Beating the Street (41 page)

In the summer and fall, I watched with fascination as more weekend worrying sank this stock just when everything in the company was going right. Saddam Hussein had invaded Kuwait, and we had invaded Saddam. The worry this time was that the Gulf War would produce a national depression in real estate, a coast-to-coast version of the Texas calamity. Hundreds of thousands of people would be walking away from their homes and sending the keys to Fannie Mae. Fannie Mae would become the nation's landlord, wasting all its billions on paint, for-sale signs, and lawyers' bills.

Never in all my years of seeing worthy companies get clobbered for no good reason had I seen one that deserved it less. Fannie Mae's delinquency problems were now minuscule, but still it suffered from fear by association. In November 1990,
The Wall Street Journal
published an article entitled “Citicorp Lenders Lament,” which described how that bank's loan delinquencies had increased from 2.4 percent to 3.5 percent. This had nothing to do with Fannie Mae, but the price of Fannie Mae stock (along with that of many mortgage-related issues) fell in sympathy.

What a pity for the shareholders who paid attention to the big global picture instead of the goings-on at the company and sold their shares because of the coming depression in housing. Except for the fat-cat houses, there was no coming depression in housing. The National Association of Realtors subsequently reported that in 1990, and again in 1991, the price of an average house increased in value.

If you kept up with the story, you knew that Fannie Mae hadn't written any fat-cat mortgages above $202,000, so it wasn't involved
in the trophy-house market. Its average mortgage was $90,000. You knew it had tightened its underwriting standards, and no longer made Texas-style loans on 5 percent down. You knew that the mortgage-backed securities business was still growing at a fast clip.

Fannie Mae stock fell from $42 to $24 in the Saddam Sell-off, and then promptly rose again to $38.

I was gone from Magellan. It was up to my successor, Morris Smith, to keep tabs on Fannie Mae. He did and the stock remained the number-one holding. The price rose again from $38 to $60. The company had record earnings of $1.1 billion.

For the sixth year in a row, I recommended Fannie Mae in
Barron's.
The stock was selling for $69 and earning $6, giving it a p/e ratio of 11, which compared very favorably with the market's p/e of 23.

Once again, the underlying story had improved. Fannie Mae was reducing its interest-rate risk by issuing callable debt. Callable debt gave Fannie Mae the right to buy back its bonds when such a move would be favorable to the company, especially when interest rates fell and it could borrow more cheaply.

It now suffers a short-term penalty for issuing callable debt, since it must pay a higher rate of interest to attract borrowers who otherwise wouldn't want to own callable bonds. But in the long run, this is another way that Fannie Mae can protect its earnings no matter what happens to rates.

Fannie Mae was still a 12–15 percent grower and still undervalued, just as it had been for the past eight years. Some things never change.

The Colonial Group of Mutual Funds

For several years, I missed one of the best-performing groups on Wall Street, the mutual-fund industry. Like the mall manager who neglected to buy the Gap as the sales results passed under his nose, I neglected to buy Dreyfus, Franklin Resources, Colonial Group, T. Rowe Price, State Street Bank, Alliance Capital Management, and Eaton Vance. I don't know why, really. Perhaps I couldn't see the trees for the forest. The only one I did buy was United Asset Management, a company that had 30–40 fund managers under contract and hired them out to other institutions.

These companies are so-called direct mutual-fund plays, as opposed to, say, Putnam, which is a subsidiary of Marsh-McLennan, or Kemper, which has a fund business but mostly sells insurance. All eight did well in 1988 and 1989, as the fear of the collapse of the mutual-fund industry after the Great Correction of 1987 turned out to have been exaggerated.

That correction gave me the chance to buy these fellow mutual-fund companies, which I had overlooked before, and at low prices. Here is another of my favorite what-if portfolios: if you had divided your money equally among these eight stocks and held them from the beginning of 1988 to the end of 1989, you would have outperformed 99 percent of the funds that these companies promote.

During periods when mutual funds are popular, investing in the companies that sell the funds is likely to be more rewarding than investing in their products. I'm reminded that in the Gold Rush the people who sold picks and shovels did better than the prospectors.

When interest rates are declining, the bond and equity funds tend to attract the most cash, and the companies that specialize in such funds (Eaton Vance and Colonial, for instance) are exceptionally profitable. Dreyfus manages a lot of money-market assets, so when interest rates are going up and people are getting out of the stock market and out of long-term bonds, Dreyfus prospers. Alliance Capital manages money for institutional clients, and also manages mutual funds that are sold to individuals through brokers. It's been a public company since 1988. The stock price took a slight dip in 1990, and then headed straight for the attic.

Given the billions of dollars that recently have been pouring into bonds, stocks, and money-market mutual funds, it should be no surprise that these mutual-fund companies have outperformed the market. If there's any surprise here, it's that nobody has yet launched the Mutual-Fund Company Mutual Fund.

The information about who is getting in and out of which kind of fund is published by the industry, and professionals and amateurs alike have an opportunity to take advantage of it. If you didn't buy these stocks after the last big correction, you could have bought them during the Saddam Sell-off at the end of 1990, which left Eaton Vance with a one-year decline of 30 percent, Dreyfus with a decline of 18.86 percent, and the others with smaller but nonetheless significant declines as well.

Once again, rumors of the collapse of this industry proved to be unfounded. All you had to do to dispel the latest fear was to look at the sales figures for mutual funds in December 1990 and January 1991. Yet in spite of my determination not to revert to my old habits, I was caught napping once again, and failed to recommend a single mutual-fund company to the 1991
Barron's
panel. The fans of Lynch's predictions (if there are any, besides my wife) missed the rebound in Franklin (a 75 percent gain in 1991), Dreyfus (55 percent), T. Rowe Price (116 percent), United Asset Management (80 percent), Colonial Group (40 percent), and State Street Bank (81.77 percent). Our mythical Mutual-Fund Company Mutual Fund portfolio nearly doubled in value that year.

In my defense, Your Honor, I hope I'm allowed to mention that I did recommend Kemper, an insurance company with a sizable stake
in the mutual-fund business via the $50 billion worth of funds it manages. This was not the sole reason I picked Kemper—its insurance business was starting to turn around, and so were its brokerage subsidiaries, including Prescott, Ball, and Turben. Kemper's stock also doubled in value in 1991, so to that extent maybe I'm redeemed.

At the onset of 1992, I reminded myself not to make the same mistake I'd made prior to 1987 and again in 1991. This time, I took a very close look at the fund situation. With interest rates dropping, and $200 billion in certificates of deposit maturing every month, a great tide of capital was emptying out of the banks and rolling into all manner of funds. This, certainly, was bullish for the big seven mentioned above. On the other hand, after huge gains in 1991, most of these stocks seemed overpriced. The one that didn't was Colonial Group.

In spite of the 40 percent appreciation in the stock in 1991, Colonial Group was selling for the same $17 it sold for in 1985, at its initial public offering. Back then, Colonial managed $5-$6 billion worth of mutual funds and earned $1 a share. Now, it managed $9 billion worth of mutual funds and was earning $1.55 a share, plus it had amassed $4 a share in cash and had bought back 7 percent of its stock. So six years after the offering, a much stronger company could be purchased for the same price, and if you subtracted the $4 in cash, you were getting it for $4 less than in 1985. The company had no debt. No Wall Street analyst had uttered a word about Colonial Group in two years.

The technique of finding the undervalued stock within an attractive group is one I've often employed with good results. T. Rowe Price was selling for 20 times earnings, Franklin was selling for 20 times earnings, but Colonial Group was selling for only 10 times earnings. Of course, you had to ask yourself why Colonial was undervalued.

One reason might have been that those earnings had stayed flat for four years. Colonial had nearly doubled its assets under management, but this was only a trickle in the great tide of capital that had moved into funds in general. People had heard of Dreyfus, T. Rowe Price, and Eaton Vance, but Colonial was not a household word.

But did this mean that Colonial deserved to be valued at half the going rate of its competitors? I couldn't see why. The company was making money. It had a habit of raising its dividend and buying back shares. It could use future profits to do more of the same.

I talked to the corporate treasurer, Davey Scoon, on January 3. He said that business had improved, especially in the muni bond funds. Colonial has several of these, so it will benefit from the rising
popularity of munis as an escape from higher taxes. It had launched some interesting new funds, such as a utility fund.

I learned long ago that if you make 10 inquiries at 10 different companies, you are going to discover at least 1 unexpected development. Unexpected developments are what make stocks go up and down, and Scoon had an interesting one to relate. The Colonial Group had just been chosen by the State Street Bank to market some new funds that State Street had concocted.

State Street is a commercial bank that does the paperwork, also known as the “back office” work, for most of the mutual-fund industry. This back office function (customer service, recording of purchases and sales, keeping up with who owns what) has been very lucrative for the bank. State Street stock had an 81 percent gain in 1991.

When Scoon mentioned State Street, it reminded me of a mistake I'd made with my mother-in-law. Some years ago, when it appeared that money-market assets were on the decline, I talked my mother-in-law into selling her State Street shares, on the grounds that (1) the company's earnings were likely to drop and (2) she'd doubled her money in the stock already. Since she took this brilliant advice, State Street stock has tripled again, a sad fact that has been hidden in her confusion over State Street's three-for-one stock split. When she looks in the paper, it appears that the stock price has gone nowhere since I gave the sell signal. She often congratulates me for this savvy call, and until now I haven't had the courage to confess the truth.

Stock splits can be a pain in the neck, but one of the good things about them is that they enable the stockpicker to cover up the mistake of having sold too soon, at least from friends or relatives who don't follow the market.

In any event, State Street's experience in the back office with other people's mutual funds led it to consider starting its own mutual funds, to get in on the front end of this bonanza. But State Street did not want to anger its clients by competing against them directly, which is why it decided to camouflage the State Street funds by hiring the Colonial Group to market them. This extra bit of business will benefit Colonial.

Putting Your Money Where Your Mouth Is

In 1992 I didn't recommend any restaurant stocks, but I should have. Every year, it seems, a new crop appears at the airports or the shopping malls, or off the exits of the turnpikes. Since the 1960s, when fast food became an accessory to the automobile and people learned to eat their lunches, then breakfasts, and finally dinners on the road, restaurant chains have become great growth companies, with new ones forever taking over where the old ones left off.