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Want to Win at Fund Investing? Learn From Longleaf

Steven Goldberg

Even though Longleaf Partners is closed to new investors, you can learn a lot about how to pick funds -- and stocks -- from the fund and its managers. Co-manager Staley Cates gave me a rare interview.



No one ever said finding good mutual funds was easy. But there are some surprisingly simple things you can do to stack the odds in your favor. Longleaf Partners, one of the best mutual funds, is a great example of a fund that does almost everything right. It's closed to new investors, but you can learn a lot about how to pick funds just by looking at Partners' attributes. I recently interviewed co-manager Staley Cates.

For starters, Longleaf is a specialist -- a smart thing to look for when you're shopping for mutual funds. Funds that are run by companies that specialize in funds tend to do better than those run by financial supermarkets, insurance companies or multinational banks. And funds that stick to just one kind of investing style or segment -- be it small companies or undervalued stocks -- often perform best of all. At Memphis-based Longleaf, you'll find just three funds, and all practice the same brand of value investing.

It has a consistent investment discipline. Funds whose managers get carried away with whatever has been working lately are accidents waiting to happen -- with your money. The best managers often display a little stubbornness. That serves them well during the inevitable periods when their investment style falls out of favor. Mason Hawkins, 59, and Cates, 42, the longest-serving managers at Longleaf, talk so frequently about buying companies at "60% of intrinsic value or less" it sounds almost like a religious chant. But their methods work.

Like most good funds, Longleaf also has low turnover. Stocks usually stay in the fund five to ten years. "Nobody cares about the long term," Cates says. That gives a leg up to those managers who do care. They can use short-term volatility to buy great companies that are temporarily out of favor. "It's a huge competitive advantage," Cates says. "It's better than it ever has been, because all those new people [hedge funds, particularly] have the attention of a strobe light. We buy stuff that everybody hates," he says. "It takes a lot of intestinal fortitude. A lot of managers say, 'Let's look like the index and try to do a little bit better.' We don't care what the index is doing."

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The managers -- like those who run many of the best funds -- make big wagers on stocks they like. Currently, Dell (DELL) makes up almost 10% of Longleaf Partners, which owns just 22 stocks. "We're different," says Cates. "We don't feel compelled to deal with every stock that has ever existed."

Expenses are low, at 0.9%, and the managers eat their own cooking. In fact, at Longleaf employees aren't allowed to buy any stocks or stock funds except Longleaf funds. With the fund managers by far the largest owners, it puts them on the same side of the table as you, the investor. "If everybody fired us, we'd still be investing our own money," says Cates.

That's a good part of why two of the three Longleaf funds are closed to new investors. When funds get too big, they often lose their edge. Altogether, Longleaf is running $41.5 billion and has ten managers and analysts. That's not too much money given their distaste for trading.

Finally, of course, it has superb long-term record. Through April 30, Partners has returned an annualized 14% over the past 20 years -- an average of three percentage points per year better than Standard & Poor's 500-stock index. And it's accomplished that record with reasonably low volatility.

No one writes about Longleaf much these days because Partners and Longleaf Small-Cap are closed to new investors. Longleaf International (LLINX) is a good fund, but it hedges away its foreign currency exposure. I think that's a mistake. Gaining exposure to foreign currencies is one of the chief reasons to own a foreign stock fund. "Our edge will be in picking stocks," is Cates' counter-argument.

If you're lucky enough to own Partners or Small-Cap, buy more. If not, look for funds with similar attributes.

Cates' view on the market

Right now, Cates says, the market is fairly valued -- not cheap, not expensive. "But people are paying much higher multiples to take things private in this private-equity bubble. Short term, it's good for stocks, but long term it's going to hurt our productive capacity."

Consequently, he doesn't see a lot of bargains. "As far as new 60-cent dollars, we don't have any." Cash in Partners is at just 7% -- which one stock would consume. Small-Cap has 16% in cash.

Hedge funds and private-equity funds have been much more active with smaller companies than larger firms. That's because it doesn't require as much capital to take over small companies as it does to acquire large ones. As a result, larger companies are cheaper, on balance, than smaller companies, Cates says. "We caution our small-cap holders, who've seen 20% annualized returns the past three years, that we can't keep that up."

Dell is a classic fallen angel -- yesterday's hot company. Founder Michael Dell has returned as CEO to try to turn the company around amid an SEC probe and other woes. "All the bad news is far more than discounted in the price," Cates says. Investors are overly focused on U.S. sales. Meanwhile, growth overseas is in double digits. If you adjust for Dell's $5.50 per share in cash, the stock trades at just ten times earnings that "were cut in half in the most heinous year they've ever had," Cates says.

Cates is also bullish on Japan: "They've made unbelievable progress. Earnings have grown in double digits over the past several years." Japan has made huge strides toward remaking its sclerotic corporate structure. "It's still the early innings, but managers there are beginning to act more like owners."

In evaluating stocks, Cates says, the numbers are just the beginning. He and his colleagues spend countless hours getting to know the managers of companies before they invest. "It's hugely, giantly important," he says. The Longleaf managers study insider ownership and trading. They look at the CEO's background. "Are they involved in charitable stuff, or are they building a 50,000-square-foot house?" They want to know whether the managers of a company have good records allocating capital. "We spend lots of time on these qualitative things. You can buy low P/Es all day long, but if management flushes the E down the toilet, it won't matter."

Steven T. Goldberg (bio) is an investment adviser and freelance writer.




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