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Russell Fuller
The foibles of human behavior create opportunities for investors like Russell Fuller, manager of the Undiscovered Managers Behavioral Growth Fund.
According to Fuller, who specializes in the arcane science known as behavioral finance, analysts and investors make the same mistakes over, and over, and over. Investors who understand those patterns, he believes, can pinpoint mispriced securities.
"Whenever you're dealing with humans, systematic mental mistakes will always happen," says Fuller. "What we try to do is identify situations where investors are making those systematic mistakes."
Stock analysts typically make two common errors, he says. The first, called "anchoring," is basing perceptions about what you don't know on what you already know.
"Let's say someone who lives in San Francisco, which as a population of about one million, is asked to estimate the number of people in New York. He knows New York is bigger than San Francisco, so he'll probably say something like three million, which is less than half the correct figure. But three million seems right to him because he's basing his estimate on what he knows about San Francisco."
Similarly, securities analysts anchor by basing any changes in earnings forecasts on what they've already predicted. "Basically, they are anchored to a preconceived notion, so it's unlikely that they will change their forecasts too dramatically, even if such a change is warranted," says Fuller.
The other common error is overconfidence. "Humans are grossly overconfident about what they think they know," says Fuller. "And financial analysts are more overconfident than the general population. So when new information comes in that should cause them to reconsider their earnings estimates, they will probably under-react to it, or ignore it altogether."
Fuller tries to find companies that have experienced some kind of fundamental, positive change that the market is not recognizing because of anchoring or overconfidence. He analyzes companies that have recently announced higher than expected earnings, and tries to determine whether the market value of the company's stock fully reflects his expectations about its future growth potential.
The earnings change must be caused by something that's likely to be repeated, such as revenue growth or an improvement in gross profit margins. That was the case with Best Buy, a consumer electronics chain and the fund's largest holding. He started buying the stock in September 1997, when it was selling for $12 a share. It had been stagnating at that level for three years.
Although the company announced a positive earnings surprise in the third quarter of 1997, investors remained skeptical because the company had been down for so long. "When I looked at Best Buy, I saw that the upward earnings revisions came from fundamental, lasting changes, not accounting fluff," says Fuller. "The company had gotten its costs under control, and had a more efficient distribution system." The stock now sells for about $70 a share.
But even experts in human mistakes sometimes make them. From time to time, Fuller buys stock of a company that reports a positive change in earnings one quarter, but fails to sustain that growth momentum. That happened early last year when he bought stock in a medical supply company called Merix at $19 a share, just after the company reported a significant, positive change in earnings. He sold the stock three months later after the earnings change proved to be a fluke, and the stock plunged to $14 a share.
So far, though, Fuller has been right more often than he's been wrong. During 1998, the fund's first full year of operation, its net asset value was up over 33 percent.
Because earnings momentum is an important component of Fuller's investment process, Undiscovered Managers Behavioral Growth Fund is, as its name suggests, a growth fund. The portfolio, which contains stocks of small and mid-sized companies, has a median market capitalization of $800 million.
The fund is part of a seven-member family founded by Mark Hurley, a former research analyst at Goldman Sachs who launched the Undiscovered Managers Funds in early 1998. Each of the funds is sub-advised by a small, "undiscovered" institutional money manager that Hurley has pinpointed as having a distinguished, but under-recognized, investment track record.
The premise behind he Undiscovered Managers Funds is that having a large amount of assets under management is not necessarily a good indicator of a manager's ability to invest. According to one study, 71 percent of the top performing managers are with smaller firms. And, these managers tend to deliver better performance in bear markets.
Besides being run by smaller investment management firms, the funds have other common characteristics. All are concentrated portfolios that each hold between 25 and 55 issues. Behavioral Growth has between 40 and 50 stocks. They have relatively low turnover designed to reduce short-term capital gains and income, and increase long-term capital gains, which are taxed at lower rates. And all the funds are available only through fee-only or fee-based financial advisors.
Name: Russell J. Fuller
Born: May 31, 1945, Scotts Bluff, Nebraska
Education: Bachelor's, masters, and PhD degrees from the University of Nebraska
Professional experience: Professor of finance, Washington State University; vice-president, Concord Capital Management; founded RJF Asset Management in 1993, and has been sub-advisor to the Undiscovered Managers Behavioral Growth Fund since its inception in December 1997.
Interests: Scuba diving, skiing
Name: Undiscovered Managers Behavioral Growth Fund
Assets: $25 million
Top five holdings: Best Buy, General Instruments, Lexmark International, Qlogic, Idec Pharmaceuticals
Performance*:
YTD: +1.1 percent
One Year: + 33.2 percent
*Year-to-date as of 1-14-99. One-year performance as of December 31, 1998.
Sales charge: No-load
Minimum initial investment: Available only through fee-only or fee-based advisors, who set investment minimums.
Telephone: 888-242-3514
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