Monthly Archives: October 2011

Pinnacle Value (PVFIX), November 2011

By Editor

Fund name

Pinnacle Value (PVFIX)

Objective

Pinnacle Value seeks long-term capital appreciation by investing in small- and micro-cap stocks that it believes trade at a discount to underlying earnings power or asset values. It might also invest in companies undergoing unpleasant corporate events (companies beginning a turnaround, spin-offs, reorganizations, broken IPOs) as well as illiquid investments. It also buys convertible bonds and preferred stocks which provide current income plus upside potential embedded in their convertibility. The fund can also use shorts and options for hedging. The manager writes that “while our structure is a mutual fund, our attitude is partnership and we built in maximum flexibility to manage the portfolios in good markets and bad.”

Adviser

Bertolet Capital of New York. Bertolet advises one $10 million account as well as this fund.

Manager

John Deysher, Bertolet’s founder and president. From 1990 to 2002 Mr. Deysher was a research analyst and portfolio manager for Royce & Associates. Before that he managed equity and income portfolios at Kidder Peabody for individuals and small institutions. The fund added an equities analyst, Mike Walters, in January 2011.

Manager’s Investment in the fund

In excess of $1,000,000, making him the fund’s largest shareholder. He also owns the fund’s advisor.

Opening date

April Fool’s Day, 2003.

Minimum investment

$2500 for regular accounts and $1500 for IRAs. The fund is currently available in 25 states, though – as with other small funds – the manager is willing to register in additional states as demand warrants. A key variable is the economic viability of registered; Mr. Deysher notes that the registration fees in some states exceed $1000 while others are only $100. The fund is available through TD Ameritrade, Fidelity, Schwab, Vanguard and other platforms.

Expense ratio

1.47% on assets of $47 million. Some sources report a slightly higher ratio, but that’s based on the fund’s ownership of a number of closed-end and exchange-traded funds. There is a 1% redemption fee for shares held less than a year.

Comments

Could you imagine a “Berkshire Hathaway for ultra-micro-caps”? Five factors bring the comparison to mind. With Deysher, you’re got:

a Buffett devotee. This is one of very few funds that provides a link to Berkshire Hathaway on its homepage and which describes Mr. Buffett’s reports as a source of ideas for companies small enough to fit the portfolio.
Like Mr. Buffett, Mr. Deysher practices high commitment investing and expects it of the companies he invests in. His portfolio holds only 47 stocks and his largest holding consumes 4% of the fund. The fund’s prospectus allows for as much as 10% in a single name. One of the key criteria for selecting stocks for the portfolio is high insider ownership, because, he argues, that personal investment makes them “pay more attention to capital allocation and not do dumb things just to satisfy Wall Street.”

Also like Buffett, he invests in businesses that he can understand and companies which practice very conservative accounting and have strong balance sheets. That excludes many financial and tech names from consideration.
a willingness to go against the crowd. Deysher invests in companies so small that, in some instances, no other fund has even noticed them. He owns companies with trade on exchanges, but also bulletin board and pink sheet stocks. As a result, his median market cap (MMC) is incredibly low. How low?
The average market cap is under $250 million, 10^thlowest of the 2300 domestic stock funds that Morningstar tracks, and he’s willing to consider companies with a market cap as low as $10 million.

Deysher acquires these shares through both open-market and private placements. He seems intensely aware of the need to do fantastic original research on these firms and to proceed carefully so as not to upset the often-thin market for their shares.

One interesting measure of his independence is Morningstar’s calculation of his “best fit” index. Morningstar runs regressions to try to figure out what a fund “acts like.” Vanguard’s Small Value Index acts like, well, an index – it tracks the Russell 2000 Value almost perfectly. Pinnacle acts like, well, nothing else. Its “best fit” index is the Russell Mid-Cap Value index which tracks firms 22 times larger than those in Pinnacle. When last I checked, the closest surrogate was the MSCI EAFE non-dollar index. That is, from the perspective of statistical regression, the fund acted more like a foreign stock fund than a small cap US one. (Not to worry – even there the correlation was extremely small.)
a patient, cash-rich investor. Like Mr. Buffett, Mr. Deysher sort of likes financial panic. He’s only willing to buy stocks that have been deeply discounted, and panics often provide such opportunities. “Volatility,” he says, “is our friend.” Since his friend has visited so often, I asked whether he had gone on a buying spree. The answer was, yes, on a limited basis. Even after the instability of the past months, most small caps still carry an unattractive premium to the price he’s willing to pay. There are “not a lot of bargains out there.” He does allow, however, that we’re getting within 5 – 10% of some interesting buying opportunities for his fund.
And he does have the resources to go shopping. Just over 42% of the portfolio is in cash (as of mid-October, 2011). While that is well down from the 53% it held at the end of the first quarter of 2011, it still provides a substantial war chest in the case of instability in the months ahead. Part of those opportunities come when stocks “go dark,” that is they deregister with the SEC and delist from NASDAQ. At that point, there’s often a sharp price drop which can provide a valuable entry point for watchful investors.
a strong track record. All of this wouldn’t matter if he weren’t successful. But he is. The fund has returned 3.9% annually over the past five years (as of 9/30/2011), while its average peer lost 1.4%. As of that same date, it earned top 1% returns for the past month, three months, six months and year-to-date, with top 2% returns for the past year and for the trailing five years. That’s accomplished by staying competitive in rising markets and strongly outperforming in falling ones. During the market meltdown from October 2007 to March 2009, Pinnacle lost 25% while his peers lost over 50%. While his peers roared ahead in the junk-driven rally in 2009 and early 2010, they still trail Pinnacle badly from the start of the meltdown to now (i.e., October 2011). That reflects the general pattern: by any measure of volatility, Pinnacle has about one-third of the downside risk experienced by its peers.
a substantial stake in the fund’s outcome. As is often the case, Mr. Deysher is his own largest shareholder. Beyond that, though, he receives no salary, bonus or deferred compensation. All of his income comes from Bertolet’s profits. And he has committed to investing all of those profits into shares of the fund.
He has, in addition, committed to closing the fund as soon as money becomes a problem. His argument, often repeated, is pretty clear: “We expect to close the fund at some point. We don’t know if we will close it at $100 million or $500 million, but we won’t dilute the quality of investment ideas just to grow assets.”

Over the past few years, Mr. Deysher experimented with adding some additional elements to the portfolio. Those included a modest bond exposure and short positions on a growth index, both achieved with ETFs. He also added some international exposure when he bought closed-end funds that were selling at a “crazy” discount to their own NAVs.

Quick note on CEF pricing: CEFs have both a net asset value (the amount a single share of the fund is worth, based on the minute-to-minute value of all the stocks in the portfolio) and a market value (the amount that a single share of the fund is worth, based on what it’s selling for at that moment. In a panicked market, there can be huge disconnects between those two prices. Those disconnects sometimes allow investors to buy $100 in stock for $60. Folks who purchase such deeply discounted shares can pocket substantial profits even if the market continues to fall.

Mr. Deysher reports that the bond ETF purchase was about a break even proposition, but that the short ETFs have been sold to generate tax losses. He pledges to avoid both “inverse and long-macro bets” in the future, but notes that the CEFs have been very profitable. While those positions have been pared back, he’s open to repeating that investment should the opportunity again present itself.

Bottom line

The manager trained with and managed money for twelve years with the nation’s premium small cap investor, Chuck Royce. He seems to have internalized many of the precepts that have made both Mr. Royce and Mr. Buffett successful.

Pinnacle Value offers several compelling advantages over better known rivals: the ability to take meaningful positions in the smallest of the small, a willingness to concentrate and the ability to hedge.

Many smart people hold two beliefs in tension about small cap investing: (1) it’s a powerful tool in the long term and (2) it may have come too far too fast. If you share those concerns, Pinnacle may offer you a logical entry point – Mr. Deysher shares your concerns, he has his eye on good companies that will become attractive investments should their price fall, and he’s got the cash to move when it’s time. In the interim, the cash pile offers modest returns through the interest it earns and considerable downside cushion.

Company website

Pinnacle Value

SouthernSun Small Cap Fund (SSSFX), October 2011

By Editor

Objective

The fund seeks to provide long-term capital appreciation by investing in a focused portfolio of small cap U.S. stocks. “Focused” translates to 20-40 stocks. “Small cap” means comparable to those in the Russell 2000 index, which places it at the higher end of the small cap universe. They limit individual holdings to 10% of the portfolio (yikes) and single industries to 25%.

Adviser

SouthernSun Asset Management, which is headquartered in Memphis, Tennessee. The firm specializes in small- to mid-cap equity investing. It was founded in 1989 by Michael Cook and has about $1.9 billion in assets under management (as of 09/11). This is SouthernSun’s only mutual fund.

Manager

Michael Cook. Mr. Cook is SouthernSun’s founder and he has managed this fund since inception. He manages another $1.4 billion in other pooled and separate accounts. He’s supported by five analysts.

Management’s Stake in the Fund

Mr. Cook has between $100,000 and $500,000 in the fund (as of December 2010).

Opening date

October 1, 2003. Before November 2008, it was known as New River Small Cap Fund.

Minimum investment

$1000 for all account types. The fund is available through a variety of platforms, including Fidelity, Schwab, Scottrade and TD Ameritrade.

Expense ratio

1.31% on assets of $388 million (as of July 2023).

Comments

SouthernSun has been recognized as the top-performing small cap value fund by both Morningstar and The Wall Street Journal. In the 2010 Annual Report, the advisor was “pleased to report the Fund was ranked NUMBER ONE based on total return for the trailing twelve month period ending September 30, 2010 in Lipper’s Small Cap Value category out of 252 funds.” That honor is dimmed only slightly by the fact that the fund’s portfolio is neither small cap nor value.

It is durn fine. It’s just not small-value.

The advisor specializes in small and “SMID cap” strategies, and SSSFX has migrated slowly but steadily out of the pure small cap realm. As of the last portfolio report, 60% of assets were invested in mid-cap stocks and the fund’s average market cap is $2.5 billion, substantially above its benchmark’s $800 million. Likewise, the portfolio sports – by Morningstar’s calculation – 23% in growth stocks against 37% in value. In the end, the current portfolio averages out to a sort of SMID-cap core.

That structure makes comparisons to the fund’s nominal peer group problematic. SSSFX’s returns place it in the top 1-2% of all small-value funds, depending on the time period you track.

Even allowing for that difficulty, SSSFX is a stand-out fund. Start with the assumption that its closest peer group would be core or blend funds that sit near the small- to mid-cap border. Morningstar identifies 75 such funds. Over the past 12 months (through 9/30/11), SSSFX has the second-highest returns in the group (behind Putnam Equity Spectrum “A” PYSAX). SSSFX also finishes second on the past three years, trailing only Appleseed (APPLX). No one in the group has a better five-year record.

What’s the manager doing? He looks for firms with three characteristics:

Financial strength: generally measured by internally-generated cash flow

Management quality: measured by the presence of transparent, measurable goals that the managers – from the C-level on down – set and meet

Niche dominance: which is a sustainable competitive advantage created by superior products, processes or technologies.

As of September 2011, those criteria tilted the portfolio heavily toward industrial firms but entirely away from energy, communications and real estate.

The manager’s selection process seems slow, deliberate and labor intensive. The 2010 Annual Report notes that they added one position in six months. In the Barron’s profile, below, Mr. Cook reports sometimes adding one position in an entire year.

There are two concerns worth considering as you look at the fund:

It is highly concentrated, especially for a smaller cap fund. Only nine of the 75 SMid-cap core funds place a greater fraction of their assets in their top ten holdings than does SouthernSun (47%). That said, most of those concentrated funds (including Appleseed, FPA Capital FPPTX, Gratio Values GRVLX and Longleaf Partners Small Cap LLSCX) have posted strong risk-adjusted returns.

It is volatile, though not gut-wrenchingly so. The fund’s five-year standard deviation (a measure of volatility) is 29. By comparison, FPA Capital is 22, Longleaf is 24, and Vanguard Extended Market Index (WEXMX, which has a similar market cap though far lower concentration) is 27. Morningstar rates is as having above-average risk and Lipper rates it as “low” in capital preservation. Both services agree, though, that the risk has been well-rewarded: Morningstar gives it “high” returns and Lipper makes it a “Lipper Leader” in the category.

Bottom Line

A strong track record earned in both small- and mid-cap investing, an efficient low-turnover style, reasonable asset base and a portfolio constructed slowly and with great deliberation makes a compelling case for keeping SSSFX on your short-list of flexible, diversifying funds.

Fund website

SouthernSun Funds. For folks interested in his stock-picking, there was a nice interview with Mr. Cook in Barron’s, May 7, 2011.

Fact Sheet (Download)

Mairs and Power Small Cap Fund (MSCFX), October 2011

By Editor

Objective

The fund will pursue above-average long-term capital appreciation by investing in 40-45 small cap stocks. For their purposes, “small caps” have a market capitalization under $3.4 billion at the time of purchase. The manager is authorized to invest up to 25% of the portfolio in foreign stocks and to invest, without limit, in convertible securities (but he plans to do neither). Across all their portfolios, Mairs & Power invests in “carefully selected, quality growth stocks” purchased “at reasonable valuation levels.”

Adviser

Mairs & Power, Inc. Mairs and Power, chartered in 1931, manages approximately $4.2 billion in assets. The firm provides investment services to individuals, employee benefit plans, endowments, foundations and close to 50,000 accounts in its three mutual funds (Growth, Balanced and Small Cap).

Manager

Andrew Adams. Mr. Adams joined Mairs & Power in 2006. From August 2004 to March 2007, he helped manage Nuveen Small Cap Select (EMGRX). Before that he was the co-manager of the large cap growth portfolio at Knelman Asset Management Group in Minneapolis. He also manages about $67 million in 64 separate accounts (as of 08/11).

Management’s Stake in the Fund

Mr. Adams and the other Mairs & Power staff have invested about $2 million in the fund. At last report, that’s 83% of the fund’s assets. Mr. Adams describes the process as “passing the hat” after “the lowest key sales talk you could imagine.”

Opening date

August 11, 2011.

Minimum investment

$2500, reduced to $1000 for various tax-sheltered accounts. The fund should be available through Fidelity, Schwab, Scottrade, TD Ameritrade and a few others.

Expense ratio

1.25% after substantial waivers (the actual projected first-year cost is 12.4%) on an asset base of $2.4 million.

Comments

If you’re looking for excitement, look elsewhere. If you want the next small cap star, go away. It’s not here.

If you’d like a tax efficient way to buy high-quality small caps, you can stay. But only if you promise not to make a bunch of noise; it startles the fish.

The Mairs & Power funds are extremely solid citizens. Much has been made of the fact that this is M&P’s first new fund in 50 years. Less has been said about the fact that this fund has been under consideration for more than five years. This is not a firm that rushes into anything.

Small Cap is a logical extension of Mairs & Power Growth (MPGFX). While Mr. Adams was a successful small cap fund manager, his prime responsibility up until now has been managing separate accounts using a style comparable to the Growth funds. That style has three components.

They like buying good quality, but they’re not willing to overpay.
They like buying what they know best. About two-thirds of the Growth and Small Cap portfolios are companies based in the upper Midwest, often in Minnesota. They are unapologetic about their affinity for Midwestern firms: “we believe there are an unusually large number of attractive companies in this region that we have been following for many years. While the Funds have a national charter, their success is largely due to our focused, regional approach.”
And once they’ve bought, they keep it. Turnover in Mairs & Power Growth is 2% per year and in Balanced, where most of their bonds are held all the way to maturity, it’s 6%.

Mr. Adams intends to do the same here. He’s looking for consistent performers, and won’t sacrifice quality to get growth. About two-thirds of his portfolio are firms domiciled in the upper Midwest. While he can invest overseas, in a September 2011 conversation, he said that he has no plan to do so. The prospectus provision reflects the fact that there are some mining and energy companies operating in northern Minnesota whose headquarters are in Canada. If they become attractive, he wants authority to buy them. Likewise, he has the authority to buy convertible securities but admits that he “doesn’t see investing there.” And he anticipates portfolio turnover somewhere in the 10-20% range. That’s comparable to the turnover in a small cap index fund, and far below the 50% annual turnover which is typical in other actively-managed small cap core funds.

Mairs & Powers’ sedate exterior hides remarkably strong performance. Mairs & Power Growth (MPGFX) moves between a four-star and five-star rating, with average to below-average risk and above-average to high returns. Lipper consistently rates it above-average for returns and excellent for capital preservation. Mairs & Power Balanced (MAPOX) offers an even more attractive combination of modest volatility and strong returns.

Bottom Line:

There’s simply no reason to be excited about this fund. Which is exactly what Mairs & Power wants. Small Cap will, almost certainly, grow into a solidly above-average performer that lags a bit in frothy markets, leads in soft ones and avoids making silly mistakes. It’s the way Mairs & Power has been winning for 80 years and it’s unlikely to change now.

Fund website

Mairs & Power Small Cap fund

October 1, 2011

By David Snowball

Dear friends,

Welcome to fall. I know you’re not happy. The question is: are you buying? You said you were going to. “Blood in the streets. Panic in the markets.” As wretched as conditions are, there’s reason to pause:

By Morningstar’s calculation, every sector of the market is now selling at a discount to fair value. Most are discounted by 20% and only two defensive sectors (utilities and consumer defensives) are even close to fair value.

Also by their calculation, the bluest chip stocks (those with “wide moats”) are priced at an 18% discount, nearly identical to the discount on junk stocks (20%).

GMO’s most recent seven-year asset class return forecasts (as of 08/31/11), have US High Quality, International Large Caps and Emerging Markets Stocks set for real (i.e., inflation-adjusted) returns of 5.8 – 7.2% per year – very close to the “normal” long-term returns on the stock market.

It’s hard and it may turn out to be insane, but you have to ask: is this the time to be running away from, or toward, the sound of gunfire?

Why Google Flu Should Be Worrying the Fund Industry Sick

The flu is A Bad Thing, for flu sufferers and society alike. Unpleasant, expensive and potentially fatal. If you want to find out how bad the flu is in any particular part of the country, you’ve got two choices:

contact the Centers for Disease Control and receive information that tells you about the severity of the problem a week or two ago, or

check Google Flu Trends – which reports real-time on where people are searching flu-related terms – to get an accurate read, instantly.

It turns out that when people are interested in a topic, they Google it (who knew?). As their interest grows, the number of searches rises. As it ebbs, search activity dries up. Google can document trends in particular topics either worldwide, by country, region or city. Research on the method’s usefulness as an early warning indicator, conducted jointly by researchers from Google and the Centers for Disease Control, was published in Nature.

The funny thing is that interest in flu isn’t the only thing Google can track. For any phenomenon which is important to huge numbers of people, Google can generate a seven-year chart of the changing level of people’s interest in topic.

Which brings us to mutual funds or, more narrowly, the apparent collapse of public interest in the topic. Here’s the continually updated Google trend chart for mutual funds:

If you want to play, you can locate the search here. There’s a second Google trend analysis here, which generated a very similar graph but different secondary search options. (It’s geeky cool. You’re welcome.)

That trend line reflects an industry that has lost the public’s attention. If you’ve wondered how alienated the public is, you could look at fund flows –much of which is captive money – or you could look at a direct measure of public engagement. The combination of scandal, cupidity, ineptitude and turmoil – some abetted by the industry – may have punched an irreparable hole in industry’s prospects.

And no, the public interest hasn’t switched to ETFs. Add that as a second search term and you’ll see how tiny their draw is.

The problem of Alarming Funds and the professionals who sustain them isn’t merely a problem for their shareholders. It’s a problem for an entire industry and for the essential discipline which that industry must support. Americans must save and invest, but the sort of idiocy detailed in our next story erodes the chance that will ever happen.

Now That’s Alarming!

FundAlarm maintained a huge database of wretched funds. Some were merely bad (or Alarming), some were astoundingly bad (Three-Alarm) and some were astoundingly bad pretty much forever (the Most Alarming, Three-Alarm funds).

While we don’t have the resources to maintain a Database of Dismal, we do occasionally scan the underside of the fund universe to identify the most regrettable funds. This month’s scan (run 09/02/2011) looked at funds that have finished in the bottom one-fourth of their peer groups for the year so far. And for the preceding 12 months, three years, five years and ten years. These aren’t merely “below average.” They’re so far below average they can hardly see “mediocre” from where they are.

There are 151 consistently awful funds, the median size for which is $70 million. Since managers love to brag about the consistency of their performance, here are the most consistently awful funds that have over a billion in assets:

	Morningstar Category	Total Assets ($ mil)
Fidelity Magellan	Large Growth	17,441
Vanguard Asset Allocation	Moderate Allocation	8,568
Lord Abbett Affiliated “A”	Large Value	7,078
Putnam Diversified Income “A”	Multisector Bond	5,101
DFA Two-Year Global Fixed-Income	World Bond	4,848
Eaton Vance National Municipal	Muni National Long	4,576
Bernstein Tax-Managed Internat’l	Foreign Large Blend	4,084
Legg Mason Value “C”	Large Blend	2,986
Federated Municipal Ultrashort	Muni Short	2,921
BBH Broad Market	Intermediate-Term Bond	2,197
Fidelity Advisor Stock Selector	Mid-Cap Growth	2,082
Legg Mason ClearBridge Fundamental “A”	Large Blend	1,879
Vantagepoint Growth	Large Growth	1,754
AllianceBernstein International	Foreign Large Blend	1,709
Hartford US Government Secs HL	Intermediate Government	1,205
Legg Mason Opportunity “C”	Mid-Cap Value	1,055
		69,484

September saw dramatic moves involving the two largest mutts.

Fidelity Magellan

Fidelity removed Harry Lange as manager of Fidelity Magellan (FMAGX). Once the largest, and long the most famous, fund in the world, Magellan seems cursed. It’s lost over $100 billion in assets under management and has chewed up and spit out several of Fidelity’s best and brightest managers. Those include:

Jeffrey Vinik (1992-96): Vinik was a gun-slinging manager who guided Magellan to 17% annualized returns. In late ’95 and ’96, he made a market-timing move – selling tech, buying bonds – that infuriated the Magellan faithful. He inherited a $20 billion fund, left a $50 billion fund (in a huff), launched a hedge fund with made 50% per year, then closed the fund in 2000. Presumably bored, he launched another hedge fund which has half its money in ETFs and bought two professional sports franchises.

Robert Stansky (1996-2005): Stansky, a former Fidelity Growth Company (FDGRX) star, inherited a $50 billion fund and – after a decade – left a $52 billion fund behind. Those end points mask Magellan’s huge growth to $110 billion in the late 90s and subsequent collapse. Stansky transformed Magellan from a mid-cap to a mega-cap fund, which made sense since his prior fund, a large-growth creature, so substantially crushed the competition (13% annually at Gro Co to 10% for the peer group). A hopeful start ended with a series of weak years and Stansky opted for retirement. He surfaced briefly as part of an abandoned plan to launch a series of Fidelity multi-manager funds.

Harry Lange (2005-11): Lange ran Fidelity Capital Appreciation (FDCAX) for a decade before taking on Magellan, and ran Fidelity Advisor Small Cap (FSCTX) for about seven years. Described by Morningstar as “one of Fidelity’s very best managers,” FDCAX outpaced its peers by almost 50% over his tenure. Lange inherited a $52 billion fund and left a $17 billion one. Early in his tenure, he dumped Stansky’s blue chip names for smaller, riskier names. That strategy worked brilliantly for three years, and then flopped badly enough that Lange left with the fund trailing 96% of its peers over his last five years.

And now it’s Jeff Feingold’s turn. Like all the rest, Feingold is a star. Ran a smaller fund. Ran it well. And now has a chance to run Magellan into . . . well, that is the cursed question, isn’t it? Frankly, I can’t imagine any reason to put my money at risk here.

Vanguard Asset Allocation

Morningstar said: “This fund has merit for investors who are seeking an asset-allocation vehicle for the long haul…” (Analyst Report, “This mutual fund takes full advantage of its flexibility,” 2/22/11).

Vanguard, talking plainly, said “no, it doesn’t.” On September 30, Vanguard fired the fund’s long-time managers and announced a plan to turn the firm’s most active fund into its most passive one. Since launch, VPAAX moved its assets between three asset classes and had the ability to park 100% of the assets into any one of the classes. Effective October 1, the fund will move toward a static, passively-managed 60/40 stock/bond split. By year’s end, the firm will seek approval to merge it into Vanguard Balanced Index Fund (VBINX).

Just when you thought it couldn’t get any worse

I then refined the search with the Observer’s “insult to injury” criteria: funds that combined wretched performance with above-average to high risk and above average fees. The good news: not many people trust Suresh Bhirud with their money. His Apex Mid Cap Growth (BMCGX) had, at last record, $293,225. Two-thirds of that amount is Mr. Bhirud’s personal investment. Mr. Bhirud has managed the fund since its inception in 1992 and, with annualized losses of 8% over the past 15 years, has mostly impoverished himself.

The bad news: lots of people trust Bill Miller with their money. With over $4 billion still tied up in his Legg Mason Value (LMVTX) and Legg Mason Opportunity (LMOPX), Miller has done a lot of damage. Value spent four of the past five years at the bottom of the large-core heap (that is, it has trailed at least 93% of its peers in each of those years) and clocks in with an annualized loss of 2.3% for the past decade. In a bizarre vote of confidence, the Board of Legg Mason closed its American Leading Companies fund and rolled all of the assets into Value. The fund responded by losing 16.75% of that money over the next four months (rather worse than the market or its pees). Morningstar’s bold judgment: “We like the management but can’t recommend this bold offering as a core holding.” (emphasis mine)

The complete Roll Call of Wretched:

Alger Mid Cap Growth “B” (AMCGX)	The fund is managed by president Dan Chung. Morningstar has rarely been clearer about a fund. They turned negative in 2003, warning about erratic performance, scandal, a lack of focus, and excessive risk. Seven analysts have each, in turn, affirmed that judgment. They’re right.
Apex Mid Cap Growth (BMCGX)	As noted above, this is Mr. Bhirud’s retirement account
Eaton Vance AR Municipal IncomeEaton Vance GA Municipal IncomeEaton Vance PA Municipal IncomeEaton Vance TN Municipal IncomeEaton Vance VA Municipal Income	Adam A. Weigold has run all of these single-state funds for the past four years.Of the “independent” trustees, only one has made any investment in either of the two national muni funds, though they do receive $230,000/year from Eaton Vance and several are old enough that a muni fund makes good sense.
Eaton Vance Nat’l Ltd Maturity Municipal Income	William H. Ahern, in his 14^th year, is old enough to invest in this fund. And smart enough not to. Neither the manager nor any of the trustees has a penny here.
Eaton Vance National Municipal Income	Thomas M. Metzold is celebrating 20 years of futility here. In all that time he’s managed to invest over $1,000,000 in other Eaton Vance funds but not a nickel here.
JHancock High Yield “B” (TSHYX)	Here’s the formula: go from “erratic” and “mediocre” to “finish in the top 3% or the bottom 3% of your peer group every year for the past six”.
Legg Mason Capital Management Value (LMVTX)	After trailing 99% of its peers in 2006, 2007 and 2008, the fund has rallied and trails only 90% over the past three years. To his credit, Mr. Miller is heavily invested in both these dogs.
Legg Mason Capital Management Opportunity (LMOPX)	You know you’ve got problems when trailing 91% of your peers represents one of your better recent performances.
ProFunds Biotechnology UltraSector (BIPIX)	The number of top decile finishes (2003, 04, 05 08) doesn’t offset the bottom decile ones (2001, 02, 06, 07, 09, 11). Oddity is 2010 – just a bit below average. Confused investors who lost 3.1 while the fund made 6.3%
ProFunds UltraJapan (UJPIX)	“Ultra” is always a bad sign for investors intending to hold for more than, oh, a day.
ProFunds UltraSector Mobile Telecom (WCPIX)	Yep. See above.
Stonebridge Small Cap Growth (SBAGX)	They charge 4.4% annually, lose 4.1% annually and trail their peers by 4.4% annually. Do you suppose expenses are weighing on performance?
Tanaka Growth (TGRFX)	Eeeeeeeee! Tanaka bought the remaining assets of the Embarcadero funds in November, 2010. You might recall that Embarcadero was the renamed incarnation of the Van Wagoner funds, each of which managed a long series of bottom 1% performances before their deaths.

Trust Us: We’re Professionals, Part One

The poor schmoos invested in these wretched funds didn’t get there alone. They had professional assistance. 52% of all the funds in Morningstar’s database carry a sales load or other arrangement designed to compensate the financial professional who advised you to buy that fund. By contrast 88% of all large awful funds and 70% of roll call of the wretched funds are designed to be sold by financial professionals. (I’m confident that none of the investors or advisors in these wretches are Observer readers.)

Trust Us: We’re Professionals, Part Two

Every mutual fund is overseen by a Board of Trustees, who is responsible for making sure that the fund operates in the best interests of its shareholders. By law, a majority of those trustees must be independent of the management company. And, by law, the trustees must explain – publicly, in print, annually – their decision about whether to keep or fire the manager. Those discussions appear in the fund’s annual or semi-annual report.

So how do these independent trustees justify keeping the same losers atop these truly bad funds every blessed year? To find out, I read the Boards’ justifications for each of these funds for the past couple years. The typical strategy: “yes, but…” As in, “yes, the fund is bad but…” Boards typically

Go to great lengths to show how careful they’ve been
Don’t mention how bad the fund has
And find one bright spot – any bright spot – as grounds for ratifying the contract and retaining their profitable spots on the board.

Here’s the Legg Mason Opportunity board at work:

The Board received and reviewed performance information for the Fund and for a group of funds selected by Lipper, an independent provider of investment company data. The Board was provided with a description of the methodology Lipper used to determine the similarity of the Fund with the funds included in the Performance Universe. The Lipper data also included a comparison of the Fund’s performance to a benchmark index selected by Lipper. The Board also received from the independent contract consultant analysis of the risk adjusted performance of the Fund compared with its corresponding Lipper benchmark index. The Board also reviewed performance information for the Fund showing rolling returns based upon trailing performance. In addition, the Directors noted that they also had received and discussed at periodic intervals information comparing the Fund’s performance to that of its benchmark index.

So, they’ve gotten a huge amount of data and have intimate knowledge of how the data was compiled.

The Board noted the Fund’s underperformance during the 3, 5 and 10 years ended June 30, 2010 and noted more recent favorable performance . . .

You’ll notice that they don’t say “The Board noted that the fund has trailed 99-100% of its peers for every trailing standard period from one to ten years.” But it has. Back to the board:

which resulted in first quintile performance for the one-year ended June 30, 2010.

There’s the ray of light. The Board might have – but didn’t – note that this was a rebound from the fund’s horrendous performance in the preceding twelve months.

The Board further considered the Adviser’s commitment to, and past history of, continual improvement and enhancement of its investment process, including steps recently taken by the Adviser to improve performance and risk awareness. As a result, the Board concluded that it was in the best interest of the Fund to approve renewal of the Management and Advisory Agreements.

Each Trustee receives $132,500 annually from Legg Mason for the part-time job of “somber ratifier.”

The Alger Board of Wobblies Trustees simply hid Alger Mid Cap Growth in the crowd:

. . . the performance for the near term (periods of 1 year or less through 6/30/10) of some of the Funds (Small Cap, Growth Opportunities, Convertible) generally surpassed (sometimes by a wide margin) or matched their peer group and benchmark, while others (Mid Cap, SMid Cap, Health Sciences) generally fell short (again, sometimes by a wide margin) of those measures, and the performance of still others (Large Cap, Capital Appreciation, Balanced) was mixed . . . (emphasis added)

The Board does not, anywhere, acknowledge the fund’s above average risks. Of the high expenses they say:

All of the Funds’ expense ratios, except those of Health Sciences Fund, exceeded their peer median. The Trustees determined that such information should be taken into account . . . [for the funds as a group] the profit margin in each case was not unacceptable.

And still, without confronting the fact that Mid-Cap Growth trails 90% of its peers (technically, 87-95% depending on which share class you’re looking at) over the past one, three, five and ten years, “The Board determined that the Funds’ overall performance was acceptable.”

Alger’s Board members receive between $74,000 – 88,000 for their work. None, by the way, has any investment in this fund.

The most bizarre judgment, though, was rendered by the Board of the Tanaka Growth Fund:

The Board next considered the investment performance of the Fund and the Advisor’s performance. The Board generally approved of the Fund’s performance. The Board noted with approval the Advisor’s ongoing efforts to maintain such consistent investment discipline.

Tanaka trails 95%, 97%, 99%, 97% and 96% of its peers (in order) for 2011 YTD and the past 1, 3, 5 and 10 year periods. Consistent, indeed.

Mutual Fund Math: Fun Facts to Figure

Folks on the Observer discussion board occasionally wonder, “how many funds are there?” The best answer to which is, “uh-huh.”

There are 21,705 funds listed in Morningstar’s database, as of 09/30/11. But that’s not the answer since many of the funds are simply different share classes of the same product. The Alger Mid Cap Growth Fund, lamented above, comes in 10 different packages. Many of the American Funds (for example, American Funds AMCAP) come with 18 different share classes.

Ask the database to report only “distinct portfolios,” and the total drops to 6628. That includes neither closed-end nor exchange-traded funds.

The average no-load fund now has 2.7 share classes (often Retail, Institutional, Advisor). The average load-bearing fund has 4.1 classes.

Investing as monkey business

Mental Floss, a bi-monthly magazine which promises to “help you feel smart again,” declared September/October 2011 to be their money issue. It’s a wonderful light read (did you know that the symbol for the British pound was derived from the Latin for “pound,” since one pound of silver was used to strike 240 pound coins?) that featured one fascinating article on monkeys as investors. Researchers, interested in the question of whether our collective financial incompetence is rooted in genetics, actually taught a colony of monkeys to use money in order to buy food.

Among the findings: monkeys showed precisely the same level of loss aversion that humans do. In rough terms, both species find losses about three times more painful than they find gains pleasurable. As a result, the monkey pursued risk-averse strategies in allocating their funds.

Despite the pain, we, in general, do not. Instead, we pursue risk-averse strategies after allocating our funds: we tend to buy painfully risky investments (often at their peak) and then run off howling (generally at their nadir).

Would you like some pasta with your plans?

The Wall Street Journal recently profiled investment advisors who publish weekly, monthly or quarterly newsletters as a way to keep their clients informed, focused and reassured (“Keys to Making the Write Investments,” 09/19/11). Among the firms highlighted is Milestones Financial Planning of Mayfield, Kentucky whose owner (Johanna Turner) is a long-time reader of, and supporter of, both FundAlarm and the Observer. In addition to her monthly “mutual fund find” feature, Johanna shares recipes (mostly recently for vegetarian spaghetti – which would be all the better with a side of meatballs). Her most recent newsletter, and recipe, is here.

Two Funds, and why they’re worth your time

Really worth it. Every month the Observer profiles two to four funds that we think you really need to know more about. They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention. They might come from a great boutique or be offered by a top-tier manager who has struck out on his own. The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought. This month’s new fund:

Mairs & Power Small Cap (MSCFX): Mairs & Power rolls out a new fund about, oh, every half century or so. Their last launch before this was 1961. The firm specializes in long-term, low-turnover, low-flash investing. Their newest fund, a pure extension of the Mairs & Power Growth Fund discipline, is sure to appeal to fans of The Newhart Show, fly-tying, the Duluth Trading Company and other sensible, sensibly-paced pursuits.

Stars in the shadows: Small funds of exceptional merit. There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar. Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples). Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention. There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight of them.

The stars are all time-tested funds, many of which have everything except shareholders.

SouthernSun Small Cap Fund (SSSFX): measured as a small-cap value fund, SSSFX has been one of the two top in the field lately. But it’s actually more of a smid-cap core fund. And, surprisingly, it’s also one of the top two funds there, too. With an incredibly compact, high-quality portfolio and low-turnover style, it’s surprising so few have heard of it.

Launch alert:

Grandeur Peak Global Opportunities and Grandeur Peak International Opportunitiesboth launch October 17, 2011.

Former Wasatch managers Robert Gardiner and Blake Walker are attempting to build on their past success with Wasatch Global Opportunities (WAGOX) and Wasatch International Opportunities (WAIOX). My August story, Grandeur Peaks and the road less traveled, details the magnitude (hint: considerable) of those successes.

Briefly Noted . . .

SEC time travel continues. The SEC’s current filings page for September 6 contained 62 prospectus filings – of which precisely two are for September 6. The other 60 had originally been filed as early as October 14, 2010. Still no explanation for why “today’s filings” include 14 month old filings.

Effective November 4, Nakoma Absolute Return (NARFX) will become Schooner Global Absolute Return Fund. Very few details are available, but since the change did not require shareholder approval, it seems likely that the Nakoma team and objectives will – for better and worse – remain in place.

In another sign of the direction in which the marketing winds are blowing, Jensen Fund (JENSX) is changing its name to Jensen Quality Growth Fund.

Federated Balanced Allocation (BAFAX) will merge into Federated Asset Allocation (FSTBX) on Sept. 30, 2012.

Value Line Convertible (VALCX) will merge into Value Line Income & Growth (VALIX) on Dec. 16, 2011.

GMO will liquidate GMO Tobacco-Free Core Fund (GMTCX) at the end of December, 2011 and GMO Tax-Managed U.S. Equities Fund (GTMUX) at the end of October, 2011.

Munder Asset Allocation Balanced (MUBAX) will liquidate on Oct. 14.

Invesco Van Kampen Global Tactical Asset Allocation (VGTAX) will liquidate on Oct. 28. Despite an exceptionally solid record and an exceptionally trendy name, the fund drew only $21 million in assets in just under three years and so it’s a deadster.

Four small Highmark Funds (did you even know there were Highmark funds?) will be merged out of existence in October, 2011. The dead funds walking are HighMark Fundamental Equity (HMFAX), HighMark Small Cap Value (HMSCX), HighMark Diversified Equity Allocation (HEAAX) and HighMark Income Plus Allocation (HMPAX).

Allianz RCM Global Resources (ARMAX) is now Allianz RCM Global Commodity Equity. Alec Patterson joined as co-manager.

In closing . . .

Dwindling consumer confidence is reflected in the Observer’s Amazon revenue, which drifted down by a third from August to September. If you’ve looking to a particularly compelling purchase, consider picking up a copy of Baumeister and Tierney’s Willpower: Rediscovering the Greatest Human Strength (Penguin, 2011). Roy Baumeister is an Eminent Scholar (really, that’s part of his official title) doing research in social psychology at Florida State. John Tierney is a very skilled science journalist with The New York Times. I first heard about Baumeister’s research in a story on National Public Radio, picked up the book and have found it pretty compelling. Here’s a précis of their argument:

Willpower is central to success in life,
You have a limited supply of it, so that exercising will in one area (quitting smoking) leaves you powerless to cope with another (controlling your diet) but
Your stock of willpower can be quickly and substantially increased through exercise.

The implications of this research, from how we invest to how we teach our children, are enormous. This is a particularly readable way into that literature.

That said, a number of people contributed to the Observer through our PayPal link in September and I’d especially like to thank Old_Joe and CathyG for their continuing support, both financial and intellectual. Thanks, guys!

Speaking of support, we’ve added short biographies of the two people who do the most to actually make the site function: Accipiter and Chip. If you’d like to learn just a bit more about them and their work here, it’s in the About Us section.

Keep those cards and letters coming! We appreciate them all and do as much as we can to accommodate your insights and concerns.

Be brave – October is traditionally one of the two scariest months for the stock market – and celebrate the golden hues of autumn. I’ll see you again just after Halloween!

With respect,

David