By Pat Regnier

(MONEY Magazine) – My wife Kathy and I have just returned home from a Saturday night at the movies. I've put on an old Elvis Costello LP that she hates. Kathy wrinkles her face at me and sorts through the day's mail. There's a bill, another bill, and then there's her latest 401(k) statement. Here comes my comeuppance for subjecting her to "The Angels Wanna Wear My Red Shoes." Kathy reads the statement, chuckles and points gleefully to the line showing the performance of the Transamerica Premier Small Company fund. It's up 16% in the past 12 weeks alone. Kathy has about 20% of her retirement money in this fund, despite the fact that I had strongly recommended against it. (She'd reasoned that she works for small companies, so she must believe in them.) Meanwhile, the fund I had recommended, an international portfolio to which Kathy grudgingly allocated a quarter of her retirement money, is down for the year. Thoroughly delighted, my wife asks: "Well, Mr. Big Shot Financial Writer, just what good is your advice, anyway?"

This is a disconcertingly good question. Just what good is my advice to anyone? You see, I hadn't just warned my wife away from Transamerica Premier Small Company. I'd also tried to scare away another 2 million or so people in a May '99 article for this magazine. I'd conceded that the fund, run then by Philip Treick and Chris Bonavico, had a remarkable short-term record: With an 80% gain, it was one of the best-performing funds of 1998. But I'd also told readers that lead manager Treick was an "arriviste" who had "hit a hot streak." I even compared him with Michael DiCarlo, a star fund manager who'd flamed out in the mid-'90s. The snide title of my story, "Bull Market Genius," said it all: Treick was a statistical fluke. He and Bonavico were buying voguish, overheated stocks, I thought, and their shareholders would suffer.

But Transamerica didn't flop. In 1999 the fund gained another 25% through August, when Treick quit to launch his own hedge fund. His co-manager Bonavico remained at the Transamerica fund, applied the same investing philosophy, and closed out the year up 94%. The fund was badly hit in April's Nasdaq correction, but the fact is that if you had sold it because of my story, you'd have missed out on an 80% profit over the past 12 months.

I blew it. But I didn't blow it nearly as badly as I did in August '99, when a bounce in cheap stocks inspired me to write a story called "Sanborn Is Back in Style." That's Robert Sanborn, who was the fastidiously bargain-conscious manager of the Oakmark Fund and one of the investors I most admired. The ink was barely dry on that item before the long-beleaguered fund began to sink again. Oakmark has lost 18% in the past year, and Sanborn was axed as its manager in March.

This is not the confession of a dumb journalist, or at least not that of an unusually dumb journalist. Every financial publication I know--MONEY, Fortune, Smart Money, Forbes and countless others--has dismally underestimated some managers while overhyping others. A list of the glossy magazines' favorites of five years ago now reads like a memorial to the might-as-well-be-dead. (See "Fallen Stars" on page 98.) Still, I'd always expected to be pretty handy at this game. I've been a certified investing geek for years--my co-workers nicknamed me "Fund Boy" when I started as a MONEY reporter. My first real job was as an analyst at Morningstar, the country's top mutual fund rankings service. I've interviewed hundreds of professional money managers. I've read more fund prospectuses and shareholder reports than any healthy person ever should. And yet the more I learn about mutual funds and the people who run them, the more I suspect that I can never really understand why one manager succeeds and another fails.

Why is it so hard to identify the best money managers and the funds that are truly worth buying? Is there any point in any of us even trying? In the hope of answering those questions, I decided to revisit Sanborn and Treick to see where I'd gone wrong, and I began to re-examine everything I'd previously believed about investing. By chance, my quest began in April, just as the tech-fueled Nasdaq index cratered. It was a timely reminder of how vicious and unpredictable the market can be--always poised, it seems, to wreck the careers of even the most revered investors. Ultimately, I would learn two simple but crucial lessons: 1) Most fund managers are very smart, and 2) being smart isn't enough.


The first stop on my journey was Chicago. I flew there to interview Sanborn, who'd recently lost his job at the Oakmark Fund. As I walked to his office, I could see the tall gray tower where I used to work as a Morningstar analyst. That got me thinking: Is this where I'd first gone astray?

I had arrived at Morningstar in 1994, barely knowing the difference between a bond and a stock. Back then, Morningstar didn't hire analysts for their business experience. They preferred people who could write a clear English sentence for the Morningstar mutual funds newsletter, which had become a bible for brokers, financial planners and regular investors. The company's training for raw recruits was invaluable: Over the next three years, Morningstar taught me most of what I know about investing. But I also picked up a few bad habits there.

For starters, I developed a knee-jerk value bias. Back in the mid-'90s, almost everyone at Morningstar favored value investing, which you might broadly define as buying cheap stocks that most investors hate, in the hope that these disbelievers will later come to their senses. Because value stocks are relatively inexpensive, this is supposed to be a conservative approach. It was once an extremely profitable one too. Investors like Jim Crabbe, whose Crabbe Huson Special fund had one of the best records around until he got hurt shorting tech stocks in 1995, were heroes to the Morningstar analysts of my day.

Don Phillips, Morningstar's high-profile CEO, is a value guy at heart, and we all knew it. He often told us that his first investment as a boy was in a fund run by value legend John Templeton. Phillips does own some aggressive funds today, but he also remains a diehard investor in the Yacktman Fund, an embattled value fund that lost 17% in 1999. And he has his entire IRA in the Clipper Fund, whose bargain-hunting managers have been known to stash nearly half their portfolio in bonds and cash as a safe haven.

Being a value investor isn't only about relishing bargains. It's also about disdaining expensive fads and bull market exuberance. This is often a useful instinct. In fact, it led to the first small triumph of my career. In 1996, I wrote an analysis of a small-company fund called John Hancock Special Equities, which was managed by none other than Michael DiCarlo--the guy to whom I'd later compare Transamerica's Treick. At that time, DiCarlo's fund boasted an average annual return of 31% over five years, beating 99% of all funds. That was largely the result of hefty bets on the tech sector and on IPOs. Without thinking about it very much because it seemed obvious, I wrote that the fund "could take a big hit someday" and that investors should approach it "with a healthy dose of fear."

DiCarlo called Phillips to complain about my analysis. But it was my good luck--and it really was just luck--that I'd "called the top" of Special Equities almost perfectly. In late 1996 small tech stocks fell, and the fund eked out a 3.7% gain vs. 23% for the S&P 500 index. The fund never rebounded, and Hancock eventually killed it. One of my bosses sent a memo to Morningstar's analysts, saying what a fine job I'd done. I even got quoted in a story about DiCarlo in the New York Times--my mother bought five copies. (As for DiCarlo, he now tells me I was "right, but for the wrong reasons." He won't elaborate.)

To me, the lesson of DiCarlo's downfall was clear: A red-hot fund was a failure waiting to happen. After all, most market trends--such as a mania for IPOs--prove fleeting. Trouble is, some trends actually last for years (take the '90s boom in blue chips), and you ignore them at your peril. Skeptics like me have had a costly habit of missing out on big gains, while clinging to the illusory safety of more contrarian funds.

Another thing about Morningstar: We believed that interviewing fund managers was the most important part of our job. Picking the right fund, we figured, is about more than just examining past performance and current stockholdings. It's also about asking, Does this manager really know what he's doing? As a journalist, I still believe in going straight to the source. And I also think investors should read as much as they can about a fund manager before trusting him or her with their money. The danger, I see now, is that you might confuse a smart manager with a smart investment.

Which brings me right back to the subject of Oakmark's Robert Sanborn and his remarkable reading list.


Now that I've copped to one bias, let me confess another. Like a lot of media types, I make snap judgments about people based on the contents of their bookshelves. So it's not hard to see why I'd be impressed with Sanborn. When I arrive at his office at Oakmark's parent Harris Associates--where he still runs some private accounts--I notice that his bookcases and desk are overloaded with books I'd love to borrow. There's everything from Ron Chernow's biography of John D. Rockefeller to a monograph by legal scholar Richard Posner to a memoir by movie agent Bernie Brillstein called Where Did I Go Right?: You're No One in Hollywood Until Someone Wants You Dead.

Sanborn has always cultivated a more cerebral style than most fund managers. His elegantly written, witty shareholder letters might include a digression on the libertarian economist F.A. Hayek or explain that the word amortization comes from the Latin for death. This is one reason why I was always willing to give him the benefit of the doubt. When you're trying to decide if a manager has that mysterious quality called intelligence, the fact that he can quote dead Nobel laureates, although beside the point, may tip the scales in his favor.

Actually, Sanborn has a lot more going for him than bookishness. He's also got a prickly, stubborn personality that any true value investor should appreciate, since value is all about being willing to defy the trend du jour. A year ago, for example, he told me that the people yanking money out of his fund--Oakmark's assets have dropped from $7.3 billion to $2.7 billion since '98--were "idiots" and that the lionized managers at Janus would "get their asses handed to them." (In fact, Janus has performed spectacularly since that prediction.)

Even today, only weeks after having his own ass handed to him, Sanborn is still shooting zingers like, "There are a lot of people who were once good portfolio managers who are now what I call monkeys." Meaning: Most managers are buying overpriced tech stocks only because they'll get fired if they don't. Sanborn continues, "I've had 20 people tell me that you can't pay too much for a company like Cisco Systems. The Japanese basically made that same statement when they bought [the golf resort] Pebble Beach: 'You can't pay too much for Pebble Beach.' You know what? You could."

It's hard to argue with this kind of lucid thinking. Cisco now trades at 120 times earnings, while the S&P 500 has an average P/E of 25. Yes, Cisco is the backbone of the Internet and all that, but can you really justify its valuation on business fundamentals alone? At its current price, Cisco must meet investors' most optimistic expectations or get clobbered.

Cisco seems to be all about hope, while Sanborn's investing is about patience and knowledge. He knows his companies' balance sheets inside and out and typically buys when the stocks cost less than his estimate of what a savvy investor would pay for the whole business. For a while this worked. From '92 through '95, Oakmark was in the top 2% of its peer group. To my mind, his approach makes abundant sense. Yet Oakmark lost 7% from 1998 through 1999, in the midst of a bull market.

What went wrong? Sanborn's most conspicuous mistake was Mattel, which he says he scrutinized at great length. Mattel's since-deposed CEO Jill Barad "was in here 10 times," he recalls, wrapping a rubber band tightly around his fist. Sanborn saw a company that had been hurt by short-term troubles--such as an inventory problem at Toys R Us--but that still had room to grow abroad and through its acquisition of the Learning Co. Even better, Mattel's stock seemed too cheap to get much cheaper. But Sanborn failed to see that the Learning Co. was a terrible acquisition: Instead of earning an expected $50 million in the third quarter of '99, it lost about $100 million. Mattel's stock was slashed by 30% in a single day.

Sanborn's mistake was a humiliating reminder that even the most rational investors can get it wrong. But Mattel wouldn't have been such a disaster if he hadn't also been out of sync with the broader market. At a time when tech stocks were soaring, Sanborn kept just 2.4% of his fund in the sector, which struck him as grossly overvalued. By comparison, an S&P 500 index fund has 13 times that amount in tech. Thus Sanborn missed one of the greatest investment opportunities of the past century.

So should we write him off as a smart guy but a dumb investor? Not so fast. Sanborn insists that he'll be vindicated in the end, and he may be right. Our interview was on April 13, and tech stocks were melting down even as we spoke. Meanwhile, investors were starting to seek safety in the kind of undervalued stocks that Sanborn had picked. Two of his biggest bets, Philip Morris and--yes--Mattel, have surged since April.

This is part of the problem with picking funds: At precisely the moment when you dismiss a fund manager as a fool, the tide tends to turn and he begins to look like a genius again. Likewise, heroes have an unsettling tendency to morph into losers: In the past year alone, George Soros, Julian Robertson and Warren Buffett have each been ignominiously mauled.

As for me, I've learned to hesitate before writing off any beaten-down money manager. When I called Michael DiCarlo in June, he told me that he now runs two hedge funds. So he's still a loser, right? Well, last year one of his funds rose 111%. The other made 353%.


From Chicago, I board a red-eye flight to San Francisco. I arrive at Aesop Capital Partners, Philip Treick's new investment firm, on the morning of April 14. It's the third worst day for the Dow since the '87 crash, and tech stocks are getting killed. I'm fully expecting to meet a distraught and frantic stock jockey. Instead, Treick seems positively elated.

Treick's office in a tony antiques district was once part of a burlesque house, and he still keeps an old sign that survived the gut rehab: GIRLS MUST NOT PUT ON STREET CLOTHES UNTIL CASHING OUT AT FRONT DESK. Standing at his desk, he shows me how he tracks the stocks in his Hare Fund, a hedge fund open only to qualified (read: very wealthy) investors. His computer displays his rising stocks in green and losing stocks in red. "It was like a countdown," he says, describing the moments before the opening bell. "Three, two, one and blam! It was like somebody threw a bucket of blood on the screen." He's losing money--and beaming.

Where Sanborn seems like a college professor, Treick, who is 36, does a great job of playing the frat boy. He went to the University of Wyoming but switched to the University of South Florida, he says, because the weather was better. He's working today in jeans and a leather motorcycle jacket, and he sports a James Dean haircut. He has a habit of calling me "Buddy." And he has a basketball hoop in the middle of his office. As for his bookcase, it's mostly reserved for pictures of his family, though he tells me he reads everything he can find about Winston Churchill. When he's really rich, he says, he'd like to buy one of the prime minister's amateur paintings.

It'd be easy not to take a guy like this seriously. He's too much fun. But Treick is way smarter, I now realize, than I gave him credit for when I first wrote about him.

Treick's success at Transamerica had a lot to do with two stocks, Dell and Amazon.com. His Dell call was undeniably prescient: He first picked it as a young analyst when it cost less than a buck, adjusted for splits. It's since risen fiftyfold. But his heavy bet on Amazon, the sexiest stock of 1998, made me suspect from the start that he was just another price-momentum addict happily riding the latest New Era fad.

When I first met him, Treick's way of talking about stocks like Amazon scared me. Although he visited companies and spent plenty of time scouring balance sheets, he seemed strangely vague about where Amazon was heading. While reporting "Bull Market Genius," I took the entire Transamerica investment team out for lunch. Over plates of greasy Szechuan pot stickers, Treick explained that the important thing about Amazon was that even though it had no earnings, it had enormous cash flow, which would allow it to make fat profits someday. That was all he knew about Amazon's future and all he really needed to know. "If you're going to look at reported earnings," he said, "you'll forever be buying stuff that's already happened."

At the time, this struck me as almost irresponsible. The investors I'd always admired, like Sanborn and Buffett, crave predictability. Buffett favors companies like Coca-Cola, which is virtually guaranteed to make huge profits off products that are already popular. Treick, on the other hand, was betting on a blurry vision of what a much hyped, money-losing company might eventually become. Yet I now realize that Treick was far better attuned to today's fast-changing economy than Buffett, who is famously tech-averse and price-conscious.

To buy a tech stock like Amazon, which has risen about tenfold in the three years since he first bought it for Transamerica, Treick was obliged to embrace uncertainty. "If [an investor] understands what the business looks like five years from now, then one of two things has happened," Treick explains. "Either he's overestimating his ability to look into a crystal ball or it's an industry where there's no change taking place."

Some industries Treick invests in change so fast that many leading firms didn't even exist five years ago. He has little use in these situations for specific long-term predictions, since he knows that any guess he makes will likely be wrong. For him, investing is about picking companies with the cash flow, management and economic scale to crush their competitors in the future. I was so hung up on issues like valuation that I didn't see how powerful his stock-picking approach could be.

It's true that Treick plays a risky game. Amazon was wildly pricey, and it's fallen sharply since we first spoke about it. But Treick's analysis of the business seems to be proving out. All that cash did pay off. It helped to bankroll Amazon's move into new areas like electronics and auctions, and the firm has trounced less cash-rich rivals like Buy.com and CDNow. In time, this should allow Amazon to sell at higher profit margins. "The lower Amazon goes, the more incredibly jazzed I get," says Treick, who still owns it. "Because the one thing I can definitely say with conviction today is that they won."

For years, I'd secretly thought the difference between an aggressive investor like Treick and a value guy like Sanborn was a matter of quality. The Sanborns of this world are contrarian and methodical--that is, smart. The Treicks are faddish and impulsive--that is, dumb. But Treick, like Sanborn, sticks to his convictions, and he digs a bargain as much as anyone. On the brutal day in April when I visited him, he bought while others panicked. "We can now practice our craft," he said cheerfully.

Will Treick's approach always work? No. The Hare Fund has fallen 5% so far in 2000, and he could easily find himself out of step with the market for the next few years. But over the long haul, his chances of doing well are as good as any value manager's. If I were rich enough to qualify, I'd even entrust him with a chunk of my own money.


Back in New York City, I struggle to figure out what it is I've learned. I realize now how closed-minded I was about Treick and how predisposed I was to believe in Sanborn. Yet even without these prejudices, I'm pretty sure I couldn't have predicted which of them would end up on top.

Part of the problem is that you have so little to go on when you pick a fund. You can study its past returns, but as the fine print in fund ads will tell you, "Past performance is no guarantee of future results." Last year the average tech fund rose 136%, while the average small-cap value fund made 5%. Does that mean tech fund managers are smarter than small-cap value managers? Of course not. I've come to understand that--at least in the short run--the manager's skill matters less than the trend he's riding or failing to ride. The market is like the sea: It's unpredictable, and everyone in it (even the canniest sailor) is at its mercy.

The key, then, is to decide whether the manager has merely benefited from fine sailing conditions or is truly gifted. Morningstar tries to do this with its widely used star ratings, which measure not just a fund's returns but the volatility it incurred to achieve them. But thanks to the outperformance of growth stocks in recent years, Morningstar's ratings have gotten out of whack: There are now 190 growth funds with five-star ratings vs. just 30 value funds. If the wind changes direction, these five-star growth funds are likely to disappoint. For all we know, the change may already be under way. In March and April, the average U.S. stock fund with five stars lost money, while one-star funds gained.

None of us know what will rise and what will fall over the coming years--value funds or growth, foreign or U.S. markets, stocks or bonds. So how can we expect to pick the investment heroes of this murky future? Rationally, this means we should just forget about choosing fund managers and should settle for index funds that mimic the market. But you probably won't, and neither will I. Only a quarter of my money is in an index fund. Because the fact is, indexing is too dull and clinical for most of us. We long instead to believe that we can find that rare creature who holds the answers to the market's mysteries. This is a natural human yearning--the investor's equivalent, perhaps, of wishing to believe in the existence of God.

And so it is that I will keep trying to find the manager with the magic touch--or at least with one or two more good ideas than the next guy. I hope to go about it with more humility, though, aware now that it's tougher than I'd ever believed. My ex-boss Don Phillips, who may know more about picking funds than anyone else alive, has come to a similar revelation. "I came into this business making big sweeping moralizations, that this is good and this bad," he says. But experience has made him more circumspect: "I think I'm a lot more agnostic about the market, less certain that there are big answers out there."