Beating the Street (14 page)

In January 1978, we told the shareholders that “the portfolio is dominated by three categories of companies: special situations, undervalued cyclicals, and small and medium-sized growth companies.” If this didn't cover the waterfront, the definition was expanded a year later as follows:

The goal of Magellan Fund is capital appreciation through investing in relatively attractive common stocks found primarily in five categories: small and medium-sized growth companies, companies whose
prospects are improving, depressed cyclicals, high yielding and growing dividend payers, and finally, companies where the market has overlooked or underestimated the real value of the firm's assets… at some point in the future, foreign stocks could represent a substantial portion of the fund.

In other words, if it's sold on a stock exchange, we'll buy it.

Flexibility was the key. There were always undervalued companies to be found somewhere. Two of my biggest gainers in this early stage were major oil companies: Unocal and Royal Dutch. You'd expect a $20 million fund to ignore major oil companies and concentrate on smaller stocks with better growth rates, but I learned that Royal Dutch was turning around and Wall Street apparently hadn't realized it, so I bought Royal Dutch. At one point when Magellan was still a pip-squeak fund, I put 15 percent of the assets into utilities. I owned Boeing and Todd Shipyards right along with Pic 'N' Save and Service Corporation International, the McDonald's of funeral homes. I doubt that I was ever more than 50 percent invested in the growth stocks to which Magellan's success is so often attributed.

Rather than being constantly on the defensive, buying stocks and then thinking of new excuses for holding on to them if they weren't doing well (a great deal of energy on Wall Street is still devoted to the art of concocting excuses), I tried to stay on the offensive, searching for better opportunities in companies that were more undervalued than the ones I'd chosen. In 1979, a good year for stocks in general, Magellan was up 51 percent while the S&P rose 18.44. In the annual report to shareholders, once again I faced the challenge of explaining my strategy, as if I'd had one to begin with. “Increased holdings in lodging, restaurants, and retail” was the best I could do.

I was attracted to fast-food restaurants because they were so easy to understand. A restaurant chain that succeeded in one region had an excellent chance of duplicating its success in another. I'd seen how Taco Bell had opened many outlets in California and, after proving itself there, had moved eastward, growing its earnings at 20 to 30 percent a year in the process. I bought Cracker Barrel and later visited the Cracker Barrel country store located in Macon, Georgia. I'd flown to Atlanta to attend an investment conference sponsored by Robinson-Humphrey, and decided to make a side trip to the restaurant. On the rental car map, Macon appeared to be a few miles away from my downtown Atlanta hotel.

A few miles turned out to be more like 100, and in the rush-hour traffic my little foray took three hours, but in the end I had a delicious catfish dinner and came away impressed with the entire Cracker Barrel operation. This 50-bagger did well for Magellan, which is why I've included it in my 50 most important stocks list on page 136.

I did a similar bit of on-site research at a do-it-yourself handyman's supermarket also located in the Atlanta area. It was called Home Depot. Again I was impressed with the courteous service, not to mention the vast inventory of screws, bolts, bricks, and mortar, the cheap prices, and the knowledgeable employees. Here the sunshine painter and the weekend plumber were liberated from the high-priced and poorly stocked local paint and hardware store.

This was the infancy of Home Depot, with the stock (adjusted backward for later splits) selling for 25 cents a share, and I'd seen it with my own eyes and bought it, but then lost interest and sold it a year later.
Figure 4-1
has caused me eternal remorse. Imagine a stock that goes from 25 cents to $65, a 260-bagger in 15 years, and I was on the scene at the creation and didn't see the potential.

Perhaps if Home Depot had begun in New England, or if I'd known the difference between a Phillips screwdriver and a sloe gin fizz, I wouldn't have misjudged this wonderful company. That and Toys “R” Us, which I also unloaded too soon, were the two worst sell orders of my entire career.

Even without Home Depot, Magellan's successes in 1979 were duplicated and then some in 1980, when my tiny club of shareholders enjoyed a 69.9 percent gain, while the S&P rose 32 percent. My latest big positions were in gaming (Golden Nugget and Resorts International, to be exact), insurance, and retail. I liked the convenience stores so much that I bought Hop-In Foods, Pic 'N' Save, Shop & Go, Stop & Shop, and Sunshine Jr. all at once.

In reviewing this early phase of my stewardship, I'm amazed at the turnover rate in the fund: 343 percent in the first year, when the portfolio contained 41 stocks, and 300 percent in each of the three years thereafter. Beginning on August 2, 1977, when I sold 30 percent of the holdings, I maintained a dizzy pace of buying and selling as oil companies, insurance companies, and consumer stocks came and went from month to month.

FIGURE 4-1

In September 1977 I purchased a few cyclicals, and by November I was getting rid of them. Fannie Mae and Hanes, both of which were added to the fund that fall, were gone by spring. My largest position went from Congoleum to Signal Companies, and then to Mission Insurance, followed by Todd Shipyards, and then the Ponderosa steak house. Pier 1 appears and disappears, so does a company with the intriguing name of Four-Phase.

It seems that I was in and out of Four-Phase with every cycle of the moon. Eventually it was bought out by Motorola (much to Motorola's later regret) so I had to stop trading it back and forth. I vaguely recall it had something to do with computer terminals, but I couldn't really explain it then or now. Fortunately, I never invested much money in things I didn't understand, which included most of the technology companies along Route 128 in the Boston area.

Most of my abrupt changes in direction were caused not by any shift in policy but by my having visited some new company that I liked better than the last. I might have preferred to own both, but in a small fund in which shareholders continued to seek redemptions, I did not have that luxury. In order to raise the cash to buy something, I had to sell something else, and since I always wanted to buy something, I had to do a lot of selling. Every day, it seemed I would hear about some new prospect—Circle K, House of Fabrics, etc.—that was more exciting than yesterday's prospects.

My frequent trading continued to lead to the annual challenge: making whatever I'd done sound sensible to the shareholders who read the progress report. “Magellan shifts from cyclicals that had appreciated in value to noncyclicals which seem likely to have sales and earnings gains” was my strategic recap for one year, followed by “Magellan reduced positions in companies whose earnings could be affected by an economic slowdown. Nevertheless, the Fund continues to be heavily invested in cyclicals that appear to be undervalued.”

As I study these reports now, I realize that many stocks that I held for a few months I should have held a lot longer. This wouldn't have been unconditional loyalty, it would have been sticking to companies that were getting more and more attractive. The seller's remorse list includes Albertson's, a great growth stock that became a 300-bagger; Toys “R” Us, ditto; Pic 'N' Save, already mentioned; Warner Communications, which a technical analyst, of all things, talked me out of; and Federal Express, a stock I bought at $5 and promptly sold at $10, only to watch it soar to $70 in two years.

By abandoning these great companies for lesser issues, I became
a victim of the all-too-common practice of “pulling out the flowers and watering the weeds,” one of my favorite expressions. Warren Buffett, renowned for his investing acumen as well as his skill as a writer, called me up one night seeking permission to use it in his annual report. I was thrilled to be quoted there. Some investors, the rumor goes, own a share of Buffett's Berkshire Hathaway company (these cost $11,000 apiece) simply to get on the mailing list for Buffett's reports. This makes Berkshire Hathaway the most expensive magazine subscription in history.

During the four-year stretch when Magellan was closed to new customers and the heavy redemptions (one third of all the shares) forced me to sell in order to buy, I acquainted myself with a wide range of companies and industries and learned the factors that caused the ups and down in each. At the time, I wouldn't have guessed that I was getting an education in how to run a multibillion-dollar fund.

One of the most important lessons was the value of doing my own research. I visited dozens of companies at their headquarters, and was introduced to dozens more at regional investment conferences, and a growing number (200 a year or so in the early 1980s) came to Fidelity.

Fidelity began a policy of taking a corporation to lunch. This superseded the old system, under which we had lunch with cronies in the office or with stockbrokers and talked about our golf games or the Boston Red Sox. Stockbrokers and cronies were amiable enough, but not as valuable as CEOs or investor relations people who knew what business was like in the insurance or aluminum sector.

Lunches soon escalated into breakfasts and dinners, until you could have eaten your way through the S&P 500 in the Fidelity dining rooms. Every week, Natalie Trakas put out a printed menu, similar to the one that school systems send home with children (spaghetti on Monday, hamburgers on Tuesday), except that ours was a menu of guests (Monday, AT&T or Home Depot; Tuesday, Aetna, Wells Fargo, or Schlumberger; and so forth). There were always several choices.

Since I couldn't possibly attend all the informational meals, I made a point to see the companies in which I wasn't invested, just to see
what I'd been missing. If I was underweighted in oil, for instance, I'd be sure to show up at the lunch with the oil company, and these conversations often led to my getting a jump on the latest developments in this cyclical industry.

This is the sort of information that is always available to the people directly or indirectly involved in a business, either as producers or suppliers, or, in the case of the oil business, as tanker salesmen or gas station owners or equipment suppliers, who can see the changes and take advantage of them.

Boston's being the capital of the mutual-fund industry made it easy for us to see hundreds of corporations a year without having to leave town. Their executives and their finance people could make the rounds of Putnam, Wellington, Massachusetts Financial, State Street Research, Fidelity, or numerous potential stops, seeking buyers for their latest public offerings or for their shares in general.

In addition to taking companies to breakfast, lunch, and/or dinner, analysts and fund managers were encouraged to attend the afternoon chitchats with additional corporate sources in one of the Fidelity conference rooms. Often our visitors had invited themselves to come in and talk to us, but we initiated many of these exchanges as well.

When a company wanted to tell us a story, it was usually the same story that everybody else on Wall Street was hearing, which is why the talks tended to be more useful if we sent out the invitations.

I'd spend an hour or so with the guy from Sears and find out about carpet sales. A vice-president of Shell Oil would give me a rundown on the oil, gas, and petrochemical markets. (A timely tip from Shell led me to sell shares in an ethylene company that soon enough fell apart.) An emissary from Kemper would tell me if insurance rates were on the rise. In 2 out of 10 of these random encounters, I'd discover something important.

My personal rule was that once a month I ought to have at least one conversation with a representative of each major industry group, just in case business was starting to turn around or there were other new developments that Wall Street had overlooked. This was a very effective early-warning system.

I always ended these discussions by asking: which of your competitors do you respect the most? When a CEO of one company admits that a rival company is doing as good a job or better, it's a powerful endorsement. The upshot was that I often went out and bought the other guy's stock.

The information we sought wasn't esoteric, or top secret, either,
and our guests were happy to share what they knew. I found that the vast majority of corporate representatives were both objective and candid about the strengths and weaknesses in their own operations. When business was lousy, they admitted it, and they told me when they thought it was turning around. We humans tend to get cynical and suspicious of one another's motives, especially where money is involved, but in my thousands of encounters with people who wanted me to invest in their companies I was lied to only a handful of times.

In fact, there may be fewer liars on Wall Street than on Main Street. Remember, you heard it here first! It isn't that financial types are closer to the angels than the merchants down the street, it's that they are so widely distrusted that their every claim is reviewed by the SEC, so they aren't allowed to lie. The lies that do get through cannot survive the next quarterly earnings report.