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Some Small Players Chalk Up Big Gains

March 22, 1998|JAMES K. GLASSMAN

Some of America's best money managers are people you've never heard of. They run small mutual funds and get little attention, or they handle the portfolios of rich folks and pension funds and stay out of the public eye.

For example, there's Tweedy, Browne Co., a venerable Wall Street firm. Building on its formidable track record of selecting stocks for wealthy clients, Tweedy, Browne started a mutual fund (American Value) that has returned an annual average of 32% over the last three years, matching the Standard & Poor's 500 stock index--and at considerably lower risk. The fund, ranked No. 1 overall by Value Line, has grown to $600 million in assets, but that's still not a giant by today's standards.

In the money-management business, bigger doesn't necessarily mean better. While he was an investment banker at Goldman Sachs & Co., Mark Hurley felt he proved this proposition with some extensive research. "It surprised me," he says now, "how many good --by orders of magnitude--small managers there were." So how can that talent be tapped?

Hurley, who had also done stints at Merrill Lynch and the U.S. Treasury Department, decided to find a way. At the start of this year, he launched a new family of funds called Undiscovered Managers ([888] 242-3514). There are seven funds, run by six management firms, each with an extraordinary track record of picking winners for private clients.

Hurley says the question that his new company has to answer is the Shakespearean one: "Is the past prologue?"

If it is, investors will do very well. Consider the Undiscovered Managers (U.M.) Special Small-Cap Fund, which is run by Abbott Keller and David Steirman of Kestrel Investment Management Corp. of San Mateo, whose clients include International Paper and Stetson University. Over the last three years, this fund has produced an incredible annual return of 33.5%, compared with 22.3% for the Russell 2,000 index, which tracks small stocks.

Les Waite and Diana Calhoun of Los Angeles, who manage the U.M. Core Equity Fund, have provided their clients (including Boeing Corp.) with annual returns over the last five years that have beaten the S&P by three percentage points. The U.M. REIT Fund--managed by William Schaff of Bay Isle Financial Corp. in San Francisco, who has clients such as Chrysler Corp.--has returned 19.4% a year on average since 1993, well ahead of the Wilshire REIT index's 16.9%.

But before you rush out to buy the Undiscovered Managers funds, recognize that there's a slight drawback: minimum initial investment is $250,000. Still, Hurley sells wholesale to 401(k) plans and financial advisors, so some companies may be offering them to employees.

Even if you can't buy these funds, you can learn from them. They have these common traits:

* Concentrated portfolios. The managers generally own 25 to 40 stocks at a time, compared with about 100 for the average mutual fund. James Kaplan, of J.L. Kaplan Associates in Boston, told me that the U.M. Small-Cap Value Fund has 33 stocks in its portfolio.

* Long-term perspective. Hurley's managers are buy-and-hold fanatics. For example, Waite says his general client portfolio contains 27 stocks, eight of which he's owned for nine years or more. Turnover is 13% annually, meaning the average stock is held for seven to eight years. Last year, Waite & Associates bought only three stocks: U.S. Bancorp, Bell Atlantic Corp. and Avery Dennison Corp., which makes office products. This low turnover also makes the funds tax-efficient.

* Value orientation. The Hurley managers are bargain hunters. They shy away from stocks that seem expensive, even if the rest of the market loves them. For example, Kaplan will buy a stock only if its price-to-earnings ratio is lower than the reciprocal of the yield on AA corporate bonds. Right now, that's a P/E of about 15.

* Strict sell criteria. Russell Fuller and Fred Stanske, who manage the U.M. Behavior Growth Fund, which tries to find stocks that the market has "mispriced," sell when "analysts' consensus estimates accurately predict a company's actual earnings"--in other words, when Wall Street seems to understand the stock.

* Great clients. "We have the luxury," Hurley says of his managers, "of picking people who have already been picked by smart people." That's a simple idea, but a profound one: You can make excellent decisions, both on stocks and on funds, by watching what intelligent investors do. All of the "undiscovered managers" have been discovered by great clients.

But the main thing is that all the funds are small, and Hurley vows to keep them that way. The funds will close to new investors when they get too big.

Large funds, Hurley believes (and research confirms), often have a hard time maneuvering. For one thing, their purchases push up prices (and sales push them down), so they start adding stocks to their portfolios to diminish the effects. "The culture changes," and managers don't seem to perform as well.

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