To Design a Poor Investor, Look No Further Than the Typical Mutual Fund

Ninety-seven percent of all stock mutual funds are down from where they stood at the beginning of 2008. If you are surprised by this not-so- trivial piece of trivia, you shouldn't be. Very few mutual fund managers actually manage their funds in a way that could produce meaningful outperformance. So if it's outperformance you want, you'll probably have to do it yourself.

According to Morningstar, the average stock fund rose 35% last year... But that wasn't nearly enough to overcome the 41% loss the year before. Only six funds achieved double-digit returns across the two-year span. And only two - two! - US equity funds have produced an annualized return greater than 10% during the last three years.

I've long held that mutual funds are full of bad habits, like a boy who can't stop picking his nose or burping at the dinner table. If you had to design a poor investor, you would need look no further than the typical mutual fund. For example, the typical mutual fund turns over its entire portfolio at least once per year and owns 160 stocks. These are two things that often lead to mediocrity: too much trading and too many stocks.

All that churning fattens the brokers of the funds. And the mutual funds often have unseemly arrangements to direct commissions to brokers who help market the funds. Owning all those stocks also means the fund managers often know little about what they own. No individual stock matters much, nor does any single issue make much of a difference, so why bother looking at any of them in detail? It is little wonder the typical mutual fund produces such an indifferent result.

So I believe you're much better off buying a small basket of stocks that meet my four basic criteria: priced cheap, in good financial shape, with a business model that's easy to understand, run by managers who own a good chunk of shares themselves.

One of the best ways to find stocks exactly like these is to comb through 13-D filings - which is a bit like panning for gold. The process is very time-consuming and the payoffs are rare. But investors who have the time and aptitude to conduct this sort of research can greatly improve their odds of success...and the magnitude of those successes.

A 13-D filing occurs whenever an investor buys more than 5% of a public company. This filing, by itself, tells you nothing. You've got to do a lot more research to determine the whos and whys of each filing. But when you come across a filing by a known "activist" shareholder, you are usually onto something worthwhile.

Yankees slugger Reggie Jackson once described himself as "the straw that stirs the drink." An activist shareholder is kind of like that. Having one of these guys in a stock you own is like having the home run-hitting Reggie Jackson in the middle of your lineup. The game can change in a hurry.

An activist is someone who takes a big position in a stock with the intention of using that clout to change things. Possible changes might include pushing for a new board of directors or for selling part or all of the company. The idea is to actively unlock value in the shares, rather than sitting back passively and hoping for the best.

You've surely seen the names of high-profile activists in the papers... Bill Ackman, Nelson Peltz, Carl Icahn and many others... Their activist exploits helped make them very wealthy.

As investors, we can tag along in such efforts because anytime someone buys more than 5% of a company's stock, he has to file a 13-D with the Securities and Exchange Commission within 10 days of doing so. You can track 13-Ds by trolling around on the SEC's Web site or by subscribing to a service that tracks them for you. Barron's and some other publications also highlight 13-D filings on a weekly basis.

These 13-Ds are great for investors like you and me. They are like little bells that go off alerting us that we should take a look at the stock. We won't buy all the 13-Ds we come across. But over the course of an investment life, we will find some fat pitches to put over the wall.

One of the stocks I recommended recently to the subscribers of Mayer's Special Situations came to my attention by way of a 13-D filing by KSA Capital Management. In that 13-D, KSA disclosed that it owned 14.1% of the company. It bought shares between $33.39-39.18 per share from Oct. 1-Nov. 4. On Nov. 10, KSA's managing member, Daniel Khoshaba, sent management a letter in which he outlined his case that the stock was dramatically undervalued and that management should put the company up for sale. The stock is AEP Industries (AEPI).

AEPI is currently trading for about $34 per share - very close to the lowest price KSA paid for its stake. But KSA paid as much as $39.18. Why? Because Khoshaba believes AEPI is worth about $110 per share. Obviously, if Khoshaba's estimate is in the ballpark, investors could make a sizeable gain buying the stock at the current quote.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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