Fund Managers Share Lessons From Crash

Don Hodges, a 50-YEAR veteran of playing the stock market, thought he had seen everything it could possibly throw at him. There was the implosion of the Nifty Fifty 40 years ago, the OPEC crisis in the 1970s, junk bonds, S&Ls, Long Term Capital and, of course, the tech boom and bust. But, he says, this recent downturn is unprecedented.

"You look at the market and it's frightening," says Hodges, who along with his son, has managed his namesake fund (HDPMX) to a top third position in Morningstar's midcap growth category over the last decade.

What has given Hodges pause this time around is the sheer size and scale of the calamity. What looked like a deteriorating situation confined to the housing market quickly spread to the world's largest banks and Wall Street firms. At one point the globe's financial system seemed to be teetering on the edge. Meanwhile, consumers grew concerned about losing their jobs at the same time food and gas prices were skyrocketing. Stocks took a hit -- the S&P 500 has lost 34% of its value the last year through Thursday -- as wild 200-plus-point swings became the norm. Fund managers found there was no place to hide from the volatility.

Well-regarded managers like Don Hodges haven't gotten to where they are without learning some humbling lessons along the way and, more importantly, not forgetting them the next time trouble rolls around. Indeed, the gaffes and good calls that were (and are being) made during the current crisis -- whichever nickname it will one day take -- will no doubt be talked about in mutual fund offices for years to come. Individual investors would be smart to pick up on the chatter, too.

This week we decided to take a breather from the chaos and poll some managers like Hodges on what they have gleaned the last year or so -- and if those lessons were already being put to work.

When the dust settles on every market or corporate collapse, inevitably investors find the seeds of the disaster were spelled out in obscure footnotes. Unfortunately, most of them never pored over the dense SEC filings to study them before it was too late. Even investment companies known for strong research were blindsided by the reach of this recent downturn.

"Accounting matters," says Michael Church, a senior portfolio manager at Church Capital in Yardley, Pa. "You can't trust what the Bloomberg screen is telling you or what Wall Street analysts are telling you. You have to pay attention to what's going on under the sheets." Church and his colleagues have redoubled their homework on companies just to make sure they haven't missed any ticking bombs.

Sometimes it's not so much the numbers as just a gut feeling. At this year's Morningstar conference, Ralph Shive, manager of 1st Source Monogram Income Equity (FMIEX) (soon to be part of the Wasatch family of funds), told us how he quizzed his fixed-income analyst about the debt obligations that were becoming so popular. Shive had run money in Texas during the S&L crisis and didn't like what he saw now. The numbers just didn't make sense. He stayed away, helping to preserve one of the best track records in the industry. The advice: Don’t invest in what you don’t understand.

After 50 years Don Hodges has many cardinal rules about investing. Now, though, he is favoring one in particular. Hodges likes to buy the stocks that were strong heading into the downturn on the theory these same names will be strong again when the market turns a corner. In short, that equates to buying well-run large caps trading at a discount.

"You get to the point where you have to ignore the market and look at the company," says Hodges. "I don't care whether a stock goes down from here. I am going to buy it because it's too much value to ignore."

Lately, Hodges has been buying stocks like Chesapeake Energy (CHK), Transocean (RIG) and Burlington Northern Santa Fe (BNI). He has also been stocking up on AMR (AMR), the parent company of American Airlines, and mining company Cleveland Cliffs (CLF).

It's easy to get caught up in the data on what sectors or industries tend to do well once the market turns a corner. But Hodges thinks fortified balance sheets, good management and strong businesses are a smarter play than speculating on riskier fare.

The Jensen Portfolio (JENSX) is a fund that sticks to a strict investing strategy. In order for companies to be considered for inclusion in its portfolio they must have a 15% return on equity in each of the last 10 years. Yes, that's each and every year. One stumble and a company is disqualified.

After a miserable 2007 -- the fund fell into the bottom 20% of Morningstar's large growth category -- it might have been tempting to do some major changes to the strategy. But the folks at Jensen only made one -- and it was a minor tweak involving their discounted cash flow analysis. Instead, the management team sat back and waited for their stocks to come back into favor.

That's happened this year. The fund is down 23.8%, about 10 percentage points ahead of the S&P 500. And investors who fled last year are coming back into the fold. Manager Robert Millen says $250 million has flowed into the fund's coffers during a time when many equity funds are seeing outflows.

"We never wavered," he says.

One refrain we heard repeatedly was that the current market situation offered what will probably wind up being a once-in-a-generation buying opportunity. "You make your money in a bear market," says Millen. In other words, if you buy good stocks at the bottom -- or at least the near bottom -- you can set your portfolio up for years to come.

Hodges echoed that sentiment and pointed out that he attributes a lot of the recent volatility to hedge funds and institutions liquidating big positions under duress. "We have been murdered in this market," he says. "But we are doubling up on some of the stocks that have hurt us the most with the idea that when the market turns, these stocks will go up 30% or 40%."