The stock stinks, but the fund's fine

By Morningstar

Longleaf Partners Fund (LLPFX) recently made some waves. In its first-quarter letter to shareholders, the managers of this highly regarded value fund made a frank admission of failure. It was the sort of clear and unambiguous confession one tends to hear only from outstanding, experienced managers who are confident in their skills yet humble enough to recognize their failings.

The admission centered on the first quarter's worst performer in the portfolio: UBS (UBS, news, msgs).

Longleaf bought the Swiss bank in late 2007, after its stock price had already fallen. Managers Mason Hawkins and Staley Cates thought new management could restore the company's focus without incurring much cost.

Wrong.

"The cost . . . far exceeded our worst-case estimates of how much the historically prudent and conservative Swiss bank's board permitted the investment bank to over-leverage its balance sheet with questionable assets," Longleaf's managers wrote.

Buying this stock last year, they conceded, "was a mistake." Elsewhere, they borrowed a tennis phrase, calling the move an "unforced error."

This isn't a case of false modesty. UBS' stock has plunged 53% this year (all percentages in this article were current as of the market's July 8 close).

That's not the only deep diver in the portfolio. Jockeying for a position in the financial headlines about the year's major disasters has been General Motors (GM, news, msgs), and Longleaf owns that one, too.

GM is down 58% this year. It's worth noting that the fund typically owns just 20 to 25 holdings, so these aren't merely tiny stakes in a sprawling portfolio. Longleaf makes a meaningful commitment to every company it buys: It entered this year with 4.5% of assets in UBS and 3.2% in GM.

So the fund must be getting crushed this year, right? And this column will focus on why investors should stick with talented managers even when their funds are struggling?

1 dog may not kill a portfolio

No. Longleaf Partners Fund is ahead of the Standard & Poor's 500 Index ($INX) by more than 3 percentage points this year. It's ahead of 90% of its rivals in the large-blend category (and would be in an almost identical spot in the large-value group).

Shareholders might not be thrilled with the absolute performance, as the fund is down more than 10% this year. (The S&P is off more than 13%.) The managers aren't happy either; they aim to post positive returns regardless of the market climate.

But the fund is certainly not suffering to the extent one might expect knowing that two substantial holdings have lost more than half their value. Most other value or blend stock funds would love to have Longleaf's year-to-date performance.

Similar examples can be found among less prominent funds. Last August, Brian Posner, then a co-manager of Legg Mason Partners Capital (SCCAX) and the CEO of ClearBridge Advisors, talked with me at length about his confidence in Lehman Bros. (LEH, news, msgs).

Among other things, he said the market thought the company was still purely a bond house when in reality it had much more going for it. We returned to that topic in a late January interview, and he reiterated his confidence. The stock still played a significant role in the portfolio.

As you may know, when Bear Stearns ran into trouble earlier this year, investors turned their attention to other Wall Street institutions, with Lehman Bros. a main target. It's now down 68% for the year.

In August, Posner also talked about another portfolio holding, American International Group (AIG, news, msgs).

That one is down 54% this year. But as with Longleaf, Legg Mason Partners Capital has not been overwhelmed by those two crushing declines. The fund's year-to-date returns and ranking are only slightly lower than those of Longleaf. (Note: Posner left ClearBridge Advisors and the fund a few months ago, but co-manager Brian Angerame remains on board.)

In the cases of both funds, the managers still held the stocks in question at the end of the first quarter -- the most recent publicly available portfolio -- having decided that the companies retained long-term potential at their depressed prices.

(In recent interviews, the managers weren't allowed to say whether they still owned them, though it wouldn't be surprising if they did.)

Diversification can pay off -- and funds can provide it

So far, therefore, the key element of the UBS story isn't the magnitude of Longleaf's miscue or the candor of its confession. Rather, this high-profile example serves as a perfect illustration how the diversification benefit touted by mutual funds is not just sales hype but a real, powerful force.

A variety of other holdings, with performances ranging from stellar to merely respectable in a falling market, enabled these funds to limit the damage from the big decliners.

If managers as talented and experienced as Mason Hawkins and Staley Cates could pick stocks that lose half their value in six months, you could, too, if you're selecting stocks on your own instead of relying on funds.

Most of us don't have nerves of steel

Unlike Longleaf Partners Fund, though, it's unlikely that an ordinary investor relying solely on individual stocks would own enough other ones, with strong enough performance, to offset the damage of two major meltdowns.

True, if you didn't sell them, it would be just a paper loss for now. Even in that case, though, you'd need nerves of steel to avoid suffering considerable anguish during these months.

No doubt, some investors with sufficient time, money and expertise can succeed by owning individual stocks alone. But as the above examples show, the risk of serious losses is great, even if you stick to large, well-known companies.

The effect of that risk on your overall fortunes increases if you own only a handful of stocks and don't have the bulk of your assets in broader offerings, such as mutual funds or exchange-traded funds. For those who like the challenge and potential gains of picking individual stocks, a less exposed way to indulge in that pastime is to pair that activity with the ownership of mutual funds or ETFs, as many readers of Morningstar.com do.

Then if one or two of your stocks plunge, the loss would affect only a small portion of your overall assets. While your pride might still suffer as a result of such miscues, your retirement plans probably would stay intact.

This article was reported and written by Gregg Wolper for Morningstar.