Thursday, November 20, 2008

Why Ken Heebner Is Better Than Buffett

The best mutual fund manager around is Ken Heebner of Capital Growth Management. The statement above is a big one. Everyone worships Warren Buffett, I am not saying he isn't good, Buffett is very very good, right at the top. Unfortunately, Ken beats him in a poker heads-up match.

Fortune: Just how good has Heebner been? We may well be witnessing the most dazzling run of stock picking in mutual fund history. Since May 1998, Focus has an average annualized return of 24%, the best ten-year record of any U.S. mutual fund, compared with only 4% for Standard & Poor's 500. Focus, which has $7.4 billion in assets, is already up 15% in 2008 (as of May 19), but it is 2007 that will be remembered as Heebner's pièce de résistance. Fueled by big bets on energy, fertilizer, and metals, Focus soared 80% last year, vs. 5% for the S&P 500. "I told Ken it was like he was walking between the raindrops," says CGM president Bob Kemp, who oversees sales and marketing at the firm, of the year Heebner had in 2007. "It amazes even us." Last year marked the fourth time since 2000 that the fund returned 45% or better. And it's not as if Heebner has needed the big years to make up for a lot of losses: Launched in late 1997, Focus has had only one money-losing calendar year (2002).

Peter Lynch's 14-year tenure at Fidelity Magellan has long been the gold standard for mutual fund excellence. During Lynch's best ten years - August 1977 to August 1987 - Magellan recorded an average annual return of 36%, according to fund tracker Morningstar. It's a remarkable achievement, but even Lynch acknowledges that he was backed by a strong tailwind. The S&P 500 returned 19% a year over the same period. In other words, Lynch beat the market by 17 percentage points a year during his heyday. Ken Heebner has beaten the market by 20 points a year during his.

And Focus isn't the only Heebner-managed fund that's excelling. CGM Realty (a sector fund), CGM Mutual (a balanced fund that owns stocks and bonds), and CGM Capital Development (closed to new investors since 1969 and soon to be merged into Focus) have been standouts too. Realty boasts a 22% annualized return for the past ten years, sixth-best in the mutual fund universe, according to Morningstar. It's also the only fund in its category that's been bucking the real estate slump. Realty's one-year total return: 34%, vs. 6% for its nearest rival.

In December 2000, he began buying homebuilders like D.R. Horton and Lennar, convinced that falling interest rates would be good for housing. The stocks went on a tear, and by 2004, Heebner's stake in the sector accounted for 19% of assets in Focus and 79% in Realty. But toward the end of 2004 he grew uncomfortable with the spread of what he termed "funny-money mortgages," and by January 2005 - mere months before the industry started to collapse - Heebner had sold off every homebuilder share he owned. Heebner used his homebuilder profits to load up on oil and coal stocks, positions he'd started to establish in 2004.

In August 2005, Heebner doubled down on commodities by taking big stakes in copper miners Southern Copper and Phelps Dodge. The price of copper - and of copper stocks - doubled in a little over a year.

In November 2006 he built large positions in fertilizer companies Mosaic and Potash Corp. of Saskatchewan. This time the stocks quadrupled.

In October 2005 he shorted mortgage lender Countrywide. Heebner was early on that one, but he stuck with the short for two years, and his conviction was rewarded in 2007 when Countrywide collapsed from $40 to $8. By then, Heebner had short positions in three more drain-circling mortgage lenders: BankUnited, IndyMac, and FirstFed Financial.

Heebner actually began 2007 with a quarter of Focus's money invested in five Wall Street banks: Bear Stearns, Citigroup, Goldman Sachs, Lehman Brothers, and Merrill Lynch. The holdings could have proved disastrous, but by June - before the credit crisis really snowballed - he was out. "How do you explain genius?" muses Douglas Pratt, a former Invesco fund manager who was an analyst at Loomis. "Ken just sees things others don't."

For better or for worse, the hyperactive trading has always been one of Heebner's calling cards. The turnover rate in CGM Focus, which typically holds 20 to 30 stocks at a time, was a whopping 384% last year, which in theory means he traded enough to buy and sell the entire portfolio nearly four times.

To be fair, we still have to see how Ken's funds performed over the critical Sep-Nov 2008 period. I checked and the fund was down about 1/3 since June 2008, its bad but not that bad. Fair is fair, even Buffett's stock is down, though not by as much. Its not fair to take a 3 or 6 month window to assess someone's performance. Ken's track record is proven over 11 years, and has ridden out the LTCM shit, the internet implosion, the Enron combustion, and now this.

Why Heebner is better than Buffett:

a) Warren Buffett is a pure buy-and-hold kind of person. He uses time to his advantage. Not that its bad, its just not as savvy and pure like Heebner.

b) Ken Heebner not only pick stocks and sectors, he maxes the bets by timing as well. Everybody knows that to pick a good sector or a good stock is easy, market timing is near impossible. Ken has been able to get them right probably 4 out of 5 times and usually within a 6 month time frame.

According to a significant article in WSJ, Buffett did spectacularly well in stock picking in his first 20 years. However, that magic wand seems a bit deflated since then. Much of the outperformance had been due to his "brand name" and its ability to negotiate super-duper deals ala the recent Goldman Sachs and General Electric deals.

WSJ: For the first two decades of his career, Mr. Buffett built the bulk of his fortune through his investing prowess, producing one of the best long-term track records of any money manager in history. More recently, however, Mr. Buffett has succeeded not through investing prowess alone, but also through exclusive deals that have come to him because of it.

Only a part of Mr. Buffett's market-beating performance has come from stock-picking. Even more of his edge has been generated by the operating subsidiaries of his Berkshire Hathaway Inc., like Benjamin Moore paint and Geico insurance. "There's no question about it," Mr. Buffett told me during the week. "Certainly over the last decade at least," the earnings of Berkshire's operating businesses "have grown at a much faster rate than the [value of the] marketable securities per share."

It is a lot harder than it used to be to measure just how good a stock-picker Mr. Buffett is. When I asked him if he knew how well Berkshire's stock portfolio has done in recent years, he answered: "I've no idea what the rate of return would be. But, knowing myself how hard it would be to do the calculations right, I'm suspicious of anybody's numbers."

An outsider, then, can barely get in the ballpark. Since the end of 1988, Berkshire's stock portfolio has grown from $3.56 billion to $69.51 billion. That is a spectacular average annual increase of 16.5%, far surpassing the 10.5% annualized return of the Standard & Poor's 500-stock index. Of course, this calculation is only a crude approximation, since it ignores the cash that Mr. Buffett added in -- and moved out -- along the way.

Over the same period, the growth in Berkshire's book value per share, which reflects all of Mr. Buffett's activities, not just his stock-picking, was 19.9%.

In other words, Mr. Buffett's skill at picking publicly traded stocks pales alongside the value he has added to the company through other means.

As recently as 1995, 73.5% of Berkshire's total assets consisted of a portfolio of publicly traded stocks that (at least in theory) any investor could have replicated. As of June 30, though, Berkshire's stockholdings made up just 25% of its total assets.

Mr. Buffett's stock picks used to drive the train; lately, they are more like the caboose. He has been buying private firms outright and landing "sweetheart" deals in public companies.

Since the beginning of 2006, Berkshire has spent nearly $17 billion buying private companies lock, stock and barrel, including an Israeli cutting-tool maker and a distributor of electronic components.

Meanwhile, on the sweetheart front, in 2008 alone Mr. Buffett has sunk $5 billion into Goldman Sachs, $3 billion into General Electric Co., $3 billion into Dow Chemical Co. and $6.5 billion into the merger of Mars Inc. with Wm. Wrigley Jr. Co. -- all with preferential terms.

Twenty years ago, Mr. Buffett struck similar bargains with companies whose quality ranged from purebred Gillette to mutts like Champion International, Salomon Brothers and USAir Group. His results were mixed. The lesson here is that even Mr. Buffett learns lessons. In his latest round of sweetheart deals, he gets a generous upside and virtually eliminates any downside, a "heads I win, tails I win" structure that other investors can only dream about.

Whether he buys stocks in what he calls the "auction market" or private businesses in the "negotiated market," Mr. Buffett tries to secure a margin of safety. That term, defined by his mentor Benjamin Graham, means that the price is so far below a business's underlying value that severe loss is improbable.

"We do try to buy our businesses like we buy our stocks," Mr. Buffett told me, "and buy our stocks like we buy our businesses." By that he means, among other things, that he wants to understand how the enterprise generates cash, how well-managed it is and whether its customers would stay loyal even if it raised the prices of its goods or services. Note carefully: None of these factors are contingent on the current price of the stock.

"Being a businessman makes me a better investor and being an investor makes me a better businessman," Mr. Buffett explained. "Most businessmen limit themselves to their own field, and most investors don't really think about businesses. And many businessmen are semi-oblivious to the yardsticks other people use outside that field. I'm always comparing everything to everything else. The question I want to answer is. 'Where do we get the most for our money in something we can understand?'"

"I prefer, and [Berkshire Vice Chairman] Charlie [Munger] prefers, the permanent ownership of [private] businesses," Mr. Buffett added. "That's been my focus for well over 20 years. But it's just that sometimes, marketable securities are so much more compelling." Mr. Buffett didn't say whether he thinks now is one of those times, but he did state publicly earlier this month that "I've been buying American stocks."

Any investor who picks stocks can try to think like Mr. Buffett and, as he pointed out, "the individual actually has an advantage over us, because their costs of buying and selling [stocks] are a helluva lot less than ours." But that advantage applies only if you actually can think like Mr. Buffett. Above all, there is much more to his success than stock-picking alone. Throughout Mr. Buffett's long career, he has changed tack repeatedly. At this point, he is on a course most investors will no longer be able to follow.

p/s photos: Warattaya Nikulha


Jasonred79 said...

You are right Dali, he is not only better than Buffet... he's probably the best. Period. For around this period anyhow.

To me what is really telling is the fact that as you said he basically bought and sold his entire fund 4 times in a year.

It's only a very rough guess, but i would say that buffet probably buys and sells 1/5 of Berkshire each year? Less than that?

That essentially means he makes 20 times as many buy and sell decisions per year per dollar compared to Buffet.

In a sense, that means that we have a much larger "sample space" to look at the percentage of his winners and losers. It's not a "real" figure, but I equate his 10 year performance sample data as similiar to a 50 year winning streak for a normal buy and hold investor.

The big difference of course is the number of major downturns that one goes through.

Still, I would say overall that if he keeps this up for another 10 years, he's going to take the uncontested throne. As it is, he's probably the champion, but possibly challenged by others.

KoSong Cafe said...

I like this post because of the topic and your objectivity in explaining the myth we have in Buffet. It depends on what basis we are rating a person's success in investments.

I have been telling people that the success of someone we know personally, could be due to a one-off good opportunity. Eg. a piece of land bought cheap and now much sought after in the Golden Triangle, or even several deals because of crony connections with the top people. What happens after that?

A sales person might be able to clinch good deals for the first year. Then he has to at least maintain it. Imagine he had growth in sales in the second year and this is expected of him for the following years. Annual growth! By then we can see the difference between mediocrity and genuine excellence.

For ordinary people like myself, being able to hold shares purchased instead of depending on the T+3 timing for contra gains, makes a lot of difference. Even that has become a luxury I cannot afford! Holding power evens out the odds.

HollyS said...

I read alot about Ken Heebner and Capital Growth Management. But rather I am more interested to invest into his funds. But to my suprise, the funds does not allow non-American to invest into the funds. This is rather dissappointing as we Malaysians are missing out alot of good investment opportunities out there. Forget about our local funds investing in overseas as they are all losing investors' money. It is not as rosy as well in Singapore.