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Lindley Estes is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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This week’s (8/8) investing column

MUTUAL FUND managers’ best-performing stocks tend to be the ones in which they have the highest conviction.

These high-conviction stocks tend to outperform the stock market significantly. Yet very few actively managed mutual funds deliver market-beating returns over time, and the record is even worse when you factor in taxes, management fees and transaction costs.

So investors would be better off with managers willing to bet big on their highest-conviction ideas.

Those are among the findings of a study called “Best Ideas” by Randolph Cohen at the Harvard Business School, Christopher Polk at the London School of Economics and Bernhard Silli at Goldman Sachs. The study was referenced in a Wall Street Journal article this past week on Bruce Berkowitz, manager of The Fairholme Fund.

Berkowitz’s fund has thrashed the Standard & Poor’s 500 since its inception in 1999. Investors who put $10,000 into Fairholme in 1999 would have had $37,797 as of May 31, compared with $8,990 in the S&P 500. Morningstar last year named Berkowitz as its domestic-stock fund manager of the decade.

Unlike many of his peers, Berkowitz is willing to put big chunks of Fairholme’s $15 billion worth of assets into his best ideas. The fund’s portfolio typically includes just a couple of dozen stocks. Fairholme’s most recent report revealed that 63 percent of the fund’s assets were in just 10 stocks. Berkowitz usually keeps about a fifth of the fund in cash so he can pounce on opportunities.

Berkowitz is willing to bet big on his convictions even when they go against the grain. His portfolio is now packed with some of the most-hated names in the financial crisis: AIG, Citigroup, Bank of America, Goldman Sachs, MBIA, General Growth Properties and Morgan Stanley. He’s betting on an economic rebound and better days for those beaten-down financial companies.

Fairholme’s strategy isn’t for the faint of heart. The fund could lose big if the economy goes into the tank. But if Berkowitz is right, the fund should continue its market-beating results.

The problem with many funds is that managers aren’t willing to stick their necks out and take big positions in their favorite ideas. Therefore many funds are run like quasi index funds except with higher expenses.

This brings to mind a famous saying of Warren Buffett: “Diversification is protection against ignorance.” Star manager Peter Lynch has referred to diversification as “deworsification,” and Buffett’s partner Charlie Munger has said that “wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

Of course for most investors there’s nothing wrong with diversification. Index funds offer diversification with rock-bottom costs and tax efficiency. This is probably the best bet for the majority of investors.

Still, as the example of Berkowitz shows and the “Best Ideas” study confirms, investors who truly want to outperform the market will need to bet big on their top convictions.

Permalink: http://news.fredericksburg.com/businessbrowser/2010/08/10/this-weeks-88-investing-column/

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