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Open Arms for Unloved Stocks

When a leading company stumbles, you can bet Michael Sandler, skipper of the Clipper Fund (CFIMX), will be waiting in the wings. One of his recent additions was Tyco International, which has been suffering from panic selling amid questions about accounting and shifts in strategy.

Sandler's team must be doing something right. Clipper Fund posted an annualized 18.3% return for the 10-year period through March, making it the best-performing large-cap value fund in that period. More recently, the fund rose 11.9% for the one-year period through April, while its peers fell an average 6.8%.

Clipper Fund's record has helped the fund earn a 5-STARS

overall rank from S&P. Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Sandler about his investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: Why is the fund's long-term record so strong?

A: Recent returns can often affect your long-term record. For instance, our numbers didn't look so good during the tech bubble when we refused to play the technology card. The best-performing managers over the long term are willing to differentiate themselves from their benchmarks.

While I can't guarantee that our future returns will be as good, I think our returns so far have come from consistently looking for leading companies whose stocks are trading at a discount to their business fundamentals.

Q: Are you a deep-value or a relative-value investor?

A: We take an absolute-value approach rather than a relative-value approach. That means we don't look for stocks that are undervalued relative to overvalued markets. We try to decide what a company is worth regardless of the economic environment, interest rates, or foreign-exchange rates.

Q: How do you find undervalued companies?

A: We visit companies, kick their tires, and tear their businesses apart to understand the underlying fundamentals. We start with a small team. When someone on our team comes up with an idea, we pick a devil's advocate to challenge the proponent's assumptions to make sure we're not missing anything.

Q: Do your holdings have common characteristics?

A: Most of our companies throw off more cash than they consume, so we try to make sure the managements are wisely investing that excess cash. To do that, we spend a lot of time with managements asking them where they want to take their companies over the longer term.

When we look at a potential holding, we first consider what is today's value of the company's future cash flow. Cash flow helps you look beyond a company's earnings to its true fundamentals. At the end of the day, a company is going to get into trouble if it isn't generating more cash than it consumes.

Q: Would you describe some holdings that meet your cash-flow criteria?

A: Fannie Mae (FNM) and Freddie Mac (FRE) have gained market share by adding portfolios to their balance sheets rather than simply guaranteeing mortgage payments. Both companies have very high margins.

Philip Morris (MO) also has high margins in several businesses, and its stock has handily outperformed the S&P 500 over the past 20 years.

Q: These companies are fairly unique situations due to the legal problems of Philip Morris and the implied government guarantees behind Fanny Mae and Freddie Mac.

A: Most of our holdings have investor concerns swirling around them, whether political or financial. For example, McDonald's (MCD) doesn't have political risks, but there are concerns about mad-cow disease, the slowing global economy, and the strong U.S. dollar. We try to look beyond the chasms for intact franchises that will emerge stronger.

Q: You have a concentrated portfolio with low turnover. Are there relatively few companies that meet your criteria?

A: We don't get that many good ideas a year, and we want to focus on our best ones. We're willing to stick with a holding that stays undervalued for some time. Quite a few companies throw off excess cash, but there aren't a lot that are cheap enough.

Share prices have come down recently, but we still haven't found a lot of undervalued companies. In previous downdrafts, we saw more interesting things.

Q: Are there any common sector or industry trends in your current holdings?

A: We purchased several REITs [real estate investment trusts] when they were undervalued in late 1999 -- the polar opposite of the dot-com bubble. Currently, our largest sectors are consumer durables, consumer nondurables, and financial services. We're bottom-up managers, so we don't look for certain sector characteristics. We'll buy companies in any sector as long as we understand what they're doing and how much they're worth.

Q: Do you avoid any industries?

A: We don't understand most, but not all, technology companies. We also feel uncomfortable about biotechnology.

Q: What are your largest holdings?

A: As of Mar. 31, they were Freddie Mac, Philip Morris, Fannie Mae, Interpublic Group (IPG), and American Express (AXP). These positions haven't changed very much lately.

Q: What have you purchased recently?

A: In the first quarter, we bought some Tyco International (TYC) when there was a lot of panic selling, which is usually the best time to buy. We still think it's undervalued. Tyco's management is trying to unlock shareholder value, and its future cash flows look strong.

Q: Have you sold anything lately that reached your goals for it?

A: We continually face that decision. We just sold Johnson & Johnson (JNJ), a very fine company, after holding it for four or five years, when its stock price rose sharply. We also sold United Technologies (UTX) when it hit our estimate of its intrinsic value three or four months after we bought it following September 11.

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