Lessons Learned When Even the Mighty Stumble

Thursday, 29 Dec 2011 08:19 AM

By Jacob Wolinsky

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Stock picking is an art, which is an all-encompassing game involving the survival of the fittest.

Most individual investors don’t have the time to research stocks, or the stomach to watch their stocks drop off a cliff.

Many investors turn to mutual funds as an alternative. The simplest fund is an index fund which tracks an index like the S&P 500. These funds have very low fees, lower capital gain taxes, and don’t need to be checked frequently.

However, many investors look for actively managed mutual funds. The goal is to find a manager who can pick the best stocks and will beat the market. Countless investors look at a funds’ performance over any number of years, and if it is good, they buy the fund.

However, 2011 was another year that really drove home the folly of doing this. Many fund managers shift their style, have too much in assets under management, or become overconfident. The result can be disastrous for the funds’ investors.

There is one money manager this year that really can teach investors an important lesson: Bruce Berkowitz. Berkowitz is a very smart man, and this piece is not to mock him, but rather to teach.

Bruce Berkowitz was named the domestic stock fund manager of the decade by Morningstar last year. Berkowitz’s Fairholme fund produced 10 years of phenomenal returns, and assets under management went as high as $23 billion.

I noticed a huge shift in Berkowitz’s investment style in 2010. Previously, Berkowitz had favored stocks which generated large amounts of free cash flow. Berkowitz bought sectors that investors feared, such as healthcare and defense companies.

In 2010, Berkowitz started buying financials which were generating little cash. Berkowitz became the largest shareholder in AIG, after the U.S. government. In total, close to 90 percent of Berkowitz’s Fairholme fund was invested in financials.

In 2011, financials took a turn for the worse. XLF, an ETF which tracks the financial sector, was down close to 20 percent this year. Fairholme’s performance was even worse: down over 30 percent, and assets under management are down to $8 billion.

The nail in the coffin was the announcement by Sears that the company would be closing over 100 stores. The announcement sent the stock down close to 30 percent.

Sears was the sixth-worst performer in the S&P 500 this year, and one of Berkowitz’s largest holdings.

What went wrong at Fairholme? The fund got too large and Berkowitz got too arrogant, which led to big bets on the financial sector.

When investors look at a mutual fund, they should pay close attention to large growth in assets under management, and shifting styles by money managers.

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