How Schneider Overcame the Devil's Advocate

Arnie Schneider, portfolio manager of  Schneider Value  and  Schneider Small Cap Value , made some major mistakes during the recent market swoon. He not only held several financial and mortgage firms that ended up going belly up or have otherwise been impaired, such as Countrywide,  Fannie Mae (FNM),  Freddie Mac (FRE), and  American International Group (AIG), but also he continued to buy them as they plummeted. At Schneider Small Cap Value, he was caught holding the bag with some other distressed stocks, such as Pilgrim's Pride, a chicken producer that went bankrupt under a mountain of debt, and American Home Mortgage--the first subprime lender to go belly up.

The results were horrific. Between Oct. 9, 2007, and March 9, 2009, (the most recent closing peak and trough for the S&P 500 Index), Schneider Value lost 70.8%. Schneider Small Cap Value dropped 69.2%.

Although this sad story isn't unheard of when the S&P 500 Index itself fell 54.9% during that time, the Schneider funds were our worst-performing Analyst Picks. We knew when we made the funds picks that their deep-value approaches carried special risks associated with companies going through hard times--even bankruptcy--but we were confident in Schneider's ability to separate the winners from the losers, given his experience and performance while at Wellington Management Company. We knew that there would be periods of weakness, and we were comfortable with the ups and downs of the funds' performance records, because we'd seen Schneider's approach work well over the long haul. Nonetheless, we were disappointed by the exaggerated losses this time around.

We had questions--both for Schneider and for ourselves. Is Schneider less skilled at investing in controversial and distressed companies than we thought? And are the funds too volatile for investors to use properly?

Let's Play Devil's Advocate
We recently tackled the Schneider funds to make sure that our analysis is as thorough as it can be. We began by visiting Schneider Capital Management in Wayne, Pa. (outside Philadelphia) to assess the operation and speak with Schneider and the analysts behind the fund. Back at Morningstar, we met to digest what we learned. Some of us made the case for Schneider's funds, while others tried to poke holes into our positive assessments of the funds.

In the end, we decided to keep both funds as Analyst Picks, but investors should recognize that they are among our riskiest choices. Below is a brief discussion of some of the issues considered.

Did Arnie Schneider Understand the Risks He Was Taking?
These portfolios contained a list of stocks that ended up stinking up performance, largely because of their debt-laden or otherwise convoluted balance sheets in a market that wasn't tolerant of such characteristics. We wondered whether Schneider truly is able to discern which troubled companies would survive.

Schneider says that he does give each company a risk rating that takes into account its balance sheet and cash flows, and historically the portfolios have not been skewed one way or the other in terms of investing in the least- or most-risky stocks based on that assessment. Schneider did say that he recently has made further distinctions among the riskiest set. Making those distinctions earlier probably wouldn't have made too much of a difference in the fund's recent performance, but we appreciate that Schneider has tweaked his process in response to the severity of the fund's losses.

More importantly, though, we're comforted by Schneider's experience and track record. He has been investing in deep-value stocks for more than 20 years, including previous harsh periods, including 1987, 1998, and the early 2000s. He cut his teeth at well-regarded investment shop Wellington Management, where he spent more than 10 years.

While it's tough to find recent examples of picks that have panned out beautifully in this market environment, we have seen Schneider make similarly bold (but scary at the time) moves in the past when others were running in the other direction. Consider his investments in hotel and aerospace stocks shortly after 9/11. Schneider recognized the negative implications for demand for travel but was willing to wait as demand eventually returned. Meanwhile, he was able to pick up stocks, such as BE Aerospace  for Small Cap Value (no longer part of that portfolio), at severely depressed prices. The kind of stocks that hurt the funds so badly in downturns are the same kind that have helped them build strong long-term records. Investing in shaky companies is nothing new here, and the strategy can pay off. The portfolios are regularly characterized by their cyclical natures--note the perennially large stakes in industrial firms--and by their exposure to financial markets, as evidenced by a regular commitment to financial stocks. But these often-unloved companies also tend to come cheap, giving the funds the potential for big gains.

Investors need to understand that Schneider's approach includes a tolerance and sometimes even preference for ugly stocks. Schneider will make mistakes, but he's had enough success stories to warrant confidence in his investment acumen.

Are the Funds Too Volatile to Be Used Appropriately by Investors?
A glance at the Morningstar Investor Returns for Value and Small Cap Value bears out that investors have not owned these funds well to date. Both funds' investor returns, which estimate how the typical investor in the fund did, are substantively worse than the more commonly reported total returns for the past three and five years. Small Cap Value's annualized 8% total return for the past 10 years through April 30, 2009, turns into a 5% annualized loss when you consider how investors moved in and out of the fund.

Of course, these funds were not alone in suffering marked redemptions, most of which came in the past year or so as markets were crumbling. And many funds' investor returns look much weaker than their total returns. Still, Schneider's funds are indeed among the more volatile in their categories.

We can't emphasize enough how important a long-term investment horizon is here, and we don't recommend that the funds consume large portions of investor portfolios. However, it is worth noting that in nearly three fourths of both funds' rolling one-year periods, they posted positive results. The funds historically have not swung wildly from gains to losses and back again.

Can the Funds Be Strong Long-Term Performers?
There's no doubt that the depth of the funds' losses has permanently impaired their performance records. However, we are encouraged by three things.

One, when the market has been up, these funds have done quite well. Consider, for example, that since the market's most-recent bottom in March 2009, Value has gained 61.3% (versus the S&P 500 Index's 35% bounce) and Small Cap Value is up 66.4% (versus the Russell 2000's 44.3% jump).

Two, even considering the huge losses recently incurred, the mutual funds' long-term performance records are superior in their respective categories, which speaks to Schneider's well-established investment acumen.

Three, we think that there could be big returns from here, considering the drubbing that many distressed investments, credit-laden companies, and economically sensitive stocks have taken, knocking prices down to historically low levels. Indeed, the funds' best annual showings, Value's 58% gain and Small Cap Value's 106% return, came in 2003, as the markets were coming out of the last bear market and as the economy was recovering from the last recession.

Conclusion
We wouldn't necessarily say that these and other concerns turned out to be completely unfounded--for example, there is key-man risk here. The funds without Arnie Schneider would simply cease to have any appeal. And we discussed other potential problems, including liquidity constraints associated with a deep-value approach. We ultimately were reassured by the funds' small asset size, the shop's track record of closing the funds when opportunities were scarcer, and the fund family's strong stewardship. Use sparingly and keep a long-term view, but we are satisfied that the funds remain among the best ways to invest in deep-value stocks, considering Schneider's experience and the undiluted nature of the portfolio.