No one expects the Janus Twenty Fund (JAVLX ) to be a stable investment. This concentrated mutual fund of just 30 stocks, which normally holds 20 to 30 positions, soared during the 1990s bull market, then plunged during the subsequent bear market. But in recent years it has done something even more remarkable: By most statistical measures, it is now less volatile than the market in general. With more attention to the mix of stocks and not just the stocks themselves, "I run a more balanced portfolio today than I did in the 2000-02 bear market," says manager Scott Schoelzel. "That helps keep our portfolio from bouncing around."
A low-risk concentrated portfolio may sound like a contradiction in terms. After all, the belief in diversification as a way to reduce risk is sacrosanct, and the average domestic equity fund holds 175 stocks. But academic studies show that as few as 50 stocks can give a portfolio volatility levels equal to those of the Standard & Poor's 500-stock index. And many funds get by with less. A screen of those with fewer than 50 stocks on fund tracker Morningstar's (MORN ) database found that more than half had lower betas -- a measure of risk -- than the S&P 500. One-third had lower standard deviations -- which Morningstar measures as the month-to-month variation in the price of fund shares. What's more, according to a 2004 Morningstar study, some 80% of concentrated funds -- also known as focused funds -- outperformed their peers from 1993 through 2003.
More upside with less downside is every investor's goal. So how are these fund managers doing that? BusinessWeek asked some who had high returns with low risk for tips. Follow their advice, and you might be able to build a winning concentrated portfolio of your own.
KNOW THE COMPANIES
Every concentrated-fund manager agrees that knowing the companies as thoroughly as possible -- a strong grasp of their financials, their products, their suppliers, their managers, and customers -- is key to controlling risk. The best managers know much more about their 10th-largest holding than the average fund manager does about his 100th. They have to because any blowups can wreck their portfolios. And because they do know more about their companies, the chances of getting hit with a nasty surprise are less than at more diversified funds.
For instance, portfolio manager Bill Frels of the 41-stock Mairs & Power Growth Fund (MPGFX ) in St. Paul, Minn., believes the familiarity factor is so important that two-thirds of the companies he invests in are located in the upper Midwest. He says the frequent contact he has with corporate managers helps him to avoid "Enron- or WorldCom-type" situations. It also gives him greater insight into their businesses than can be had by Wall Street analysts who just crunch numbers from financial statements. "When you're looking at a computer to pick your investments, you don't know what's behind the numbers," he says. "The numbers don't have a face."
Unlike portfolio managers, most individual investors will not have access to CEOs. Still, that's not the only way inside. Investing in your own backyard is one approach. Some find insights into companies they know through the workplace -- say, a competitor, customer, or supplier. And others invest in companies based on their familiarity with its products -- such as Warren Buffett and his love of Coca-Cola (KO ). The danger of such investing, says Frels, is that you may adore the company and lose the detachment needed to analyze it objectively. So he always compares the financial results of his locally owned companies with competitors from outside the region. If they are underperforming, he'll drop the stock.
DIVERSIFY AMONG SECTORS
A concentrated portfolio can be well diversified, while a diversified portfolio can be too concentrated. How's that? "In 2000, the S&P 500 was 35% in tech stocks," says portfolio manager Tom Marsico of the Marsico Focus Fund, (MFOCX ) which holds just 26 stocks. "Even though people thought it was a diversified index, it was highly concentrated." By contrast, Marsico doesn't like to have more than 20% of his holdings in any one industry: "That's the key to my keeping risk under control." Even within broad sectors such as health care or financial services, Marsico tries to keep a mix of sub-sectors that react differently to market conditions. His top biotech stock, Genentech (DNA ), behaves differently from Zimmer Holdings (ZMH ), which makes medical devices.
Janus Twenty's Schoelzel employs a similar strategy, limiting individual sector exposure to 25%. But he takes the additional step of studying how the sectors in his portfolio interact or "correlate" with each other. "Some of our bear market underperformance came not from tech stocks but from financial services," he says. "Investment banks that underwrote the public offerings of tech stocks fell right alongside them."
Schoelzel now employs risk managers to monitor correlations between stocks and sectors. If stocks in two sectors are moving too much in tandem, he lightens up his positions.
Individual investors can study correlations and volatility at a free Web site, riskgrades.com. The site assigns each stock a "risk grade" and then one for your portfolio. Ideally, the risk grade of the whole should be less than the average of the parts. One caveat: Risk is always changing, so you need to monitor it. For instance, risk grades for stocks in the energy sector have recently surged, and they're even higher than those for technology stocks.
MARGIN OF SAFETY
Value managers have their own form of risk control called the "margin of safety" that's straight out of financial textbooks. They'll buy a stock only at a deep discount to what they perceive is its "intrinsic value," or the price it would fetch in a private acquisition. The idea is to buy at prices so low they have little room to fall. Because of this strategy, the top-performing Fairholme Fund (FAIRX ) has one of the lowest betas, 0.51, of any equity fund, even though it holds only 29 stocks and has a hefty 34% position in the financial services sector.
Fairholme portfolio manager Bruce Berkowitz says one of the best examples of how he employs the margin-of-safety principle is the fund's purchase of telecom giant WorldCom.
When the company emerged from bankruptcy last year as MCI, it traded for $13 a share, even though it had $16 a share in cash and little debt. That meant the market was pricing the stock as if WorldCom's telecom business were worth less than nothing. "That cash was our margin of safety," says Berkowitz.
Stocks that pay dividends are generally less volatile than ones that don't. For one thing, the cash flow from the dividend cushions the portfolio in bear markets. In addition, many investors who own these stocks hold them for the long term so they can collect their payouts, thus reducing the daily volatility caused by active traders.
With a heavy emphasis on dividends, the TCW Galileo Dividend Focused Fund (TGIGX )has a low beta and standard deviation despite holding only 48 stocks. Manager Diane Jaffee takes additional risk-control measures, such as capping any one sector at 35% of the portfolio and looking beyond the dividend to see if there's a catalyst for improving business prospects. "Our weightings in traditional dividend stocks such as utilities and financial services are lower than our peers," she says. "So we're actually more diversified than they are." In fact, about 14% of the fund is in tech stocks, which is unusual for dividend-oriented funds.
Growth-stock investors have their own defense mechanisms. Robert Millen, co-manager of the 28-stock Jensen Fund (JENSX ), buys only companies that have delivered a return on equity of at least 15% a year for the past decade. Companies with that kind of profitability, he says, are not necessarily cheap, but they are more resistant to market downdrafts. Says Millen: "We're buying quality companies at a reasonable price. They don't vary much from year to year in terms of their financial performance -- whether the market goes up, down, or sideways."
These companies often succeed because they have competitive advantages or "economic moats" that protect their businesses. Millen's top holding is Stryker (SYK ), the dominant player in the orthopedic implant industry. True, it has patents protecting many of its products from competitors, and patents eventually expire. But what won't change is the growing ranks of seniors, who are the main customers for Stryker's products. Among the Jensen Fund's other moat-protected holdings are General Electric (GE ), Procter & Gamble (PG ), PepsiCo (PEP ), and Anheuser-Busch (BUD ).
Many investors would not associate frequent trading with low-risk portfolios. But portfolio manager Bill D'Alonzo of the 34-stock Brandywine Blue Fund (BLUEX ) keeps risk in check with lots of buying and selling. The fund's annual turnover ratio is 247%, which means the average stock is held for just five months. "We're constantly weeding out stocks that have hit our price targets or have stumbled," he says.
Here's how the defensive trading works. D'Alonzo first bought wireless company Nextel (NXTL ) at 15 a share in June, 2003, then sold it in December of that year when it hit his 26 price target. In June, 2004, the stock dropped 20% on worries about a competing technology. D'Alonzo, deciding the concerns were insignificant, purchased the stock again at around 21. He sold it once more late last year for a 17% gain when news broke that Sprint (S ) would be acquiring Nextel.
D'Alonzo keeps a close eye on valuations. If one of his holdings trades above 50 times his estimate of the next 12 months' earnings, he'll often unload it and look to buy it back at a lower price. But he'll also push the button if normally chatty company executives clam up or if an outfit starts slashing prices to move products. Worse yet, if the company has an ugly earnings report that is not the result of a one-time event, he'll sell. "If you spot one cockroach," he figures, "that probably means there's more."
By Lewis Braham