From the March 2008 issue of Wealth Manager Web • Subscribe!

Getting Personal

When it comes to actively managed funds, advisors may want to take a closer look at just what "actively" means. Some fund managers may be choosing companies based purely on financials, while others want to know who's sitting behind the desk in the corner office. The differences have to do with their individual philosophy, their opinion of which factors make a company a success in the long term.

Take the case of Al Dunlap--better known as "Chainsaw Al"--the infamous chief executive officer of companies such as Scott Paper and appliance maker Sunbeam Oster. Dunlap sent Scott Paper's stock price rising as he cut jobs and slashed cash flow at the same time. He managed to sell the company to rival Kimberly Clark in 1995 and then moved on to Sunbeam. A similar story ensued. Chainsaw Al quadrupled the company's stock price with his job slashing ways and his infectious optimism.

Did this work? With all this optimism, the stock price rose, and certainly the positive feelings could have rubbed off on any fund managers who met with him. And that could be a problem.

"There is a risk of too much interaction with management, and you can become too colored in your view. A CEO tends to be a charismatic, optimistic person, and this may prevent you from getting a realistic assessment," says Vinson Walden, portfolio manager of the Santa Fe, N.M.-based Thornburg Global Opportunities Fund. "We do generally try to find management, but it is not so much meeting with management but rather to find the right management team and look for good governance structures so we don't have to look over their shoulders."

Of course, Sunbeam's stock ultimately cratered. Dunlap was fired in 1998, and eventually, Sunbeam was forced to file for bankruptcy.

Getting An Edge

According to industry researcher Strategic Insight, active management is popular. "While demand for index funds (including ETFs) has been rising, so has been the demand for actively managed funds. For all of 2007, Strategic Insight projects net flows to actively managed stock and bond funds to near $265 billion--the highest amount of the past decade and second only to the all-time record of $296 billion reached 14 years ago in 1993," the firm reports.

In this heated environment, would getting to know the company, its products and management save investors from trading losses?

"There are a million different styles of research. Some people, all they do is meet with management," says Charles Norton, portfolio manager of the Dallas-based Vice Fund and principal of GNI Capital. "With Regulation FD (the Fair Disclosure ruling of 2000), the advantage of meeting with management is greatly reduced. They cannot tell you anything that is not public." The purpose of Reg FD was to put professionals as well as individual investors on a level playing field.

For Jerry Jordan, president and portfolio manager of the Boston-based Jordan Opportunity Fund, tracking down the management is not the key to making the investment decision. "We look for the themes," Jordan explains. "Only if there is something very specific will I call a company directly. It is more likely that I will call a research analyst to debate issues. I have owned stocks whereby every time I meet management I say these guys are so dumb, but not too dumb to screw up this asset." Jordan quotes well-known investor William O'Neill, who said stock price movement is 50 percent due to the market, 25 percent due to the industry and 25 percent due to the company. "Even the dogs in a good industry or business still make money," Jordan says.

"We let the balance sheet talk to us," says Daniel Scalzi, CEO of Matrix Investment Management. The New York-based research firm was started four years ago and began managing money in the last two years. Although it has $75 million in assets under management, Matrix does not run a mutual fund.

"I have never met a CEO who doesn't think their business is not going to be great for the next 10 to 20 years," says Scalzi, a 35-year Wall Street veteran.

Matrix's investment style looks at the real economic profits of a company rather than accounting profits--that is the return on capital. It then produces its focus list of best investment ideas. In March of this year, Barron's named it to the number one list in both the six-month and full-year category in 2006. In September 2007 its recommendations again topped the list, according to Barron's with a 33 percent total return for the prior 12 month period. By late November, however, Scalzi told Wealth Manager, it had about a quarter of the money it manages in cash.

But take the case of the Fairholme fund where meeting with management plays a big part in its strategy.

"With very few exceptions, yes, we are going to meet with management. Absolutely," says Keith Trauner, co-manager of the fund. "Meeting with management is part of the process. We meet before putting down big cash. We want to spend time with management before funding them because we want to determine at least three things. First, are they shareholder-oriented; second, do they have a history of success, and third, to make sure that they understand capital allocation," he says firmly.

According to Morningstar data, the Fairholme fund has $4.896 billion in assets. Average annual total return for the year-to-date ended November 28, 2007, shows an 11.52 percent gain,

Trauner's approach to investing is like a marriage--a strong commitment. "We liken selling to a divorce. It is messy and costly," he says, adding that selling is not an easy decision. In his opinion, the best thing to see is a management that knows how to invest the cash from operations.

"We do a lot of what is essentially investigative reporting. We talk to as many people as possible, and our constant goal is to try to disprove what we think is true. But also from an accounting perspective we look to follow the movement of cash," Trauner says.

In talks with management, Trauner says, the focus does tend to be on the long-term view, where company management thinks they will be in five years' time, and also, what their greatest competitive worries are. It's no wonder the firm holds Berkshire Hathaway stock going back 20 years.

The odds of catching a cup of coffee with management diminish greatly if the fund tracks not just a few dozen stocks, but hundreds--even thousands. And some investors look at managers who schmooze with skepticism.

"The fact that management is going around meeting with portfolio managers promoting the company's stock is not as good as simply running the company," says John Buckingham, chief executive officer and chief investment officer of Laguna Beach, Calif.-based Al Frank Asset Management. Buckingham says his firm will track 1,300 companies, 300 of which are in the Al Frank Fund. According to Morningstar, the fund, which was 10 years old in January, is up 11.1 percent year-to-date through Oct. 31. The fund has $275 million in assets, while the firm has about $800 million in assets under management. The strategy is to buy undervalued companies and hold them for the long term.

"The longer we hold companies, the less risky they become. We are buying risky companies to start," Buckingham says. "We often joke that the more we know about a stock, the worse it does. Our fundamental rule is to look at P/E ratios and price/sales, price/book, debt levels and cash levels. We are playing the percentages. The level of safety and risk control that investors assume is not going to limit the risks associated with an investment, no matter how much you talk to management...I don't have any way to quantify the quality of management."

Neither, it seems, do some Wall Street giants as the entire financial sector was caught up in the subprime mortgage mess. The result was the booting of some of the Street's biggest bosses--notably Merrill Lynch's Stan O'Neal and Citi's Charles Prince--for not managing risks effectively and causing losses of tens of billions of dollars. Merrill quickly named NYSE Euronext Chairman and CEO John Thain as its new chief executive officer. As word leaked of Thain's appointment in mid-November, the company stock rose.

"At Merrill Lynch, is John Thain the second coming? I don't know. This whole concept of one man making a difference?" Buckingham asked with skepticism. "You could argue that same point with 'Chainsaw Al' Dunlap."

Justin Daniels is a freelance business writer.

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