FundAlarm Annex - Fund Report

Fund name: Oakmark Global Select

Objective: Seeks long-term capital appreciation. It seeks to attain its objective by primarily investing in a relatively small number of equity securities of U.S. and non-U.S. companies. The Fund could own as few as 12 securities, but generally will have approximately 20 securities in its portfolio.

Adviser: Harris Associates L.P. Based in Chicago, Harris Associates was founded in 1976 to provide investment advice to wealthy individuals and institutions. The firm now manages separate accounts and $32 billion in the six Oakmark funds.

Manager: Bill Nygren and David Herro. Mr. Nygren joined the firm as an analyst in 1983, he was their Director of Research from 1990 to 1998, and he manages the Oakmark and Oakmark Select funds. Mr. Herro arrived in 1992 as a portfolio manager and analyst; he manages Oakmark International, oversees 11 separate accounts, and co-manages Oakmark International Small Cap.

Inception: October 2, 2006.

Minimum investment: $1,000

Expense ratio: 1.75% after a waiver of about 0.30% of expenses through early 2007.

Comments: Four or five years ago, this should have seemed like the ultimate no-brainer. Two of the hottest managers in the fund world (six straight top quartile years for Nygren, four for Herro) coming together to offer a unique product at a low cost: who could ask for anything more? Since then, the luster has faded (Select’s three-year peer ranking is dismal, International’s is mediocre) and the denunciations have begun.

The question is whether the new fund is worth the risk. Here are three arguments in its favor:

Oakmark’s approach is disciplined, consistent and shareholder-friendly. They use the same value-driven, bottom-up process in all of their funds. They seem not to panic, even when hundreds of millions of dollars walks out. And the management is deeply committed to their funds: on whole, Harris reports that "the employees of the Funds' adviser, Harris Associates L.P., the Funds' officers and trustees and their families have over $200 million invested in The Oakmark Funds." Nygren and Herro have invested over $1 million into each of their other funds and have committed to doing likewise here.

Global Select will be a unique product. While there are dozens of "world" or "global" stock funds, there are only two such funds which tightly focused portfolios. This one and the breathtaking (as in "bad") American Heritage fund. The argument for a concentrated portfolio is well-known: that it offers the best prospect for adding alpha.

Concerns about Nygren’s performance are overblown. Three factors lead me to that conclusion. First, the quality of his portfolio hasn’t deteriorated. That is, he hasn’t gone sprinting off in pursuit of small gold mining companies, energy limited partnerships or Chinese internet search firms. All of those moves would have been (briefly?) profitable but would have signalled the collapse of a system that has worked in the long-term. Select’s current problems are driven by the precipitous decline of two holdings (Pulte and Dell), which is not unusual in a concentrated portfolio.

It should also be emphasized that good managers have horrendous streaks. Pretty much all of them. Years of atypically weak performance might simply be one of the prices you pay for years of atypically strong performance. Managers who’ve put together back to back years in the deepest depths of the basement – in several instances, bottom 2% sorts of years – include Joel Tillinghast at Fidelity Low-Priced Stock (five stars from Morningstar, now closed to new investors), Steven Romick at FPA Crescent (five star, closed), the Messrs. Bruce and Bruce at the Bruce Fund (five star), George Mairs at Mairs & Power Growth (five star) and a host of others. If "stupid pills" exist, apparently their effect is transitory.
Finally, much of the performance concern might be generated by comparison to an inappropriate peer group. Select’s assets are spread evenly across the range of large-cap firms, but it qualifies as a "large value" firm for the purpose of constructing a Morningstar peer group. As with Delphi Value, a different peer group might lead to a more moderate take on the fund’s performance. Select has, for example, outperformed the S&P500 – a rough surrogate for the whole large cap universe – in two-thirds of the quarters and three-quarters of the calendar years since 2001.

Bottom line: Global Select is likely to be a risky operation, but both of the managers are talented, experienced and disciplined. Investors willing to take the risk are getting access to a lot of talent and a unique vehicle.

Company link: Oakmark funds

October 1, 2006

Update (posted December 1, 2008):

Assets: $232 million	Expenses: 1.35%
YTD return: (36.4%) (through 11/29/08)
Who’d have guessed it? Bill Nygren, left for dead in the dustbin of history, is kicking (relative) butt. Oakmark’s YTD loss places it in the top 10% of all world stock funds and it has done as well during the market’s recent resurgence as during its long decline. During the last week of November, the fund gained 14% -- about 2% ahead of its peers – while looking 10 percentage points less YTD. That’s a better performance than its legendary sibling, Oakmark Global, or Nygren’s flagship Oakmark Select funds. The fund made money steadily in the first three quarters of 2007 but badly lagged its peers. Beginning with the market slide in the fourth quarter of 2007, the fund’s performance solidified. The managers made major revisions in the portfolio, turning over two-thirds of its holdings. Given that it holds only 19 stocks, which was a major upheaval. The fund’s third quarter performance was anchored by two financial companies. The best performer was Capital One, up 35% and described as "conservatively managed, maintains strong capital ratios, has limited mortgage exposure, and oversees a strong, stable deposit base." The worst performer was the eternal albatross, Washington Mutual, which Nygren finally sold. In a letter to Oakmark and Oakmark Select shareholders, Nygren explained the mistake he made with Washington Mutual: Owning Washington Mutual was a big mistake for which I fully accept responsibility. Though we believed home prices had been rising at an unsustainable pace, we took comfort that previous home price bubbles had corrected with home prices plateauing for several years rather than sharply falling. Expecting that to continue, I took too much comfort in the fact that the overwhelming majority of mortgages Washington Mutual owned had balances of less than 80% of appraised value. Believing that the collateral was so valuable, I wasn’t as concerned as I should have been with softening underwriting standards. After all, if the borrower defaulted, the house could still be sold for more than the mortgage debt. After nationwide prices fell 20%—and further in hot markets—the collateral was no longer worth more than the loan, and serious losses resulted. A mortgage market previously viewed as secure became viewed as very risky. Sellers flooded the market, and prices fell sharply. Because of its leverage, Washington Mutual’s assets, marked-to-market, were no longer greater than its liabilities. The question whether Nygren can ever recover the world-beating performance he showed for Oakmark Select’s first seven years is unknown. The fact that he’s paired with David Herro, who has had an eerily similar career path, is intriguing. With luck, the two are bright enough and strong-willed enough to serve as a check on one another’s blind spots. The key test lies ahead: assuming the market begins to turn upward in ’09; will these two be able to keep the portfolio positioned aggressively enough to catch the wave?