners Capital has not been overwhelmed by those two crushing declines. The fund's year-to-date returns and ranking are almost identical to those of Longleaf. (Note: Posner left ClearBridge Advisors and the fund a few months ago, but comanager Brian Angerame remains on board.)

In both funds' cases, the managers still held the stocks in question at the end of the first quarter--the most recent publicly available portfolio--having decided that the companies retained long-term potential at their depressed prices. (In recent interviews, the managers of each weren't allowed to say if they still owned them now, though it wouldn't be surprising if they did.)

Diversification Can Pay Off--and Funds Can Provide It
So far, therefore, the key element of the UBS story isn't the magnitude of Longleaf's miscue or the candor of its confession. Rather, this high-profile example serves as a perfect illustration how the diversification benefit touted by mutual funds is not just sales hype but a real, powerful force. A variety of other holdings, with performances ranging from stellar to merely respectable in a falling market, enabled these funds to limit the damage from the big decliners.

If managers as talented and experienced as Mason Hawkins and Staley Cates could pick stocks that lose half their value in six months, you could too, if you're selecting stocks on your own instead of relying on funds. Unlike Longleaf Partners Fund, though, it's unlikely that an ordinary investor relying solely on individual stocks would own enough other ones, with strong enough performance, to offset the damage of two major meltdowns. True, if you didn't sell them, it would be just a paper loss for now. Even in that case, though, you'd need nerves of steel to avoid suffering considerable anguish during these months.

No doubt, certain investors with sufficient time, money, and expertise can succeed owning individual stocks alone. But as the above examples show, the risk of serious losses is great, even if you stick to large, well-known companies. The effect of that risk on your overall fortunes increases if you only own a handful of stocks and don't have the bulk of your assets in broader offerings such as mutual funds or exchange-traded funds. For those who like the challenge and potential gains of picking individual stocks, a less exposed way to indulge in that pastime is to pair that activity with the ownership of mutual funds or ETFs--as many readers of Morningstar.com do.

Then if one or two of your stocks plunges, it would only affect a small portion of your overall assets. While your pride might still suffer as a result of such miscues, your retirement plans could probably stay intact.