All-Star Managers' Second-Quarter Update

Each quarter, we review the shareholder letters and holdings of 16 of our favorite fund managers. When we last checked in, this group of value managers was "beginning to get excited" about opportunities created by lower stock market prices. Only a few months later, the psychological stress of watching prices fall seems to be taking a toll on even the best investors, leading  Legg Mason Value Trust's (LMVTX) Bill Miller to propose a "12-step program" for value managers "losing clients and assets over and above...losses in the market." More than one manager mourned the recent death of legendary investor Sir John Templeton by invoking his call to "buy at the point of maximum pessimism," perhaps subconsciously hoping that the moment has passed.

But despite their apparent troubles, none of our managers has abandoned the value approach. In fact, virtually all are, like  Ariel's (ARGFX) John Rogers, "brimming with optimism."

We share that perspective, along with the investors listed below, and believe that opportunities abound for investors willing to sort through the growing bin of bargain stocks.
 
 
 

All-Star Managers
Ariel (ARGFX)	John Rogers Jr.
Baron Asset (BARAX)	Ronald Baron Andrew Peck
Fairholme Fund (FAIRX)	Bruce Berkowitz
Gabelli Asset (GABAX)	Mario J. Gabelli
Legg Mason Value (LMVTX)	Bill Miller
Longleaf Partners (LLPFX)	O. Mason Hawkins G. Staley Cates
Oak Value	David R. Carr Jr. Larry Coats Jr.
Oakmark Select (OAKLX)	Bill Nygren Henry Berghoef
Olstein All-Cap Value  (OFALX)	Robert A. Olstein
Selected American Shares (SLASX)	Christopher C. Davis Kenneth C. Feinberg
Sequoia (SEQUX)	Robert D. Goldfarb David Poppe
Third Avenue Value (TAVFX)	Martin J. Whitman
Torray (TORYX)	Robert E. Torray
Tweedy, Browne Value (TBGVX)	Christopher H. Browne William H. Browne
Weitz Partners Value (WPVLX)	Wally Weitz
Yacktman (YACKX)	Donald Yacktman Stephen Yacktman

Fear and Loathing in the Financial Sector
With high-profile disasters like Bear Stearns,  Fannie Mae (FNM), and  Freddie Mac (FRE) looming fresh in investors' minds, there is plenty of blood in the streets for value investors willing to wade into the maelstrom in financial stocks. Not surprisingly, financial firms like  American Express (AXP) and  AIG (AIG) remain at the top of our list of widely held stocks--each was owned by seven funds in the second quarter. Along with  Berkshire Hathaway's (BRK.B) Warren Buffett, we share the fund managers' confidence in wide-moat credit card company American Express. We believe the company's closed-loop network--and its resulting control of the entire credit card value chain--will continue to produce returns on equity in excess of 30% over the long run. The full list of stocks held by five or more funds on our list is below:

Widely Held Stocks
Company	Number of Funds Holding	Morningstar Rating
American Express Company (AXP)	7
American International Group  (AIG)	7
Berkshire Hathaway Inc. B (BRK.B)	6
eBay, Inc. (EBAY)	6
Johnson & Johnson (JNJ)	6
Liberty Interactive A (LINTA)	6
Cisco Systems, Inc. (CSCO)	5
Citigroup, Inc. (C)	5	Under Review
Dell, Inc.	5
Intel Corporation (INTC)	5
Microsoft Corporation (MSFT)	5
Telephone and Data Systems, Inc. (TDS)	5
Tyco International, Ltd.	5
UnitedHealth Group, Inc. (UNH)	5

Unfortunately, some funds have already suffered permanent damage from ill-conceived purchases of financial services companies. Bill Miller's troubles with Countrywide, Bear Stearns, and Freddie Mac have been well-documented, but the Legg Mason Value Trust head is not alone in his suffering. As Christopher Davis and Kenneth Feinberg of  Selected American Shares (SLASX) explained, "In the current environment, the cause of such deterioration is not temporarily falling earnings, but rather permanent dilution as companies are forced to raise new capital at distressed prices."

Selected was not alone in experiencing dilution of its stakes in AIG,  Wachovia , and  Merrill Lynch  in the second quarter. In addition to the seven funds holding AIG, four held Merrill Lynch, and  Gabelli Asset (GABAX) joined Selected as owners of Wachovia. Unfortunately, only a few months after these funds reported their holdings, AIG is once again scrambling to raise capital,  Bank of America (BAC) is set to purchase Merrill Lynch, and  Lehman Brothers  has filed for bankruptcy. While hindsight is admittedly 20/20, we don't think the dilution of ownership in these companies was completely unforeseeable. As successful value investor Seth Klarman warned almost 20 years ago, "There can be no margin of safety from investing in the shares of thinly capitalized financial institutions that own esoteric or risky assets." In our opinion, investment advice doesn't get much clearer!

Health-Care Stakes Continue to Grow
Some new health-care-related names joined  Johnson & Johnson (JNJ) and  UnitedHealth Group (UNH) among value managers' holdings in the second quarter. Both  The Fairholme Fund (FAIRX) and  Tweedy, Browne Value Fund (TWEBX) opened positions in health insurer  Wellpoint (WLP) during the quarter. Fairholme's Bruce Berkowitz attributes Wellpoint's attractive share price to "slowing growth, rising costs, and election-year politics" but he believes the company possesses "essential products and services and large free cash flows relative to purchase [price]." Morningstar analyst Matthew Coffina shares that view, writing that "WellPoint has significant competitive advantages that will support outsize returns over the long run."

The worries weighing on the share prices of UnitedHealth and Wellpoint also created other opportunities in the health-care sector--shares of drug companies began to appear in several portfolios during the quarter. While Fairholme bought shares in  Pfizer (PFE),  Oakmark Select (OAKLX) and  Olstein All Cap Value (OFALX) purchased the stock of wide-moat pharmaceutical company  Schering-Plough  in the second quarter. Morningstar analyst Damien Conover shares the funds' managers' positive view of the company's prospects, believing that cost cuts and a strong pipeline will contribute to healthy growth and expanding margins in the years to come.

Although falling prices can produce psychological strain--Bill Miller facetiously remarked that value investors may "have plenty enough bargains already"--all great investors know that lower purchase prices produce better future returns. With that in mind, we're glad to see that our all-star managers are sticking to what they do best--buying stocks at a discount to intrinsic value--and we at Morningstar plan to continue doing the same.