July 17, 2009

Evidence Suggests Active Managers Have a Tailwind

We have observed a growing discrepancy since the stock market began to freefall last September. On one hand, the overall economic environment continues to be extremely fragile. On the other hand, many managers we talk to report finding what they believe to be outstanding opportunities at the individual stock level, even after factoring in a very negative economic environment for their companies. These two views aren't necessarily at odds with one another. We believe there are occasional periods, often driven by economic extremes (the financial meltdown of 2008 or the tech boom/bust earlier in the decade) when stock prices become disconnected from fundamentals resulting in some stocks becoming significantly underpriced, while others become overpriced. Ultimately we believe these mis-pricings must be corrected. In the following paragraphs we lay out some of the evidence supporting our belief that the correction process presents a period of great opportunity for skilled active managers. Moreover, we believe the financial meltdown of 2008 resulted in major market dysfunctions that may have created an unusually large opportunity for skilled managers do very well.

So we believe we are in the midst of a period in which the environment for stock picking may be much better than the overall outlook for the market. Remember, the stock market is merely a market of stocks, and their aggregate performance gives no indication of what's actually happening under the hood. At its simplest, consider how different the opportunities are for a stock picker if a market return of 5% results from the majority of stocks earning between 0% and 10%, versus the same 5% market return comprised of most stocks earning between -10% and +20%. Earning good returns doesn't require that all stocks be cheap relative to their prospects, only that some stocks be cheap (and of course that the managers can identify them).

A number of data points suggest the current picture is much more encouraging when it comes to stock pickers. First is data about the degree to which the valuations of individual stocks are spread apart. We initially looked at data from Empirical Research (see chart 1). This data goes back to the early 1950s, and based on a composite of four traditional measures of valuation compares the magnitude of the variation between the cheapest group of stocks relative to the overall market. The "spread" in valuation reliably increases at times of major distress, such as 1973-74, the recession of early 1990s following the Savings &Loan debacle, and the earnings collapse that occurred in the recession that began in 2001 following the tech bubble bursting. More recently, this measure showed stock valuations were very widely spread last fall as the crisis unfolded, roughly as wide as they'd ever been during the 50-plus years in Empirical's data set. The spread has narrowed since then but is still wider than normal. Our common sense and experience suggested to us that those types of environments would favor active managers, and we mentioned this in our shareholder reports.

Source: Empirical Research Partners Analysis, National Bureau of Economic Research.

Chart 1 - The differential between the cheapest stocks and the broader market became very wide in late 2008 and remains historically wide.

We pursued this idea further and looked at data on a range of large-cap U.S. equity funds with histories going back to 1991. Using Morningstar and Value Line data, we divided the funds into Growth, Blend and Value groups, and then selected the top half (based on performance over the full period beginning November 1, 1990 and ending December 31, 2008) to create subsets of "outperforming" funds. We were curious as to whether these better-performing funds earned more of their outperformance during periods beginning when valuation spreads were widest. We looked at the median annualized margin of outperformance over the full period, as well as for the three-year periods that began when valuation spreads were historically very wide (see chart 2). The results for this broad group of equity managers are also suggestive that these types of environments can favor active managers, since the majority of managers outperformed by wider margins during the periods that began with wide valuation spreads.

We also put weight in the fact that the active managers we've been talking to regularly since last fall have reported to us that in some cases stock valuations were becoming completely disconnected with their underlying fundamentals (even admittedly bad fundamentals). We have believed for several months now that one reason for this disconnect was that as highly stressed financial institutions (including hedge funds) were forced to reduce their leverage, they sold any liquid assets they could to raise capital. Some stocks were being dumped at any price. Supply and demand imbalances can create pricing anomalies in the short term, and with a temporary glut of supply as hedge funds and other investors dumped stocks, and a lack of demand as investors hunkered down to weather the storm, our managers were reporting that some stocks they followed or owned were trading at what they considered to be ridiculous levels. Since then, we've focused on questioning our managers' assumptions to make sure they are factoring in a sufficiently negative overall environment at the company level. That was a process that unfolded over a period of months. It is clear that the pricing anomalies have begun to reverse from extreme levels, but we continue to hear from many of our managers that stock picking opportunities remain above average.

Finally, if this is indeed a period in which some stocks may do very well even as the overall market does not, we'd expect to see some evidence in the form of performance. Looking at the performance of the Masters' Select funds, the evidence seems quite compelling. All five of the Masters' funds beat their benchmarks through the first half of this year, four by a very wide margin. Four of the five funds began their periods of outperformance in late 2008.

Of course, there is no guarantee that the Masters' funds will continue to outperform, but the recent data is consistent with what we'd expect in a highly dislocated environment and we are hopeful time will show we are in fact at the early stages of what will prove to be a good period for active managers and our funds.

Click here for the most recent quarter-end standardized performance data for the Masters' Select Funds. Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.mastersfunds.com. The funds impose a 2.00% redemption fee on shares held less than 180 days. Performance does not reflect the redemption fee. If reflected, performance would be lower.

The performance quoted does not include a deduction for taxes that a shareholder would pay on distributions or the redemption of fund shares. Indexes are unmanaged, do not incur expenses, taxes or fees and cannot be invested in directly.

Each of the Masters' Select funds may invest in foreign securities. Investing in foreign securities exposes investors to economic, political and market risks and fluctuations in foreign currencies. Each of the funds may invest in the securities of small companies. Small-company investing subjects investors to additional risks, including security price volatility and less liquidity than investing in larger companies. Masters' Select Value and Masters' Select Focused Opportunities are non-diversified funds, which means that each respective fund may concentrate more of its assets in fewer individual holdings than a diversified fund. Though primarily equity funds, the Value and Focused Opportunities funds may invest portions of assets in securities of distressed companies. Debt obligations of distressed companies typically are unrated, lower rated, in default or close to default and may become worthless.

Litman/Gregory Fund Advisors is ultimately responsible for the performance of the Masters' Select Funds due to its responsibility to oversee the investment managers and recommend their hiring, termination and replacement.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies as measured by total market capitalization, and represents about 98% of the U.S. stock market. The S&P Global Ex-U.S. LargeMidCap Index (formerly called the S&P Citigroup Global (ex U.S.) Index), is a broad based index that represents the largest 80% of investable companies in 52 developed and emerging market countries. The Russell 3000 Value Index is a broad based index that measures the performance of those companies within the 3000 largest U.S. companies, based on total market capitalization, that have lower price-to-book ratios and lower forecasted growth rates. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The S&P 500 Index is a capitalization-weighted index of the stocks of 500 leading U.S. companies. Indexes are unmanaged, do not incur expenses, taxes or fees and cannot be invested in directly.

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The Masters' Select Funds are distributed by Quasar Distributors, LLC.