The Case for a Concentrated 1-Star Fund

 Clipper Fund's (CFIMX) long comeback from the finan­cial crisis continues in fits and starts, but it does continue. The fund is off to a good start in 2013, but the year is young, and its record since current managers Chris Davis and Ken Feinberg came on board in early 2006 has not been up to the reputation and standard they have set at other funds. The fund was up about 8.4% for the year to date through March 1, 2013, ahead of the S&P 500 and 92% of large-blend funds. Since January 2006, however, the fund has been inconsistent, finishing three calendar years in the category's bottom fourth and posting an anemic 1.9% annualized gain versus 5.2% for the S&P 500 and 4.1% for its average peer through March 1, 2013.

Self-Inflicted Wounds
Investment styles and strategies go in and out of favor, and investors who stick with this fund can be rewarded over the long term. Davis and Feinberg still apply a high-conviction, value-leaning, focused brand of investing that has and will continue to produce a portfolio that can look out of step with its benchmark or typical peer from time to time. Nevertheless, it has delivered strong results over the long term at a separate account run in the same style.

Still, the fund has suffered self-inflicted wounds that cannot be explained solely by the whims of market fashion. Davis and Feinberg stuck with  American International Group (AIG), for example, until the government plucked it from oblivion even though they harbored doubts about its executives' ability to manage the insurer's risks. No loss weighs more heavily on this fund's record during Davis and Feinberg's tenure. AIG's collapse virtually wipes out the gains of the funds' three biggest positive contributors since 2006-- Costco Wholesale (COST),  Berkshire Hathaway (BRK.A), and  CVS Caremark (CVS)--according to a Morningstar attribution analysis.

AIG isn't this fund's only ailment, though. Prior to their rebounds this year, troubled information technology giant  Hewlett-Packard (HPQ), oil exploration and production company  Canadian Natural Resources (CNQ), and asset custodian  Bank of New York Mellon (BK) have detracted from returns.

The fund has also been hurt by what it hasn't done. Many of its peers have benefited from owning  Apple (AAPL) in recent years, but Davis and Feinberg took a pass on the computer and telecommunication device company, in part because they believe its profitability will erode as it becomes more of a consumer electronics maker--a position by which they still stand and one that has helped the fund this year as Apple has continued its slide from its September 2012 high. /p>

Time to Put on the Rally Caps?
Davis and Feinberg clearly have not been at the top of their game in recent years, but they can do better. They are seasoned investors whose long-term records at  Selected American (SLADX),  Davis Financial (RPFGX), and the Davis Concentrated Equity separate account remain strong. Despite some suspect stock-picking in recent years, their process has merit. Davis and Feinberg still use fundamental analysis to get to know companies' managers, business models, balance sheets, and capital allocation skills and try to buy the ones they like at a discount to their "owner earnings" or cash flow adjusted for factors like capital spending, pension obligations, stock options, and depreciation.

It is a Buffettesque, good-companies-at-fair-prices tactic that has led the managers to anchor the fund around a handful of stocks with significant defensible competitive advantages, such as  American Express (AXP) and  Microsoft (MSFT). This fund's smaller asset base also has allowed the managers to add more esoteric and illiquid holdings here than in their larger funds. They, for example, took a signifi­cant position in distressed investing firm Oaktree Capital Group before it went public last year and also have invested in Brazilian credit card firm Cielo and drugmaker Brazil Pharma. This gives the portfolio a mix of the stolid and the opportunistic.

The fund has seen negative cash flows in recent years, but the managers have tried to use them to fund owners' advantage by trimming or selling their least favorite ideas to fund redemptions or purchases of other stocks. In the past year, for example, the fund has shed stocks that have done well since purchase and looked fairly valued, such as drugmaker  Roche Holding AG (RHHBY) and document-storage company  Iron Mountain (IRM). As a result, the fund is more concentrated in its top 10 than it was five years ago--it keeps 74% there versus 68% in 2007. Davis and Feinberg contend most of those top holdings' share prices have not kept pace with their business and earnings growth. They say CVS Caremark's, American Express', and Costco's owner earnings have grown faster than their stocks have appreciated in the past five years. Bank of New York Mellon's owner earnings have decreased over the same period, but its share price is down a lot more, Davis and Feinberg say, and the asset custodian is trading at low multi­ples on depressed earnings that could get a jolt from its money market and securities-lending businesses.

The Other Side
Recent new additions to the portfolio include property-casualty insurer  Markel (MKL), which the managers have held for at least 15 years in other portfolios, and  Google (GOOG), which the managers also have owned in Selected American for six or more years. The fund added Google in 2012's second quarter when antitrust investigations and a poor earnings report weighed on its shares. It struck Feinberg as a unique opportunity to buy a dominant company. Davis and Feinberg don't view Google as a technology bellwether as much as a media company. It is the biggest gatekeeper of Internet content, and it continues to claim global market share as the number of devices connected to the Internet grows. That gives Google a big moat fortifying its strong operating margins and returns on invested capital. They also like the demand-driven advertising model that allows advertisers to see the return on invest­ment of their advertising dollars. Davis and Feinberg worry some about the company's capital allocation discipline but are encouraged that one of the founders, Larry Page, is in charge. It was hard to pass up such a dominant company trading at a midteens forward price/earnings, Feinberg says.

Google has contributed to the fund's improved returns in recent months as has another 2012 pick, Bremuda-based insurer Everest Re Group (RE). Only time will tell for sure whether those and other picks will help it recharge the fund's resurgence from the market's low point. Davis is confident the fund, which has gained 27.7% annualized from March 9, 2009, through March 1, 2013, compared with 24.8% for the S&P 500 and 23.0% for the average large-blend fund, can regain its stride. "We have no doubt at all that we are going to get through this," he said earlier this year. "We are going to be here for the other side whenever it gets here."

Clipper's stock-picking woes have taken it down a peg. It still has a decent shot at outperforming, though, because of its experienced and shareholder-friendly management, reasonable expenses, and consistent and highly active approach.