Refining the Investment Manager Roster

By Greggory Warren, CFA | Stock Analyst

In yesterday's article discussing the relaunch of Ultimate Stock-Pickers, we talked about the value of sifting through the holdings, transactions, and writings of professional investment managers--especially those that have been able to beat the market (as represented by the S&P 500 Index (SPX)) over long periods of time.

While most everyone will agree that Warren Buffett has had a long and successful track record of producing market-beating returns, even through volatile market environments like we've witnessed over the last 10 years--a feat that was highlighted in a recent Stock Strategist article on  Berkshire Hathaway (BRK.A) (BRK.B)--he has also had his share of missteps along the way.

The same could be said of many of the star managers who have fallen to earth during the course of the bear market, all of which has made the task of putting together an Investment Manager Roster more difficult. After all, we don't want to exclude managers from the list who have had solid long-term track records just because they underperformed the market in 2008. On the other hand, we do need to recognize the impact that stock selection has had on near-term performance, because, at the end of the day, our primary objective with Ultimate Stock-Pickers is to generate investable ideas.

Our task, then, is to sift through the universe of investment managers we cover here at Morningstar (via the research efforts of our mutual fund and stock analysts) and come up with a roster that not only produces data on what some of the best managers in the business are buying and selling, but is also diverse enough to buffer us from the danger posed by group-think among managers who happen to follow the same investment style.

While it would greatly enhance the production of a quarterly list of common holdings, purchases, and sales if every manager in the roster followed the same style, the problem with this approach is that managers of a feather sometimes make the same wrong bets together, much like value managers did with the financials over the last couple of years. The list of value funds that piled into Bear Stearns, Lehman Brothers, Countrywide Financial,  Fannie Mae (FNM),  Freddie Mac (FRE), and  AIG (AIG) before each of these firms collapsed reads like a who's who of some of the best-performing value managers over the last two decades. Bill Miller, the longstanding manager of  Legg Mason Value (LMVTX), whose fund had beaten the market for 15 straight years (1991-2005), was ultimately laid low by his poorly timed and highly dubious bets on financials last year, pushing the Morningstar rating on his landmark fund to 1 star.

Given the role that financials have traditionally played in the toolbox of most value investors, and the path that this heavier focus on that particular sector took us down during the course of the credit crisis and the bear market, we've decided to increase the number of large-cap growth and blended funds included in the Investment Manager Roster. While we will always be drawn to value managers, given the impact that investors such as Benjamin Graham and Warren Buffett have had on our own investment research, we believe that we should also be willing to look outside of the value investing toolbox--especially if it helps us come to stronger conclusions about our own research, as well as securities we might be looking to buy or sell.

Mixing Up the Investment Manager Roster
With value and growth styles typically coming in and out of favor at different times, we feel that having a mix of managers should allow us to identify higher-conviction buys and sells than we might generate by focusing on just one investment style alone. After all, if more than a handful of managers across the spectrum of large-cap funds are buying the same security, wouldn't that be a stronger signal than a similar number of value investors all piling into the same name? We expect to monitor our mix of managers closely, though, to ensure that we're actually getting useful information and not just spreading the universe of transactions over a wider base.

As for the performance hurdles we look at when assessing the managers on the list, we remain committed to focusing on institutional investors that have a proven track record of beating the markets in both good times and bad. We are, however, willing to cut some of our top managers a little bit of slack right now in light of the impact that the performance of the past year has had on their long-term track records. Much like a major league baseball manager might be willing to let a hitter stay in a critical spot in the lineup on the belief that he will eventually hit his way out of a slump, we want to give these slumping managers the chance to demonstrate that they can bounce back to form.

That said, we do expect to be far more proactive with the Investment Manager Roster than we have been in the past, moving managers off the list and replacing them with better-performing peers whenever we feel that such a move is warranted. We believe that this type of flexibility is necessary for us to work toward our ultimate goal with the roster, which is to build and maintain a list that can consistently generate high-conviction buys and sells from the ongoing transactions of some of the best managers in the business.

A Closer Look at the New Roster
Our updated roster remains a unique mixture of managers who work for insurance companies, as well as those employed by traditional asset managers. The three insurance firms that we continue to look at closely are  Alleghany ,  Markel (MKL), and Berkshire Hathaway. The stock analysts covering these companies regularly sift through the holdings of each firm, looking for insights into overall portfolio strategy and capital allocation decisions.

Unlike most of their peers in the mutual fund business, managers of equity portfolios at insurance companies tend not to be impacted by investor redemptions during poor market environments, so we believe there is some real value to having them on our list--plus, it doesn't hurt much to have Warren Buffett included in a roster of top asset managers. At this point, we are considering the addition of a fourth insurance firm,  Fairfax Financial (FFH), a Canadian property and casualty insurer that invests heavily in U.S. equities, to the list and expect to highlight our analyst's take on the firm's fourth-quarter transactions in an article that will be published later this week.

As for the remainder of the Investment Manager Roster, it is still made up of 13 mutual funds that have been on our list for some time now, namely:  Davis NY Venture (NYVTX),  Dodge & Cox Stock (DODGX),  Fairholme (FAIRX),  Jensen (JENSX),  Matrix Advisors Value (MAVFX),  Mutual Shares (TESIX),  Oak Value ,  Sequoia (SEQUX),  Sound Shore (SSHFX),  Tweedy, Browne Value (TWEBX),  Vanguard PRIMECAP (VPMCX),  WHG Large Cap Value (WHGLX), and  Wintergreen .

To that list of names we have added the following nine funds:  Amana Trust Growth (AMAGX),  Amana Trust Income (AMANX),  Aston/Montag & Caldwell Growth (MCGIX),  Chase Growth (CHASX),  Columbia Dividend Income ,  Harbor Large Cap Value (HAVLX),  Oakmark Equity & Income (OAKBX),  Parnassus Equity Income (PRBLX), and  Yacktman (YACKX). And to free up room for these additions to the list, we removed the following four funds from the roster:  Ariel Appreciation (CAAPX),  Longleaf Partners (LLPFX),  Third Avenue Value (TAVFX), and  Weitz Value (WVALX).

While the group as a whole is still bent somewhat toward large-cap value managers, we are excited about the contribution that will come from some of the new managers we've added to the list--several of which have been able to produce market-beating returns despite having restrictions placed on their universe of potential investments.

In the coming months, we plan to delve a little bit deeper into the holdings and research methodology of more than a handful of the managers we've listed on our revised Investment Manager Roster, which we believe will highlight many of the reasons why we consider these investors to be a step above the rest of the pack. This effort is scheduled to start later this week as we take an in-depth look at the methods and performance of Jensen Investment Management, managers of the Jensen Fund. In the meantime, keep an eye out for tomorrow's Ultimate Stock-Pickers article, which delves into the top holdings, purchases, and sales of the 25 managers in our roster.

Disclosure: Greggory Warren, CFA has a position in the following securities mentioned above: Amana Trust Growth AMAGX; Amana Trust Income AMANX.