Beating the Street (13 page)

To summarize our discussion of mutual fund strategies:

• Put as much of your money into stock funds as you can. Even if you need income, you will be better off in the long run to own dividend-paying stocks and to occasionally dip into capital as an income substitute.

• If you must own government bonds, buy them outright from the
Treasury and avoid the bond funds, in which you're paying management fees for nothing.

• Know what kinds of stock funds you own. When evaluating performance, compare apples to apples, i.e., value funds to value funds. Don't blame a gold-fund manager for failing to outperform a growth stock fund.

• It's best to divide your money among three or four types of stock funds (growth, value, emerging growth, etc.) so you'll always have some money invested in the most profitable sector of the market.

• When you add money to your portfolio, put it into the fund that's invested in the sector that has lagged the market for several years.

• Trying to pick tomorrow's winning fund based on yesterday's performance is a difficult if not futile task. Concentrate on solid performers and stick with those. Constantly switching your money from one fund to another is an expensive habit that is harmful to your net worth.

The Early Years

Recently, I cleared the latest red herrings (the name for prospectuses on Wall Street) off my desk, pulled the thick loose-leaf books of Magellan's reports to shareholders from their perch on a dusty shelf, and attempted to make sense of 13 years of managing the fund. I was aided in this effort by Fidelity computer whizzes Guy Cerundolo, Phil Thayer, and especially Jacques Perold, who produced printouts of my biggest gains and losses. This list is more instructive than I thought it would be—even I am surprised by some of the results. The popular theory that small growth stocks were the major factor in Magellan's success falls wide of the mark.

I offer this review in the hope that it will serve some practical benefit to other fund managers and also amateur investors who might want to learn from my mistakes, or, if not that, anyone who might be curious about what worked for me and what didn't. I have divided the material into three chapters dealing with the early years, the middle years, and the later years, in the style of diplomats who write their memoirs, only because it's a convenient way to organize things and not because there's any highfalutin importance about the life of a stockpicker, which I was and still am.

Fidelity is not a public company. If it had been I'd like to think I would have been sensible enough to recommend that people buy shares in it, having seen firsthand every day the new money pouring
in and the new funds launched, and the other effects of brilliant management, first by Mr. Johnson and then by his son, Ned.

The Magellan Fund did not start with me. Ned Johnson started it in 1963 as the Fidelity International Fund, but a tax on foreign investments, promoted by then-President Kennedy, forced the managers of international funds to sell their foreign stocks and buy domestic stocks. For two years the International Fund was really a domestic fund in disguise, until it became Magellan on March 31, 1965. Magellan's biggest position then was Chrysler, which came back from the edge of bankruptcy 20 years later to become my biggest position, proving that you can never give up on certain companies.

When Magellan was launched, I was a student at Boston College, caddying golf games on weekends. This was during the great fund boom, when everybody wanted to buy funds. The fund mania even reached my own mother, a widow of limited resources. A schoolteacher who was moonlighting as a part-time fund salesman convinced her to buy Fidelity Capital. She liked the fact that “a Chinese guy” was running it, because she believed in the brilliant Oriental mind. The Chinese guy was Gerry Tsai; he, along with Ned Johnson at Fidelity Trend, were fund managers
sui generis
in that era.

My mother never would have known that a Chinese guy was running the Fidelity Capital Fund if the salesman hadn't told her. A flotilla of fund floggers traveled the countryside, many of them part-timers, making house calls along with the vacuum cleaner, insurance, burial plot, and encyclopedia salesmen. My mother agreed to a plan in which she would invest $200 a month, forever, to secure us a prosperous future. This was money she did not have, but Fidelity Capital outperformed the S&P, as it tripled in the 1950s and doubled again during the first six years of the 1960s.

The stock market is a fickle business, although it's difficult to believe that today, after so many years of exciting gains. Severe corrections lead to long stretches when nothing happens, Wall Street is shunned by the magazine editors, nobody is bragging about stocks at cocktail parties, and the investor's patience is sorely tested. Dedicated stockpickers begin to feel as lonely as vacationers at off-season resorts.

When I hired on as an analyst at Fidelity, the market was just entering one of those doldrums. Stock prices had peaked and were headed toward the 1972–74 collapse, the worst since the 1929–32 collapse that preceded the Depression. Suddenly, nobody wanted
to buy mutual funds. There was no interest at all. Business was so terrible that the flotilla of floggers was forced to disband. The salesmen returned to selling vacuum cleaners or car wax or whatever else they'd sold before the funds got hot.

As people fled the stock funds, they put the cash into money-market and bond funds. Fidelity made enough profit from these sorts of funds to keep at least some of the unpopular equity funds alive. These survivors had to compete for the few customers who were interested in stocks, an endangered species that was vanishing at a fast clip.

There was little to distinguish one equity fund from another. Most of them were called “captial appreciation funds,” a vague term that gave managers the leeway to buy cyclicals, utilities, growth companies, special situations, whatever. While the mix of stocks would differ from one capital appreciation fund to another, to the fund shopper they all looked like the same product.

In 1966, Fidelity Magellan was a $20 million fund, but the steady outflow of money from the customer's redemptions reduced it to a $6 million fund by 1976. It's hard to pay the electric bill, much less any salaries, from a $6 million fund when the management fee of .6 percent generates $36,000 for annual operating expenses.

So in 1976, in an effort to economize by doubling up, Fidelity merged the $6 million Magellan Fund with another casualty of investor lack of interest, the $12 million Essex Fund. At one point, Essex had been a $100 million fund, but it had done so poorly in the bad market that it had produced a $50 million tax-loss carryforward. This was its major attraction. The management and trustees at Fidelity thought that the Magellan Fund, which had been capably managed by Dick Haberman since 1972, and from 1969 to 1972 by Haberman and Ned Johnson, could take advantage of the tax losses of the Essex Fund. The combined entity didn't have to pay any taxes on the first $50 million in capital gains.

This was the situation I inherited in 1977 when I was named fund manager: two funds rolled into one, $18 million in assets, the $50 million tax-loss carryforward, a terrible stock market, a small and rapidly declining number of skittish customers, and no way of attracting new ones because Fidelity had closed Magellan to buyers.

It wasn't until four years later, in 1981, that Magellan was reopened and people could buy shares again. This long shutdown has been
widely misinterpreted in the press. The popular view is that Fidelity had devised a clever strategy of waiting for its funds to compile a decent performance record before bringing them out, in order to stimulate sales. Magellan is often identified as one of several so-called incubator funds that were given an extended tryout.

The truth is much less flattering. Fidelity would have been delighted to attract more shareholders all along. What stopped us was the lack of interested parties. The fund business was so dismal that brokerage houses had disbanded their sales departments, so there was nobody left to sell the shares to the few oddballs who might have been interested in buying.

I'm convinced that the obscurity in which I operated for the first four years was more of a blessing than a curse. It enabled me to learn the trade and make mistakes without being in a spotlight. Fund managers and athletes have this in common: they may do better in the long run if they're brought along slowly.

There's no way an analyst who is familiar with perhaps 25 percent of the companies in the stock market (in my case, mostly textiles, metals, and chemicals) can feel adequately prepared to run a capital appreciation fund, in which he or she can buy anything. Having been director of research at Fidelity from 1974 to 1977 and having served on the investment committee gave me some familiarity with other industries. In 1975, I had begun to help a Boston charity manage its portfolio. This was my first direct experience with a fund.

My diaries of visits with companies, which I have kept as religiously as a Casanova kept his datebooks, remind me that on October 12, 1977, I visited General Cinema, which must not have impressed me, because the stock doesn't show up on my buy list. It was selling for less than $1 then and is selling for more than $30 today—imagine missing this 30-bagger right off the bat. (This $30 figure has been adjusted for stock splits. We've done the same with stock prices throughout the book. Therefore, the prices you see here may not correspond with the ones that you see in the business section, but the gains and losses described in this text are absolute and correct.)

My diaries are full of such missed opportunities, but the stock market is merciful—it always gives the nincompoop a second chance.

During my first months, I was preoccupied with getting rid of my predecessor's favorite selections and replacing them with my own picks, and with constantly selling shares to raise cash to cover the endless redemptions. By the end of December 1977, my biggest
positions were Congoleum (51,000 shares worth a whopping $833,000—this would be an insignificant holding 10 years later), Transamerica, Union Oil, and Aetna Life and Casualty. I'd also discovered Hanes (thanks to my wife, Carolyn, who was crazy about their L'eggs), Taco Bell (“What's that, the Mexican telephone company?” asked Charlie Maxfield, my first trader, when I placed the buy order), and Fannie Mae, of which I'd bought 30,000 shares.

Congoleum I liked because it had invented a new vinyl flooring without seams that could be rolled out across an entire kitchen as if it were a carpet. Besides doing floors, this company was also building battle frigates for the Defense Department with the same modular techniques that were used on prefab houses. The Congoleum prefab frigate was said to have a promising future. Taco Bell I liked because of its tasty tacos, because 90 percent of the country had not yet been exposed to the tasty tacos, and because the company had a good record, a strong balance sheet, and a home office that resembled a neighborhood garage. This leads me to Peter's Principle #7:

The extravagance of any corporate office is directly proportional to management's reluctance to reward the shareholders.

Aside from being public companies, my original picks (Congoleum, Kaiser Steel, Mission Insurance, La Quinta Motor Inns, Twentieth Century-Fox, Taco Bell, Hanes, etc.) seem to have nothing in common. From the beginning, I was attracted to a mystifying assortment, the most notable absence being the chemical sector that I had researched so thoroughly as an analyst.

The March 31, 1978, annual report for Magellan came out ten months into my tenure. The cover is illustrated with an elaborate and ancient map of the coast of South America, showing the names of various inlets and rivers. Three charming little galleons, presumably Magellan's, were drawn on the margins, sailing happily toward Cape Horn. In later years, as the fund got larger and more complicated, the illustrations got simpler. Soon, the Spanish names were erased from the inlets and the rivers, and the flotilla was reduced from three ships to two.

I'm reminded from that March 1978 report that the fund was up 20 percent in the prior 12 months, while the Dow Jones average lost 17.6 percent and the S&P 500 lost 9.4 percent in the same period.
Some of this success must have resulted from my rookie's contribution. In my letter to shareholders, in which I was always obliged to try to explain the inexplicable, I described my strategy as follows: “Reduced holdings in autos, aerospace, railroads, pollution, utilities, chemicals, electronics, and energy; added to positions in financial institutions, broadcasting, entertainment, insurance, banking and finance, consumer products, lodging, and leasing.” All this for a ten-month stint on a $20 million portfolio with fewer than 50 stocks!

The fact is that I never had an overall strategy. My stockpicking was entirely empirical, and I went sniffing from one case to another like a bloodhound that's trained to follow a scent. I cared much more about the details of a particular story—for instance, why a company that owned TV stations was going to earn more money this year than last—than about whether my fund was underweighted or overweighted in broadcasting. What could happen is that I would meet with one broadcaster who would tell me that business was improving, and then he'd give me the name of his strongest competitor, and I'd check out the details, and often end up buying the second broadcaster's stock. I followed scents in every direction, proving that a little knowledge about a lot of industries is not necessarily a dangerous thing.

Since Magellan was a capital appreciation fund, I was allowed to buy anything—domestic stocks of all varieties, foreign stocks, even bonds. This gave me the latitude to fully exploit my bloodhound style. I was not constrained the way a manager of a growth fund was. When the entire growth sector was overvalued, which happened every few years, the growth-fund manager was forced into buying the overpriced inventory, otherwise he didn't have a growth fund. He had to choose from the best of a terrible lot. I was free to wander off and learn that Alcoa's earnings were on the rebound because the price of aluminum was going up.