Time to Bail on Oakmark Select?

Bill Nygren has all the attributes I look for in a fund manager. He's smart, disciplined, patient, hardworking -- and ethical. He's a value investor's value investor. In late 1996, he visited Kiplinger's to unveil a new, highly concentrated fund, Oakmark Select, which was to invest in 20 or fewer stocks. I bought it for myself and recommended it repeatedly in Kiplinger's Personal Finance magazine.

A decade later, I'm ready to pull the plug. (In doing so, I'm parting company with my colleagues at the magazine, who include Select in the Kiplinger 25.) Select posted terrific returns through 2002, earning an annualized 21% from its inception -- an average of 13 percentage points per year better than the typical fund that focuses on the stocks of undervalued, midsize companies, according to Morningstar. In 2003, Select put up middling numbers, and since then performance has been subpar every year. From the start of 2003 through August 28 of this year, the fund returned an annualized 11% -- an average of two percentage points per year less than the returns of the typical large-company blend fund, the category into which Select had slid as Nygren began investing in larger and faster-growing companies with somewhat pricier stocks. After 4½ years of not-so-hot returns, my patience has reached its limits.

[Editor's note: Kiplinger's Personal Finance is also disappointed by Nygren's recent results and continues to watch his performance closely. We pick funds for the long term, however, and are not yet ready to bail out of Oakmark Select. Its performance has been below-average, not terrible, and, as Steve Goldberg points out, the fund and its manager have many positive attributes.]

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What ails Nygren

What went wrong? It hasn't been any one thing; it has been several things, some big, some small. Nygren explains all of them -- and he candidly admits he's as frustrated as anyone with the returns. He even wrote a letter to shareholders recently outlining his disappointment. "Too often in this business, people disappear when the numbers aren't good," he told me. "I'm not going to do that."

One of his biggest mistakes was a classic one for a value investor-being early. About five years ago, he began selling off many of the beaten-down stocks in Oakmark (symbol OAKMX) and Oakmark Select (OAKLX) and replacing them with higher-quality companies. "If you can buy a higher-quality company for the same price as a lower-quality company, that's value investing, too," he said then. Today he says: "That was beyond early; that was a mistake. In hindsight, we missed how tremendous the cyclical recovery in earnings would be." Consequently, stock prices of higher-quality companies stagnated while those of lower-quality companies, including those more responsive to the business cycle, continued to advance as their profits skyrocketed.

Oil and other industrial materials were among the biggest beneficiaries of that economic recovery. Nygren's second big mistake was to avoid these companies. History argues that commodities are bad long-term investments. While there have been short-term spikes in commodity prices -- and commodity stocks -- innovation and capital investment usually results in an increase in supply, and profits and share prices retreat. But thanks largely to tremendous growth in emerging markets, especially China, the current commodity cycle has turned out to be far longer than Nygren anticipated.

More recently, mistakes in individual stocks have haunted Nygren. H&R Block (HRB) lost more money in subprime mortgages than he had expected. Homebuilder Pulte Homes (PHM) has been hurt much worse by sinking housing than Nygren had expected.

The subprime mess has also hurt his biggest and most controversial holding, Washington Mutual (WM). The nation's largest savings and loan makes up 14% of Select -- and it has plunged nearly 20% this year on fears that it will be hurt by a surge in mortgage defaults. Nygren argues that Washington Mutual holds higher quality loans that its peers and that it will do fine once the panic passes. The stock has doubled since Nygren made it a 15% position in 2000, but all that appreciation occurred in the first year.

Morningstar issued a report Sept. 4 saying Oakmark looks attractive. The report's author sees the same positives and negatives that I do, but comes to adifferent conclusion. My patience is exhausted; obviously, Morningstar'sisn't.

Not all bad

So there you have it. A good manager with all the right instincts -- and subpar performance. Let's be fair: Select hasn't been wretched. Over the past five years, Select has trailed Standard & Poor's 500-stock index by an average of three percentage points per year. Bad but not horrendous. And over the past ten years, Select has beaten the S&P 500 by an average of 7.5 percentage points per year. Oakmark's five-year return, an annualized 8.5%, is almost identical to that of Select. Nygren's view: "As frustrating as it is to be below trend, if you don't make the big mistake, you stay in the game. If you avoid the big mistake, things will work out."

Those with good memories will recall that Nygren replaced Robert Sanborn as skipper of Oakmark in 2000 -- just as Oakmark's style was about to rebound. (Sanborn now runs a hedge fund.) Plainly, patience had run out with Sanborn's anemic performance at precisely the wrong moment. I may well be making that same mistake now with Nygren.

He stays focused on the important things. He looks for good businesses -- and doesn't worry about which way the stock market is buffeting them over the short term. Turnover is low in both funds. He has an able staff of researchers to assist him, as well as co-managers on each of the funds. Nygren's only investments in stocks are through Oakmark funds, meaning that his interests are aligned with those of shareholders.

My decision to bid adieu to Oakmark Select could well prove to be a big mistake. I'm prepared to eat crow if returns bounce back over the next few years. But for now, I'm putting my money elsewhere.

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