Sunday, October 9, 2011

Steve Jobs and Lessons for Fund Owners

We have all benefited from the life and genius of Steve Jobs. One can only speculate whether in our own lifetimes, Apple Computers, “Toy Story,” the iPad and the iPhone would have been produced and at the prices we paid, without the guiding force of Jobs. He married Art with Technology, and came up with magic to give us products that we didn’t know we wanted, but demanded nevertheless. His attention to detail, particularly to the fit and feel of Apple’s products, was amazingly accurate. Part of his genius was organizing the supply chain of essential parts that would be assembled into his finished products. Knowing of his medical condition, Steve Jobs left his company with new products planned out for the next four years. He built a team of successors that he felt would carry on with his goals. Clearly, I am a fan. The smartest thing I ever did outside of marrying Ruth was to give my late, learning-disabled daughter an Apple IIc. Because of its intuitive operating system and keyboard, she was able to communicate with a whole new world of people and learning. Important disclosure: I personally own Apple shares which I received many years ago as a distribution from a closed-end fund. Luckily I kept half the position; since then, I stupidly sold a portion to take an outsized profit to offset some realized losses from other transactions and to free capital for new investments. Like Steve Jobs, I was able to make mistakes and learn from those errors. Jobs certainly did make blunders, several which could have bankrupted Apple if others had not intervened. Despite the very fact that as good as he was, he had a combination of tremendous successes and near-fatal mistakes. These extremes are somewhat similar to many very successful fund portfolio managers.

Lessons from Fidelity Magellan

Chapter 16 of my book Money Wise details some early lessons from the progress of Magellan, from its initial restricted launch through some of the later portfolio managers. This chapter should be required reading for all those interested in the economics and portfolio history of the mutual fund business. While there have been many portfolio managers of the fund, none were better than Ned Johnson and Peter Lynch. Very recently a new portfolio manager has replaced one who produced lackluster results. To some degree, his appointment is recognition of less-than-successful succession planning, which highlights how difficult the task is, particularly for the management and board of Apple. In terms of Magellan, like with Apple, there are two elements that are required to make succession work. The first is the outward results: e.g., will the iPhone 5 and iPhone 5s continue Apple’s astounding growth? To do so, these devices will need to open up new markets as well as to convince owners of Apple’s older versions to crave these new phones. On the fund side, I wonder, will Magellan become a performance leader once again? The other key element to whether a successor works out well is on the business side. Can Apple’s management keep its gross and net margins where they are, through managing both the supply chain and distribution margins up to the current level? For Magellan, the issue is more challenging. The fund is largely a retirement vehicle, as distinct from a performance vehicle; its shareholders are different and getting new flows from retirement plans will take a lot of work. Further, at one point in time Magellan was the flagship and largest fund within Fidelity. It is not today, which raises the question as to whether it will get all of the top attention that may be needed to succeed in a much more competitive world.

I have a reasonable degree of comfort in the prospects for Apple over the next four or so years; I approach the decision in terms of Fidelity Magellan differently. If one already owns shares in the fund, I would not redeem them until one sees the next portfolio of the fund after the new manager took over. The key that I would be looking at is to see how many of the old holdings are left in the portfolio. In the case of someone contemplating buying into the fund on the basis that the new portfolio manager has a better record than the old one, I would wait until the publication of the second listing of investments in the portfolio. I would be interested in whether the portfolio looks like his old portfolio or whether he is branching out to new names and policies.

Applying successor concerns to Fairholme

As famous as Peter Lynch was during his high performance years, Bruce Berkowitz has been shepherding his Fairholme Fund for the eleven years between 2000 and 2010. In all but two of those years he handily beat his peer group as measured by the Lipper Large Cap Value Fund Index, in most cases by ten percentage points. (For our UK members of this blog community, the name Fairholme may seem to be familiar, it is the name of the street where Bruce lived while he was in the brokerage business when he was in London.) Bruce’s fame was such that Morningstar named him as the best equity manager of the decade. As with Peter’s Magellan fund, the outstanding performance attracted a huge amount of inflows. So much in the way of inflows, that Fairholme was larger than Lynch’s Magellan when Peter was managing it. (Fidelity merchandised Magellan after Peter Lynch stepped down, to a point that it had assets over $100 billion, and for a time was the largest active stock fund.) Unfortunately, we have seen poor performance patterns appear after great performance. For the twelve months ending September 30th, Fairholme was down -22.20%, compared to the minor -3.54% loss of the Lipper Large Cap Value Fund index. All of the decline could be attributed to Fairholme’s poor third quarter of -25.47%, compared to its peers of -16.67%. Bruce’s concentrated portfolio, with heavy emphasis on financial-related stocks, was hurt. Is this poor performance similar to the period when Steve Jobs was producing poor financial results and lost control of his own company? Only the future will tell whether Bruce can snap back, though I hope so. For many years until he moved to Florida, his New Jersey office was about a mile away from my office.

Just as I focused on Magellan in terms of both the investment and business side, I think shareholders need to examine Fairholme. Bruce is managing what he does with a small staff of investment and administrative people. If something unfortunate was to happen to him, I do not see a succession plan in place. Who could run both the portfolio and the business? Unlike the present day Magellan where existing holders may be wise to wait to review the new portfolio manager’s holdings, my fear is that Fairholme’s holders won’t be patient. This does not appear to be a Steve Jobs type of succession in terms of people and products.

Why did I focus on Fairholme and succession issues?

For awhile we did use Fairholme in a number of portfolios that we manage; however we limited the size of the commitment below what we would have done had there been a well thought-out succession plan. Further, we cut back our position, as the fund’s analysis was very different than our views on specific holdings, most particular in the financial sector. (Please bear in mind that I manage a small private financial services fund.) The purpose of sharing my views is to indicate some of the ways I analyze funds and fund managers. Further, as with all good analysts, I could reverse my views on the basis of new information and once again build positions in Fairholme. When Steve jobs returned to Apple, both he and the company were better off than before he left. Both had matured and were ready for exponential new growth. From the time he came back until this last week, the price of the shares of Apple went up 7000%. Thus, there is always hope for a great second act.

Wall Street protesters

I am gathering my thoughts about the significance of these demonstrations. I may devote next week’s blog to thoughts about the meaning of the “occupations” for the rest of us. Please share your thoughts with me on how I should think about these events.
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