The Tortoise and the Hare


By Robert Barker A year ago, the stock researchers at Morningstar set out to see how well they could run their own money. So they set up a pair of live portfolios, one called the Tortoise, focusing on value stocks, and another for growth stocks, called the Hare.

How did they do? To find out, I sat down with the portfolios' manager, Mark Sellers, during the Chicago research firm's annual conference, which this week brought together some 1,300 investors and advisers. Sellers, who also edits the Morningstar StockInvestor newsletter, posted a 0.34% return on both portfolios overall. That's much better than the Standard & Poor's 500-stock index, which lost 14.3% over the period.

As for which did better, the Tortoise or the Hare, and what Sellers is buying now, read on through the edited excerpts below:

Q: How did you do in your first year?

A: The Tortoise Portfolio was up 19.8%, for the 12-month period started June 18, 2001, and ended June 17. The Hare was down 19%.

Q: How did that compare to the typical similar mutual fund?

A: The Tortoise outperformed 99.7% of large-cap blend [a mix of value and growth stocks] funds. The Hare was in the 53rd percentile of the large-cap growth stock funds. So a little above average. The combined performance of the two portfolios, about 30 stocks, was a positive 0.34%. So, quite well on a combined basis, but we did have some losers in the Hare.

Q: Tell me what went wrong in the Hare?

A: First was just that growth stocks in general got hammered last year and large-cap growth in particular. A receding tide sinks all yachts -- the old John F. Kennedy line. The second reason was that we made some contrarian bets -- we bought some stocks when they were very cheap and we watched them get cheaper.

Q: What's a good example?

A: Qwest (Q) would be a perfect example. Our analyst was negative all the way down to about $25 a share. But he was too early, or just wrong. But we didn't buy it until we talked to [Weitz Value Fund manager] Wally Weitz, and he was pretty high on Qwest. At that time, the stock was maybe $18 or $19. It bounced up a couple of dollars to $22, and that's where we bought it. Weitz, a really brilliant manager, and our analyst were positive. I thought it's probably close to the bottom for Qwest. It was a contrarian bet, and as soon as we bought it, it started marching right back down.

Q: The stock's now around $3. Outstanding investors aren't always outstanding, are they?

A: Not in every pick.

Q: Why else did the Hare trail the Tortoise?

A: The third reason is related to our contrarian strategy. Our stated strategy for both portfolios is that we only buy stocks with wide economic moats.

Q: You mean by that big competitive advantages. But the moats shrank?

A: We tried to hold to that strategy, but, throughout the year, stocks that maybe didn't have sustainable competitive advantages started to look really cheap. And we started to buy some of those types of stocks, so we deviated from our "wide-moat" strategy.

Q: An example?

A: Qwest is an example. There's a moat there because it owns a Baby Bell, U.S. West, but it's not a wide-moat company. Tellabs (TLAB) might be another one. Another stock we bought was ICOS (ICOS), which is a biotech stock that was in third-stage of the FDA approval process. But the FDA requested more information, and of course the stock tanked. The drug, a competitor to Viagra, has not been approved. It's just in limbo right now, so the stock is not doing well at all.

Q: What about the Tortoise? Why did it do well?

A: First, just value stocks in general did very well last year. Second reason, we held a lot of cash. And that allowed us to buy stock during the panic after September 11 and to take advantage of select bargains throughout the year. We always had our gun loaded. As [Warren] Buffett says, if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun. There were only a couple of times when we got below 10% cash [as a percent of the portfolio's assets]. Third reason is just retail stocks -- we made a lot of bets on retail last year. We [expected] interest rates [would be] going down, and we were lucky in that consumer spending really held up.

Q: Which retail stocks did well for you?

A: Liz Claiborne (LIZ), Sears (S), Home Depot (HD) -- we got into that one at $31 [it closed around $37 on June 27]. Office Depot (ODP), and then another retail stock, Shop-Ko (SKO), we got in at $9 a share. It's now $19. Unfortunately, we sold it at $8 after September 11. We thought the balance-sheet issues, because it's a highly leveraged company, might be a problem. So we sold it after that and put the money into Home Depot. If you net those two buy and sell transactions out, that was probably a mistake.

Q: Oops.

A: Most of the time when you sell a stock, more often than 50%, it's the wrong move. Another retailer was Jo-Ann Stores (JAS.a). That stock was up about 180% before we finally sold it a few weeks ago. We bought it at $9.75 or so and sold it at $27.

Q: What's on your shopping list now?

A: We certainly don't feel good about retail at this point. Last year turned out to be the perfect environment for retail stocks. They're definitely not cheap any more. Financial stocks are another area that I didn't think looked cheap at the beginning of the year, although they're starting to look a lot cheaper now.

Q: Have you bought any recently?

A: Northern Trust (NTRS) is one. We're considering purchasing J.P. Morgan (JPM), if there's a lot more fallout from WorldCom (WCOM). That probably would be a strong buy at around $28. It's got a nice dividend yield. Citigroup (C) at around $35, I'd be a buyer. These are stocks that are close to being in the portfolio.

Q: Let's take one. What's to like about Northern Trust?

A: They have an interesting niche. They focus on high-net-worth clients. They do a lot of hand-holding and custom portfolio management for these people, and it's a very relationship-oriented business. But once they get the customer, they can then sell them other services. It's just real "sticky" money. A lot of banks are trying to get into this and a lot of fund companies and private asset managers, but Northern Trust has been doing it for a long time. They've really got an edge.

Q: You like it where?

A: Under $43.

Q: If other banks want to get into this line and Northern's already in it, is it a potential takeover target?

A: It's possible, but that's not why we bought it. It would be a nice side benefit if it happened.

Q: What else do you like?

A: The payroll processors, Automatic Data Processing (ADP) and Paychex (PAYX). They would actually benefit from a rise in interest rates, which I could see happening over the next year.

Q: They're helped by getting interest on the float?

A: Definitely. They send in the tax receipts for companies, they deduct it from the payroll, and they have maybe 10 to 20 days -- and sometimes longer, sometimes up to three months -- between when they collect those payroll taxes and when they have to send them to the IRS. So any incremental rise in interest rates is going to help those companies.

Q: At what price to you like Paychex or ADP?

A: Paychex under $30 looks pretty attractive [and] ADP under $43. We were able to get into it at $42.60.

Q: Other stocks you like?

A: Some of the large-cap chip names. There are only a few. Intel (INTC), Linear Technology (LLTC), and Applied Materials (AMAT). Those three companies are going to be around 20 years from now, unless they merge or something. The baby is being thrown out with the bathwater in that whole sector.

Q: How long will it take for them to rebound?

A: The main thing with any of these picks is that we don't know how they'll do in the next year or two. We only think that five years from now they're going to do 10% to 20% on an annualized basis.

Q: What was your biggest mistake in the first year, and what have you learned from it?

A: Just a reinforcement of something that I already knew. And that is that the three most important words in investing are "margin of safety." Buying a stock when it's at its fair value is a recipe for mediocre returns at best. So you should require a large margin of safety on any stock you buy.

Q: What percentage -- 20% below fair value?

A: My thinking these days is that low-risk stocks you might be able to get into at 20% below fair value and feel comfortable. Medium-risk stocks, a 30% to 40% discount. High-risk stocks, 50% to 60% discount. And there are definitely some high-risk stocks that I could see avoiding altogether, because they're so hard to estimate what the fair value is that any discount is specious.

Q: What were you proudest of?

A: The fact that we had a lot of cash when we needed it. And we waited to deploy the cash until we saw the bargains. Ninety percent of investing is discipline and patience. Ten percent is brains. I think we did very good on the 90% part and we were mediocre on the 10% part. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online


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