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5 best-ideas funds

Concentrated stock funds may offer higher returns than index funds.

  • By Mark McLaughlin,
  • Fidelity Interactive Content Services
  • – 04/24/2013
  • Investing in Mutual Funds
  • Mutual Funds
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You may have 200 friends on Facebook but how many of those friendships do you consider true long-term relationships? Mutual fund managers face a similar dilemma in trying to keep track of the latest developments on hundreds of stocks in their portfolios.

If you're a believer in quality over quantity, if you'd prefer to follow the ups and downs of just a few close friends, best-ideas mutual funds may be for you.

Also known as concentrated or focused funds, these portfolios typically hold 20 to 30 stocks, allowing fund managers to dig deep into every company. By investing in their highest conviction ideas, these fund managers aim to beat the market by relying on their stock picking skills rather than factors they can't control such as market or industry forces.

"By limiting the portfolio, we're maximizing the effect of stock selection,'' says Bill Nygren, co-manager of the Oakmark Global Select Fund (OAKWX), which holds 20 stocks across U.S. and foreign markets.

Some studies suggest concentrated funds may have a performance edge as well. Because they hold so few stocks, these funds look very different from a benchmark index such as the S&P 500 (.SPX). Studies have generally confirmed that the most actively managed funds beat "index huggers" over long periods.

Risks of avoiding the crowd

While concentrated funds have their merits, they can be risky.

Straying far from a benchmark can mean missing out on the handful of stocks that drive the index's returns — think of Apple's (AAPL) impact on the S&P 500 in the stock's glory days.

A concentrated fund may also be streaky, beating the market for a while and then falling behind.

Because of these risks, Morningstar analyst Michelle Canavan recommends concentrated funds for a supporting role in a portfolio. "In small doses, concentrated funds can diversify a return stream, but you have to be able to look beyond short-term performance," she says.

Alexey Bulankov, a financial planner with McCarthy Asset Management in Redwood Shores, Calif., suggests concentrated funds for no more than 20% of an equity allocation for aggressive investors and as little as 5% for more conservative investors.

One other factor to consider: How these funds overlap with the rest of your portfolio.

If you own an S&P 500 index fund and buy a concentrated fund with large stakes in companies like Apple or ExxonMobil (XOM), for instance, your overall exposure to these stocks may be excessive. Portfolio evaluation tools on sites such as Morningstar.com can analyze the funds and stocks in your portfolio to determine your overall concentrations.

We asked Lipper to run a screen for no-load funds with fewer than 50 holdings and three-year returns in the top 20% of their peer group. We also factored in the level of risk the funds were taking, avoiding funds with high volatility and wide performance swings.

Based on our screens and additional research, here are five funds to consider. You should do your own research or consult an adviser before investing.

Oakmark Global Select

  • Ticker: OAKWX
  • Annual expense ratio: 1.23%
  • Number of stocks: 20
  • 3-year average annual return: 9.4%
  • Top 5 holdings: Daimler (DDAIF), Fiat Industrial (FIATY), Kuehne+Nagel (KHNGY), Canon (CAJ), Daiwa Securities (DSEEY) (as of 3/31/13)

Harris Associates launched Oakmark Global Select (OAKWX) in 2006 to combine the best ideas of veteran fund managers Bill Nygren, who covers U.S. value stocks, and David Herro, who searches for bargains internationally.

The Chicago-based managers each bring eight favorites to the portfolio and they "fight over the last four," says Nygren, a 30-year industry veteran.

The managers look for stocks trading at a 40% discount to the company's value if it were taken private. To avoid "value traps" with deceptively low P/E ratios, they only buy stocks if the business is growing, and they look for management teams that run the business like owners rather than caretakers.

"We set these criteria to avoid expensive companies, poor growers and poor management," says Nygren.

Overall, the fund's stock picking has paid off with strong returns, adjusted for risk. Morningstar analyst Shannon Zimmerman notes the fund has produced 120% of the gains of the average world stock fund over the last five years while suffering just 93% of the losses.

The downside: Nygren and Herro are "deep value" investors willing to stick with their holdings through difficult periods. They intend to invest in each stock for at least five years, an approach that requires patience from investors.

Weitz Partners Value

  • Ticker: WPVLX
  • Annual expense ratio: 1.20%
  • Number of stocks: 28
  • 3-year average annual return: 15%
  • Top 5 holdings: DirecTV (DTV), Berkshire Hathaway (BRK/A), Aon (AON), Valeant Pharmaceuticals (VRX), Redwood Trust (RWT) (as of 3/31/13)

Turning 30 in June, Weitz Partners Value (WPVLX) is one of the older concentrated funds on the market, and it has demonstrated staying power. Over the last 15 years, the fund returned an average 7.5% a year, beating 95% of funds in its peer group, according to Morningstar.

Like their Omaha neighbor Warren Buffett, managers Bradley Hinton and Wally Weitz look for stocks trading at deep discounts to their appraisal of the business (ideally at less than 70 cents on the dollar).

Few stocks make the cut, and those that do play a big role. "Really good ideas are rare so we want to make them matter," says Hinton.

Currently, they see value in a range of industries and market caps, including DirecTV, defense contractor FLIR Systems (FLIR) and semiconductor maker Texas Instruments (TXN). They also hold a 4.2% stake in their neighbor Warren's company, Berkshire Hathaway.

Finding good values has been more challenging as the market has rallied: The fund now holds 27% in cash, the highest level in seven years, according to Morningstar. But Hinton stands ready to pounce. "We buy when people are scared and trim when [the market is] back in risk-on mode,'' he says.

The downside: The fund may lag in markets that favor higher growth stocks. Twice in the last 10 years, yearly performance has landed in the bottom 4% of its category.

Fidelity Focused Stock Fund

  • Ticker: FTQGX
  • Annual expense ratio: 0.93%
  • Number of stocks: 50
  • 3-year average annual return: 15.2%
  • Top 5 holdings: MasterCard (MA), Canadian Pacific Railway (CP), Eastman Chemical (EMN), Google (GOOG), Citigroup (C) (as of 2/28/13)

As a golfer, Stephen DuFour aims to stay in the middle of the fairway, and he manages Fidelity Focused Stock Fund (FTQGX) similarly: He looks for stocks offering growth at a reasonable price and tries to avoid the sand traps — deep value stocks or aggressive high fliers that can stymie your returns if you don't get them exactly right.

"It's very hard to find a company trading at an attractive price and growing earnings at a good clip," he says.

Stocks that make it into the fund must have consistent revenue and earnings growth, a healthy balance sheet and a reasonable P/E ratio relative to their growth and industry. Top themes now include electronic payments companies, wireless connectivity firms and U.S. manufacturers benefiting from cheap domestic energy.

The fund has a higher turnover rate than some rivals since DuFour frequently "rehydrates" the portfolio with stocks he views as more attractive. His focus on downside protection has paid off: The fund beat its category average by seven points when the market crashed in 2008, and it has generally captured more of the market's upside than downside, according to Morningstar data.

The downside: DuFour trades a lot to keep his best ideas on the playing field, which increases the number of chances to be right or wrong. The fund is slightly more volatile than the S&P 500, according to Morningstar, based on its three-year standard deviation.

Vulcan Value Partners Small Cap

  • Ticker: VVPSX
  • Annual expense ratio: 1.25%
  • Number of stocks: 29
  • 3-year average annual return: 19%
  • Top 5 holdings: Universal Technical Institute (UTI), Eaton Vance (EV), Dun & Bradstreet (DNB), Iconix Brand Group (ICON), NetSpend Holdings (NTSP) (as of 12/31/12)

C.T. Fitzpatrick, manager of the Vulcan Value Partners Small Cap Fund (VVPSX), likes bad news. When a company on his watch list misses earnings expectations he often swoops in to buy shares. Prepaid card provider NetSpend Holdings did that in late 2010, allowing Fitzpatrick to invest at around $5 a share. The company is now being acquired for $16 a share, giving the fund a handsome gain to be reinvested in the next fallen angel.

Fitzpatrick, based in Birmingham, Ala., looks for small companies that generate a lot of cash and run a stable business. And with just 28 stocks in the fund, Fitzpatrick rejects more than 98% of companies in the small-cap universe. "There's less risk to owning more solid businesses in smaller numbers,'' he says.

One recent purchase: Curtiss-Wright (CW), a leading maker of industrial systems for energy and aviation companies. Fitzpatrick says overblown concerns about defense spending cuts have hurt the stock but its ability to generate high levels of cash and solid profit growth remain intact.

The downside: Smaller companies are inherently riskier than larger businesses and the fund is more volatile than the S&P 500. Fitzpatrick has a solid pedigree as a former manager with Longleaf Partners, but he has yet to face a market downturn with this fund, which launched in late 2009.

Hennessy Focus Fund

  • Ticker: HFCSX
  • Annual expense ratio: 1.43%
  • Number of stocks: 24
  • 3-year average annual return: 16.2%
  • Top 5 holdings: American Tower (AMT), CarMax (KMX), Penn National Gaming (PENN), O'Reilly Automotive (ORLY), Markel (MKL) (as of 3/31/13)

Less is more for Hennessy Focus Fund (HFCSX), which operates under the theory that holding around two dozen stocks can provide 90% of the benefits of diversification. Indeed, the fund is the most concentrated on our list with the top five holdings accounting for 43% of assets and the top 10 comprising 71%.

Run by a team of three managers in Arlington, Va., the fund focuses on companies meeting a few key criteria: a high-quality business, sustainable competitive advantages, a skilled management team and a long runway for growth.

It may take years for a stock to move from the managers' watch list to the portfolio. But once the stocks are in, the fund holds them as long as their growth remains strong.

O'Reilly Automotive has been in the portfolio since 2005, for instance, delivering 20% annual growth in line with its compounded earnings per share growth, according to co-manager Brian Macauley.

Insistence on high growth leads the fund to small- and mid-cap stocks. And the managers dive into industries where they see good values. The fund holds 15.6% in two gaming companies, for instance: casino operator Penn National Gaming and slot machine maker Bally Technologies (BYI).

"One investment often leads to the next," says co-manager Ira Rothberg, adding that both companies have strong growth potential and look attractively priced.

The downside: The management team has only run the fund since August 2009. While returns have landed in the top 8% of the mid-cap growth category, their approach has yet to be tested in a bear market.


Mark McLaughlin is a Los Angeles-based contributing writer for Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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