Four New Ultimate Stock-Pickers Outperforming in 2011

By Jim Ryan | Senior Stock Analyst

With the market up more than 5% year to date, we thought we'd take a look at our best performing managers from last year and see what kind of results they've been delivering so far in 2011. As you may recall, Bruce Berkowitz was our top performer during 2010, with his  Fairholme  fund posting an annual gain of more than 25% versus a total return of 15% for the S&P 500 Index . Close behind him was David Winters at the  Wintergreen  fund, which posted a 21% total return for the year. These two managers were not only our top performers during 2010, but were also nominees for Morningstar's Stock Manager of the Year. Berkowitz (who was named Morningstar's Domestic Stock Fund Manager of the Year as well as Domestic Stock Fund Manager of the Decade in 2009) got the nod on the domestic side and Winters picked up a nomination for the international award. While neither manager walked away with the prize, investors in their funds were not too upset as they received yet another year of market-beating performance in the aftermath of the collapse of the credit and equity markets.

Equally as impressive was the performance of David Williams at  Columbia Value & Restructuring , which returned more than 19% last year (after recording a nearly 47% gain in 2009). Unlike many value mangers, Williams tends to stick with his winners long after they've overcome the challenges that led him to invest in them in the first place, which has meant his turnover has been practically nonexistent. During the last year, Williams eliminated a total of 14 stock positions, established new stakes in nine firms, and maintained holdings in 49 other securities. While running a slightly larger portfolio, Nick Kaiser has had even lower turnover in his fund, which is not only a byproduct of  Amana Trust Growth's  commitment to a disciplined research process but a strict adherence to its investment mandate--to limit the amount of short-term buying and selling that can be done by the fund. While Amana Trust Growth's 16% return last year might pale in comparison to the performance at Fairholme and Wintergreen, Kaiser did so by investing in less than half of the stocks that Berkowitz and Winters had available to them (given his fund's adherence to Islamic law, which prohibits investment in any firm that generates more than 5% of its revenue from alcohol, tobacco, pork processing, gambling, or the borrowing or lending money).

Total Return (%) Track Record for Our Best Performing Managers (Year to Date)

Total Return data as of  March 4, 2011. Source: Morningstar.

Proving the old adage that past performance is no guarantee of future results, all four of last year's top managers are underperforming the market so far in 2011, with only Amana Trust Growth coming close to matching the more than 5% return posted by the S&P 500 through last Friday. It's also interesting to note that four of our top managers who struggled to beat the benchmark last year are actually outperforming the index in 2011, which goes to show that you can't keep a good investor down for long. No doubt, it is a bit unfair to pick short-term time periods to draw conclusions about the performance of our top managers, especially as most of them have rather handily beaten the market during the last 10 years, but one of our primary goals with Ultimate Stock-Pickers is to find investable stock ideas that we can pass along to our readers. Having already looked at some of the highest conviction purchases made by our top managers, as well as their top holdings, purchases, and sales, a glance at the holdings of those with the hottest hand right now can only expand our analysis.

 Dodge & Cox Stock  has been leading the way this year, likely due to the large stakes John Gunn and Kenneth Olivier have taken in media firms like  Time Warner ,  News Corporation , and  Comcast --all three have generated returns in excess of 15% so far in 2011. While the fund always has been fairly diverse, media was its third-largest sector allocation at the end of 2010. Larger commitments to financial services and health care, which represented the fund's first- and second-largest sector allocations, respectively, coming into 2011, also didn't hurt as both sectors have outperformed (albeit narrowly) the market since the start of the year. But stock selection has been just as important as sector allocation, as will be seen when looking at Fairholme, which had more than 80% of its portfolio in financials at the end of 2010 and is currently trailing the index by a fairly wide margin. For some perspective, Dodge & Cox had just 17% of its stock portfolio in financials--spread across seventeen securities--coming into 2011. While its largest holding,  Wells Fargo , is up just 3% year to date, Dodge & Cox's second-largest financial services stock,  Capital One Financial , has risen more than 14% since the start of the year. Meanwhile, the fund's 19% weighting in health care was also broadly diversified among 12 different holdings, with many of its smaller positions making up for the poor year-to-date performance from top holdings like  Novartis  and  Merck .

Sector Allocation and Stock Selection Driving Outperformance
Running neck and neck with Dodge & Cox Stock this year is  Matrix Advisors Value , with manager David Katz picking up ground through his fund's exposure to energy, which was the highest returning Morningstar stock sector through the end of last week. Matrix Advisors Value's two largest stock holdings at the end of 2010 were in  ConocoPhillips  and  Devon Energy , both of which are up more than 15% since the start of the year. The fund's biggest commitment, though, remains in financial services, which made up 23% of total stock holdings coming into 2011. Results were a bit mixed for this part of portfolio, with outperformance from  J.P. Morgan Chase  offset by underperformance in other top holdings like  State Street  and  Bank of New York Mellon . Katz runs a fairly diversified portfolio, though, with exposure to consumer services, hardware (the third-best returning sector year to date), and health care running equal to his exposure to energy (at 12%-13% of the total portfolio), which helps to limit the impact that financial services might have on returns in any given period.

Coming into 2011 with a portfolio allocation similar to Matrix Advisors Value, the managers at  Sound Shore  also have been outperforming the market. With close to 25% of the fund's stock holdings invested in energy (14%) and hardware (10%), and another 5% invested in media stocks, Sound Shore had exposure to three of the strongest performing sectors during the first two months of 2011. The fund's largest energy holdings, Devon Energy and  Marathon Oil , are up 16% and 40%, respectively, since the start of the year. Meanwhile, outperformance from hardware names like  Applied Materials  and  Texas Instruments  more than offset the poor performance of Sound Shore's holdings in Flextronics . Investments in both Comcast and Time Warner also proved to be fruitful, given the strong performance from both stocks since the start of the year. While management's belief that Sound Shore's bottoms-up, fundamental research process would serve it well this year seems to be panning out, we're just starting the third month of 2011, with plenty of uncertainty still hanging over the market.

Looking more closely at  Yacktman , which has had the best overall performance of the 22 fund managers on our Investment Manager Roster during the last three-, five-, and 10-year time frames, the fund had a much larger stake in media firms than the three other managers who have been outperforming the benchmark this year. Donald Yacktman's and Stephen Yacktman's commitment of 11% of the portfolio to News Corp paid off handsomely, as the stock has rallied some 20% since the start of the year. It also didn't hurt to have holdings in  Viacom  (up 17%), Comcast (up 16%), and  DISH Network  (up 19%). The fund's large allocation in consumer goods, which made up 27% of the portfolio at the end of 2010, has been a drag on performance, though, with the sector gaining less than 3% since the beginning of the year. The returns for top holdings in  PepsiCo ,  Coca-Cola , and  Procter & Gamble , which account for close to one quarter of the value of the fund, have been negative so far in 2011. That said, the managers at Yacktman continue to believe that sticking to their strategy of investing in "extremely high quality, attractively priced businesses" (like those in its portfolio at the end of last year), will allow them to continue to build on their long track record of market outperformance.

Berkowitz and Winters Hit Speed Bumps Coming Into 2011
Having been concerned that Bruce Berkowitz's large concentration in financial services stocks--especially some of the more problematic names like General Growth Properties ,  American International Group , and  Bank of America --would come back to haunt him, we aren't too surprised to see the Fairholme fund in negative territory this year. With AIG down more than 30% year to date and close to half of the fund's financial services holdings in negative territory, it's been difficult for Berkowitz to match the nearly 6% gain seen in the sector (let alone the market) year to date. By our calculations (and this does not include any portfolio changes since Fairholme's last reported holdings), the fund has seen a more than 3% decline in its financial services holdings since the start of the year (and this includes the 25% gain in  St. Joe's  during that same time horizon). With Berkowitz spending a lot of time in the last couple of months battling for control of St. Joe, we have to wonder if this had an impact on the fund's near-term performance. That said, his extremely heavy concentration in just one sector of the market almost guarantees that his returns will not always sync with the returns for the broader market.

Running a slightly less concentrated portfolio, David Winters still had close to one third of his stock holdings invested in financial services, and another third invested in consumer goods, which goes a long way toward explaining the fund's underperformance so far this year. Winters maintains one of the more eclectic portfolios among our 26 managers, with Wintergreen's top five holdings--Jardine Matheson , The Swatch Group ,  Canadian Natural Resources ,  British American Tobacco , and  Anglo American --accounting for one third of the value of the fund's stock holdings at the end of last year. But lacking exposure to the three best performing sectors--energy, media, and hardware--so far this year, the fund is going to struggle to beat the market, even with more than three quarters of Wintergreen invested outside of the United States. Meanwhile, Columbia Value & Restructuring's 23% bet on energy was not enough to offset less impressive results from the remainder of its portfolio. It also hasn't helped that negative returns from top holding  Alpha Natural Resources , and below sector returns for  PetroBras  and  Consol Energy , have limited the returns that Columbia should have gotten from its heavier energy bet.

As for Amana Trust Growth, while the fund was more heavily weighted toward the hardware sector, it had relatively little exposure to energy and media, which left manager Nick Kaiser trying to augment the fund's performance with heavier weightings in health care and telecommunications (which have outperformed the market year to date), as well as outsized positions in consumer goods, consumer services, and industrial materials (which have underperformed the market this year). The fund is far more diversified across sectors than any of the other three top managers from last year, which goes a long way toward explaining why its performance is much closer to those of the S&P 500 this year. It also explains the fund's strong historical track record, with its three-, five-, and 10-year returns all ranking among the best in the large-growth category. The main driver behind these great returns has been Kaiser's excellent stock-picking and his ability not only to construct portfolios that perform well in both up and down markets, but to do so with far less volatility than his peers.

Top-10 Stock Holdings of 2011's Best Performers

Stock Price and Morningstar Rating data as of March 4, 2011.

The top holdings of our best performing fund managers so far this year mainly consist of firms with moats, with seven of them carrying wide moats and the other three having narrow ones. All four of these managers held  eBay , which saw its shares rise 8% the day of its analyst meeting last month as the company unveiled aggressive medium-term growth aspirations that caught many analysts (including our own) by surprise. That said, the firm's stock price is now back down where it was before the meeting, so much of the gain that our managers booked through the first two months of the year came prior to the second week of February. Looking at the rest of the list of top-10 holdings, four names-- Pfizer , Comcast, ConocoPhillips, and   Covidien --are beating the market by a wide margin, while four others-- Microsoft ,  Wal-Mart , Coke, and Bank of New York Mellon--are struggling to get into positive territory, with Bank of America basically performing in line with the market. On average, though, these top-10 holdings are up more than 7% year to date, which helps to explain some of the outperformance at our four best performing managers this year.

Top 10 Widely Held Outperforming Stocks (Year to Date)

Stock Price and Morningstar Rating data as of March 4, 2011.

Looking a bit deeper at top performing stocks that are widely held by our best performing managers more than confirms the assumptions we made above for each of them. The strength of media stocks like Comcast, News Corp, and Time Warner have contributed greatly to the results at Dodge & Cox Stock, Sound Shore, and Yacktman. That said, the runup in media stocks during the last year also has brought stock prices more in line with our own analysts' fair value estimates. Comcast, for example, now trades at a slight premium to our fair value estimate, having jumped more than 40% since last October. While Michael Hodel, the analyst who covers the stock for Morningstar, believes that the shares are now fully valued, he also thinks that the business plan at Comcast is sound, with the media giant just completing its takeover of NBC Universal.

Looking at News Corp, whose shares have more than tripled in value over the last two years, Morningstar analyst Mike Corty believes the stock is fairly valued after its recent run. In his view, News Corp's cable network business has generated consistent growth for the firm and helps offset its ad-dependant newspaper and broadcast TV segments. He also believes that the company's pursuit of  British Sky Broadcasting  makes strategic sense as it would add more fee-based revenue to offset some of the more cyclical segments at the media conglomerate. While Corty thinks that Time Warner's shares are slightly undervalued, he would require a somewhat wider margin of safety before recommending the stock despite having recently raised his fair value estimate as a result of increasing his revenue growth projections. While he views Time Warner as a dominant content company, with a leading filmed entertainment studio and widely distributed cable networks, Corty feels that emerging alternatives for content outside the standard pay-TV model could hurt general entertainment channels like TBS and TNT.

Not too surprisingly, the three other names--Devon Energy,  Valero Energy , and  Chevron --were energy stocks. Both Devon Energy and Valero Energy were held by Matrix Value Advisors and Sound Shore, while Chevron was held at both Dodge & Cox Stock and Matrix Value Advisors. All three of these names have ridden the rise in oil prices, which has been driven by the unrest in the Middle East, as well as increasing demand from countries like China and India. With energy stocks likely to continue moving higher as long as these two conditions exist, it will make finding investable ideas all that more difficult than it was even just a few weeks ago. While there are five 4-Star stocks on our list of top-10 holdings of our four best performing managers in 2011, only Bank of America, Pfizer, and Covidien are (at the time this went to press) trading at deep enough discounts to their fair value estimates to warrant further investigation. Morningstar analyst Jaime Peters notes that while Bank of America may not be the enviable empire-building company it once was (after it finally recovers from the damage caused by the credit crisis), completely discounting the firm would be a huge mistake for any competitor. The company's retail banking and wealth management businesses are endowed with competitive advantages that she believes should allow the firm to eventually outearn Morningstar's estimate of its cost of equity. While the path to recovery is unlikely to be smooth, Peters expects Bank of America's performance to continue to improve over time.

While Pfizer began to run as early as July of last year, with the stock up more than 35% since that time, the shares are still within reach of our Consider Buy price. Morningstar analyst Damien Conover thinks that Pfizer's acquisition of Wyeth gives the firm a much more diversified lineup of drugs, which should help reduce some of the volatility in the company's earnings. He also expects cost-cutting efforts to help moderate the firm's upcoming patent cliff, with annual cost savings of $6 billion by 2012 roughly equivalent to the annual profits produced by Pfizer's blockbuster drug Lipitor. Conover would prefer to see the stock trade lower before recommending purchase of the shares. The same could also be said for Covidien, whose shares have risen more than 30% since the end of the second quarter of 2010. Morningstar analyst Alex Morozov thinks that the stock still has some room to run, especially as the medical device maker continues to use its strong cash flow to repurchase its shares. Looking out, he believes that Covidien's earnings should receive a significant boost from its sales momentum and margin expansion, which will be driven by favorable product mix and operational and financial leverage. Morozov also believes that investors would be well served to take a look at  Medtronic (MDT), which has been under pressure for much of the last year as patients have either delayed or forgone nonacute care in response to unemployment and higher out-of-pocket costs and deductibles for workers. Debbie Wang, our analyst who covers the stock, believes that Medtronic should recover longer term, with the next two years of evolutionary upgrades to existing products helping the firm tread water until it can roll out its more revolutionary, emerging technologies in 2013-2015.

So Can the Current Best Performing Managers Keep The Lead?
As we noted above, it is inherently unfair to focus on short-term time periods in order to draw conclusions about the performance of our fund managers, so asking whether or not these four managers can continue to outperform this year is perhaps not the right question. After all, while some of our Ultimate Stock-Pickers will do better than others during the short run, all of them have built stellar records of outsized market performance over time. Depending on the time frame chosen, there always will be different fund managers that take the lead, only to fall back to the hottest hand at any given moment. From our point of view, we think it's just as important to look at the current stock selections and strategies of these outperforming managers as it is to look at the group as a whole. At the end of the day, though, it doesn't really matter much who is at the top of the heap, as long as they all continue to outperform in the long run.

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Disclosure: Jim Ryan does not own shares in any of the securities mentioned above.