Top funds stand by subprime bet

Bill Miller and Ron Muhlenkamp are taking hits now on housing-related stocks. But that doesn't mean they're ready to throw in the towel.

By Penelope Wang, Money Magazine senior writer

NEW YORK (Money) -- Can fund managers be too smart for their own good? You might think so, given the way so many top mutual funds have been crushed by their bets on subprime mortgage lenders and housing-related stocks.

In recent weeks, as mortgage defaults have risen, shares of subprime lenders have plunged. Countrywide Financial, one of the nation's largest subprime lenders, sank 16.1 percent in the past month. Similarly, homebuilder stocks continue to slump - Pulte Homes (Charts), for one, is down 19 percent over the past year.

This debacle has damaged the returns of many of the best fund managers around, including Bill Miller of Legg Mason Value (with a loss of 1.6 percent year to date), Ron Muhlenkamp of the Muhlenkamp fund (- 3.7 percent), and Wally Weitz of Weitz Hickory (- 0.7 percent).

All three have held on to these stocks in the belief that real estate will rebound.

How did these smart stock-pickers make such a big mistake? Well, actually, they don't see it that way. For these managers being out of step with the market is a sign that they are doing their jobs. After all, the best way to earn returns is by spotting opportunities long before everyone else.

Take Bill Miller, who made headlines last year when he failed to beat the S&P 500 for the first time since 1991. Legg Mason Value (LMVTX (Charts) recently held a hefty 3.5 percent of its assets in Countrywide (Charts), which makes it one of the fund's top 10 holdings.

Miller has built his record by standing by his convictions - last year, for example, he stuck with Yahoo, despite its lousy stock performance. That stock is up 20 percent this year. So it's no surprise that the fund is hanging on to its stake in Countrywide.

"The fallout among smaller subprime lenders will give survivors like Countrywide even more market share," says Legg Mason analyst Mitchel Penn, who points out that Countrywide, which gets only 10 percent of its revenues from subprime lending, continues to deliver solid growth. "We liked the stock when it was trading at $44 a share," says Penn, "and we see even more value now."

And The $2.3 billion Muhlenkamp (MUHLX (Charts) fund, with a 4.5 percent stake in Countrywide, is also holding firm. "We think the economy hit a low in the third quarter of last year and is headed for a soft landing," Muhlenkamp says. "There's usually a delay until the worst of the bad news trickles out. And if you can buy stocks like Countrywide while they are still out of favor, you are getting a great deal."

He adds, "If I didn't already own the stock, I would have to buy it."

Still, as Muhlenkamp readily admits, his strategy can sometimes lead him into stocks too early or cause him to hang on too long.

Last year, for example, he held a large position in homebuilder stocks, which plunged in value. His fund gained only 4.1 percent, one of the worst showings in his category, although the fund's five-year return remains in the top third of his peers.

"I didn't anticipate how quickly the industry would fall off - and how investors would move out of these stocks," Muhlenkamp says. Over the past few months, he has trimmed his homebuilder stake by half.

One of the largest real estate bets can be found in $394 million Weitz Hickory (WEHIX (Charts), which has invested more than 20 percent of its portfolio in mortgage- and housing-related stocks. Among the funds' biggest holdings: Countrywide, Redwood Trust, and Newcastle Investment. (Weitz could not be reached for comment today.)

"Weitz is a fearless contrarian," says Morningstar analyst Todd Trubey. "If things fall 80 percent or 90 percent, that's when he gets interested. And if he thinks a stock can weather the storm, he will hang on or even increase his stake."

Weitz's strategy has delivered solid results over the long term - its three-year annualized return of 12 percent ranks in the top 40 percent of its peer group. But shareholders had to sit through a rollercoaster performance, with chart-topping gains one year followed by subpar returns the next.

"Anyone who owns any of one of these contrarian funds has to remember to focus on the long-term," says Trubey. "You need to understand that you will be in for a bad quarter, or a bad year, or longer."

Over the long run, these managers have been right a lot more often than they have been wrong. And they may do well again. Still, if you can't stand the suspense, you may be better off in a less risky fund instead.


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