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Morningstar FundInvestor
December
2015
Valeant Pharmaceuticals
’
VRX
recent plunge—and
the pain endured by its largest shareholders—
highlights the risks of taking large bets on individual
companies. Several fund managers held sizable
stakes in the stock, though
Sequoia
SEQUX
stood out
for its position, which reached
29%
of fund assets
in mid-
2015
. The fund lost
22%
from August
2015
to
November
2015
as Valeant’s stock price fell
65%
on
allegations of fraud and aggressive pricing practices.
That’s not to say investors should avoid concentrated
funds. Patient investors with long horizons may find
much to like with them. In fact, Morningstar’s fund
analysts assign Sequoia a Morningstar Analyst Rating
of Gold, reflecting their view that it’s a best-of-breed
fund for investors willing to ride out short-term bumps.
Still, it’s worth noting when a fund’s concentration
markedly changes. Some fund shareholders certainly
noticed that Sequoia’s stake in Valeant had more
than tripled as a percentage of the portfolio during
the past three years. Keeping an eye on such changes
helps keep investors apprised of the risks they face.
To identify situations where concentration risk has
grown, we screened the Morningstar
500
for
funds that have meaningfully increased their alloca-
tion to their top
10
holdings during the past three
years. While the funds below don’t carry as much
stock-specific risk as Sequoia, the recent changes
still merit consideration.
Royce Special Equity Multi-Cap
RSMCX
and
Royce
Special Equity
RYSEX
have become considerably
more concentrated in the past three years. The top
10
stock holdings grew to
58%
of assets from
34%
in the former, and to
48%
of assets from
33%
in the
latter. Each fund currently keeps more than
7%
of
assets in its largest holding, compared with less than
4%
three years ago. As the market rally gets long
in the tooth, manager Charlie Dreifus says he’s found
more names to sell than buy. He’s a stickler on valua-
tions and faces the challenge many value managers
do after a long rally. His strong record of managing
risk is comforting. Still, the funds’ recent change in
complexion bears monitoring. Several top names have
turned in double-digit losses in the year to date
through November
2015
.
Westport
WPFRX
has also consolidated its portfolio.
During the past three years, the fund’s number
of positions has fallen to
32
from
50
, while its top
10
names have grown to
54%
of assets from
31%
. It’s
nice to see that the top holdings have long held spots
in the portfolio.
Universal Health Sciences
UHS
,
the largest position at
8%
of assets, was first bought
in December
2008
, and all of the other top
10
names
were purchased in
2011
or earlier. Longtime skipper
Ed Nicklin is in his late
60
s, and the firm’s co-owner
Andy Knuth is in his mid-
70
s, which raises concerns
about succession planning, another red flag.
Delafield Fund
has about
40%
of assets in its top
10
positions, marking a notable increase from
25%
three years ago. It focuses on small- and mid-cap
companies and holds no more than
5%
of assets in
any stock. While that may not seem to court sig-
nificant company-specific risk, the fund stands out
versus small- and mid-cap competitors, which
tend to have more-diversified portfolios compared
with large-cap strategies. The average small-cap
fund holds
22%
of assets in its top
10
holdings, while
the typical mid-cap strategy stashes about
27%
of assets in its
10
largest positions. Delafield is also
concentrated from a sector standpoint, with
82%
of the portfolio invested in just three sectors: materials,
industrials, and information technology.
K
Contact Leo Acheson at
leo.acheson@morningstar.comRising Concentration Points to
New Risks
Red Flags
|
Leo Acheson
What is Red Flags?
Red Flags is designed to alert
you to funds’ hidden risks. Such
risks can take many forms,
including asset bloat, the
departure of a solid manager, or
a focus on an overhyped asset
class. Not every fund featured
in Red Flags is a sell, and in fact,
some are good long-term
holdings. But investors should
be prepared for a potentially
bumpier ride in the near future.