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Can a Stumbling Clipper Regain Its Stride?

A close look at Morningstar's only 1-star Analyst Pick.

 Clipper (CFIMX) managers Chris Davis and Ken Feinberg are on the hot seat.

From the managers' Jan. 1, 2006 start at Clipper through April 12, 2011, the fund lost 0.38% annualized, while the S&P 500 gained 3.13% and the typical large-blend fund advanced 2.75%. The fund has done better since the March 9, 2009, bottom of the bear market, rising nearly 48% annualized through April 12, more than 8 percentage points better than the S&P 500 Index and nearly 10 percentage points better than the large-blend category.

Still, the fund is now Morningstar's only Analyst Pick with a 1-star rating, and many wonder which is the real Clipper--the crashing one or rallying one. Davis and Feinberg's track record since 1994 at  Davis New York Venture (NYVTX) suggests the rallying one, but let's dig in.

Once Bitten, Twice Shy?
An investor who has suffered a setback must still be willing and able to invest with conviction to dig out of his or her hole. A skilled manager who becomes indecisive or timid after a rough patch can end up fighting the last war, which is "a sure way out the door," at Davis Selected Advisors, Davis said recently.

Don't show Davis and Feinberg the door, yet. This is still a high-conviction fund. It has just 24 holdings and 72% of its assets in its top 10, including more than a fifth of its money in its two largest positions, which at the end of March 2011 were  Costco Wholesale (COST) and  Canadian Natural Resources (CNQ).

The duo also remains committed to its process. Davis and Feinberg aim to buy and hold the shares of good companies at discounts to their true earnings power and sometimes pay up for leading franchises with strong long-term growth prospects. Costco, for example, has one of the highest forward price/earnings ratios in the portfolio, yet it remained at the top of the fund's list at the end of the first quarter because it dominates the warehouse-club segment of the retail sector and is poised to take market share from other discounters and grow internationally.

Running to Stand Still?
Concentration alone doesn't prove conviction, though. Managers show how much they believe in their processes by sticking with them even after they serve up some stinkers. Davis and Feinberg kept the faith after their 2008 drubbing. Even as they were licking their wounds from  American International Group (AIG) and Merrill Lynch, the managers bought  Goldman Sachs (GS) when it was trading below its book value in 2008 and early 2009. That was consistent with Davis and Feinberg's long-stated preference for dominant businesses at attractive prices. So were the fund's purchases of  CVS Caremark (CVS),  Diageo (DEO),  Coca-Cola (KO), and Wells Fargo (WFC) during roughly the same time period.

In the past year, the fund sold  J.P. Morgan Chase (JPM), but not because Davis and Feinberg thought it was no longer a premier bank. They grew wary of the institution's large, opaque derivative exposure and new government regulations that targeted major revenue sources, such as credit cards. The managers decided there were enough unknowns to warrant getting out as the stock recovered. The fund also recently sold Coca-Cola after nearly two years of strong gains.

They saw better opportunities in Brazilian debit and credit card processor Cielo SA, which offered a way to participate in burgeoning emerging-markets consumerism without assuming a lot of credit risk, and SKBHC Holding, a privately held California-based holding company formed to acquire struggling community banks and revive them. The fund added the former during a stock offering last summer and the latter in 2010's fourth quarter after a long search for ways to let traditional mutual fund investors benefit from the massive consolidation and restructuring of local banks now under way.

Recent purchases have included the dominant document-management company  Iron Mountain (IRM) and retailer  Bed Bath and Beyond (BBBY).

Is There Value Beyond Price?
If the stocks in the fund have not all been blockbusters recently, many of them have made solid fundamental progress. Most of the companies in the fund have positive free cash flow to go along with decent margins and returns on equity and returns on assets. Most of them also, in the judgment of Morningstar stock analysts, have economic moats (competitive advantages that should help them to continue to generate cash and earnings for a while). Those companies in the portfolio that pay dividends, on average, have increased their payouts at a faster pace than the typical S&P 500 stock over the past five years. Some that cut their distributions during the recession, like Wells Fargo, have restarted paying and growing them. Finally, most of the fund's holdings have increased their book values per share faster than the average benchmark constituent during Davis and Feinberg's tenure.

It's harder to measure the progress of Clipper's more off-the-beaten-path holdings, such as privately held Oaktree Capital Management. Yet there are signs the specialty money manager is moving in the right direction. With nearly $80 billion in assets, the firm gets a solid investment-grade rating from Fitch. The bond-rating firm lauds Oaktree's consistent revenues, fund flow and asset growth, positive operating cash flows, and diversified institutional client base, which includes reputable firms like Vanguard. Founder Howard Marks also is known for fostering a strong, risk-conscious culture.

Owning more illiquid, private holdings such as Oaktree and SKBHC can be problematic. Legally, funds can't have more than 15% of their assets in private ventures. They can be hard to sell if a fund manager feels it necessary because of redemptions or deteriorating fundamentals. Private placements also can be difficult to value. Indeed, some funds have been accused of using such holdings to pump up net asset values with bogus valuations.

Clipper's positions in closely held firms amount to a small part of a portfolio of otherwise large, liquid stocks. Oaktree's shares also can be bought and sold on an exchange, albeit one limited to qualified institutional investors, so it has more trading and pricing opportunities than does a typical private firm. Clipper also carries its position in SKBHC at a discount to what it cost it to get in. So, initially, the holding company is likelier to sap Clipper's performance than to artificially inflate it, Davis says. Finally, funds that have gotten into trouble with private investments in the past have often done so with risky tech and biotech startups. Oaktree, founded in the mid-1990s, is no startup, and though SKBHC formed two years ago, it's led by veteran bankers and has the backing of large institutional investors, including Oaktree and Goldman Sachs.

They've Felt Your Pain
It has been a rough five years for Clipper, but its current portfolio�a mix of stalwarts and opportunistic plays with decent valuations�could take the heat off its managers. No matter what happens, Davis and Feinberg, their employees and families have nearly $80 million invested alongside Clipper owners. These factors and the fund's below-average expenses should instill confidence in the fund.

 

Dan Culloton has a position in the following securities mentioned above: CFIMX. Find out about Morningstar’s editorial policies.