| Learning
from the World's Most Successful Fund Managers |
Published: September 28, 2005
There are more than 8,000
mutual funds available to U.S. investors. While many funds beat the
major market averages in a given year, the vast majority of those funds
have not been able to consistently outperform the S&P 500 over a
longer -- say 5 or 10-year -- holding period.
But there are a few standouts.
A handful of managers have managed to consistently navigate the markets,
through both bull and bear market cycles, to produce superior returns
for their investors.
As you might expect, those
master fund managers have gained an almost iconic status with the
investing public. Names like Peter Lynch of the Fidelity Magellan Fund
and John Neff of the Vanguard Windsor Fund spring to mind as prime
examples of superstar fund managers.
And
their fame is well deserved. As you can see in my chart, Peter Lynch
managed the Magellan Fund from 1977 until 1990 through the bear market
of the late 1970s and into the bull market of the 1980s. $10,000
invested in the fund back in 1977 would have grown into more than
$288,000 by 1990. The same amount invested in the S&P 500 would have
grown to only roughly $65,000 over the same period.
And John Neff's record is no
less impressive. During his near 32-year tenure at Windsor from early
1954 to 1995, John Neff beat the S&P 500 by an average annualized
rate of more than +3%. While that might not seem like a great deal at
first blush, it's a phenomenal return especially when you consider the
vicious bear market cycles of the mid and late 1970s, which occurred
right in the middle of Neff's tenure. An investment of $10,000 in 1954
grew to more than $608,000 by 1995 (versus just $250,000 for an
investment in the S&P 500 over the same period).
Although both Neff and Lynch
are now retired, that doesn't mean there aren't plenty of master fund
managers at work today in the industry. One of the most respected is
Bill Miller -- manager of the Legg Mason Value Trust. Miller has been
running the fund since 1982 and has amassed a spectacular record of
beating the S&P 500. Even more impressive, he has managed to beat
the S&P 500 every single year for the past 14 years, including
during the 2001/2002 bear market.
Learning from the Masters
But we can do a lot more than simply marvel at the success of these
master managers. All investors can learn a great deal by studying the
methodologies and techniques employed by the likes of Lynch, Miller and
Neff to generate outstanding long-term returns. All mutual funds'
records and portfolios are public information -- available to anyone
with a time lag of just a few months. And, the better-known managers
like Neff and Lynch have written books detailing their methodologies. In
a sense, we can all be apprentices to the world's most successful fund
managers.
Let's take a look at some of
the key lessons gleaned from carefully studying the records and writings
of investment masters Lynch, Neff and Miller:
Peter Lynch
- Buy What You Know:
Peter Lynch believed, like Warren Buffett, that investors should
focus on companies they can understand and relate to. Rather than
try to jump on the latest high-tech product, it's a better idea to
focus on industries where you can easily understand the fundamentals
at work.
- Look for "ten-baggers":
Lynch believes that large, well-established companies can't offer
truly superior returns for investors. Instead, he prefers to look
for what he calls "ten-baggers" -- stocks that have the
potential to rise in price by +1,000% (10 times) within five years
or so. Large-cap companies rarely move that far, that fast. As such,
in most cases Lynch focuses on small or mid-cap names.
- Debt-to-Equity less than
25%: In his book One up on Wall Street, Lynch
writes that he'd always flag a company with a debt-to-equity ratio
over 25%. With too much debt, it's tough for a company to raise the
capital necessary to expand and grow.
- Look for Cash:
Lynch always favored companies with cash on the balance sheet and
strong cash flows. Cash flow growth has been the hallmark of some of
the world's most profitable stocks.
- Valuation Levels:
Lynch compared a stock's growth rate with its price-to-earnings
ratios. He searched for stocks with a forward P/E below its growth
rate (meaning a price-to-earnings-to-growth (PEG) ratio under 1.0).
- Sell Discipline:
Lynch believed in selling stocks when their growth rate started to
slow. This often means looking for companies with little scope to
continue expanding geographically or into new markets.
John Neff
- Dividends: Neff
was famous for investing in stocks with higher-than-average
dividends. He states in his book John Neff on Investing that
dividends make the return from a stock more assured because even if
companies fall a little short on their growth expectations, they're
likely to keep paying their dividend.
- Low P/E ratios relative
to growth and dividends: Like Lynch, Neff looked for
stocks with P/Es that looked low relative to prospects for future
earnings growth and dividends. Neff also preferred stocks with low
P/Es even if that meant investing in more "boring,"
slow-growing industries. Neff believes that stocks with low P/Es are
more likely to benefit from an expansion in their P/Es as growth
prospects improve.
- Ignore well-known growth
names: Neff believes that the well-known growth/momentum
names will inevitably have trouble maintaining their growth rates
and rich valuation levels.
Bill Miller
- Look for Big Winners:
Like Peter Lynch, Miller has had considerable success finding
companies that can produce truly superior returns -- smaller stocks
with the potential to double, triple, or quadruple or more. He
doesn't mind taking on a bit more risk to find such opportunities
among smaller firms.
- Don't be a slave to
valuation levels: Although Miller is a value manager, some
of his biggest winners in recent years have been Yahoo, Cisco, AOL
(before the Time Warner merger) and Interactive Corp. -- these are
hardly typical value plays and all sport higher-than-average P/E
ratios. Miller believes that companies with higher P/Es can be great
investments if their long-term earnings growth potential is high
enough. He also likes to look for companies such as Yahoo and Amazon
with a large, existing base of customers that can be leveraged to
produce further growth.
- Don't be afraid to change
your style: Miller has stated on multiple occasions that
the markets are constantly evolving -- he's stated that he has no
fixed investing discipline. His portfolio has shifted notably in
recent years from resembling a growth portfolio in the late 1990s to
an extreme value portfolio in the bear market of 2001/2002.
While studying the
methodologies of the masters is a useful and worthwhile task, we can
also profit from these fund managers on an even more direct basis. We
can learn a lot more from the world's best fund managers than a few tips
on methodology -- we can sit at the feet of today's most successful
managers and even get investment ideas directly from their portfolios.
The portfolio holdings of all
mutual funds are a matter of public record -- holdings must be reported
to the Securities and Exchange Commission (SEC) on a fixed schedule. As
a result, we can see new picks and pans of the most successful managers
with a time lag of just a few short months.
By reviewing the portfolios of
the most successful funds, investors can look for common elements -- stocks
held by several of today's leading funds. If several investing masters
hold many of the same stocks, then those stocks are probably worth a
closer look.
Good investing!
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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Paul Tracy
founded StreetAuthority and became Editor in Chief in 2001. Prior to
that he spent several years as Managing Editor at a multi-million dollar
financial publishing firm with over 150,000 subscribers. In addition to
his role as managing editor and lead financial writer, he was also
responsible for equity research and managing a team of seasoned
professional financial writers, researchers and market commentators.
Paul's previous experience
includes a position at Robert W. Baird & Co.'s full-service
brokerage operations as well as economic research work on a Money and
Banking project funded by the National Bureau of Economic Research. He
has also spent time doing outside consulting and research for the
University of Virginia, has appeared as a guest expert on several
prominent financial radio shows, and has been a featured speaker at
various investment conferences across the U.S.
Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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