Jim Cramer's Stay Mad for Life

by James J Cramer

  I have never favored investing in mutual funds, but I realize there’s a huge need for good mutual fund advice, and it’s one that’s not really being met. So I decided I would take my perspective, my years of money management experience, and come up with a truly rigorous method for evaluating mutual fund managers and, by extension, the funds they manage. If you’re going to invest in mutual funds, you should at least have some good advice before you do it. As I was telling you before, most of the companies that rank or rate mutual funds do so either in a way that’s easy to understand and totally without value—for example, by looking only at the performance of a fund over a certain time frame, or in a way that’s much more comprehensive but also totally opaque. You can devise a system to rate mutual funds based on performance, risk, consistency, fees, taxes, you name it—a really comprehensive method—but if you tell people only the end result, what grade the fund gets, you’re not really giving them very much information. What does a high rating mean? Does it mean you should invest in the fund? Does it mean that within its category the fund is better than its competitors? Is it predictive or not? These are questions that don’t get answered.

  To give you a comprehensive list of well-managed mutual funds, I had to come up with my own methodology, one that would consider the variables that I believe are of the utmost importance when evaluating a money manager. I put my system together (I’ll explain it momentarily) and I compiled a list of actively managed mutual funds with their managers that I believe will not only make you money over the long term but will outperform the benchmarks. That’s what really counts.

  Before I discuss my system and my list of funds, I have to give you all the big caveats. First, nobody ever got upset because he or she invested in an index fund. I know that many of you want an actively managed fund anyway, but if you haven’t even considered investing in an index fund, take a minute to think it over. Your fees will be much lower, which means that you start with a big advantage. Index funds also outperform the majority of actively managed funds in any given year. They are a good, intelligent investment. Second, I believe that it’s the fund manager who makes or breaks the fund, and if the manager at any one of the funds I’m listing in this book leaves, you should leave too. You’ll need to do homework to check on this, because mutual funds are notorious for not alerting you when they replace your fund manager for whatever reason. Third caveat: I have a talent for picking stocks; I’ve done it successfully for decades, and my record at my hedge fund of compounding at 24 percent annually after fees speaks for itself. But this is my first time taking a truly rigorous look at mutual funds. I believe this is the first time anyone has taken a rigorous crack at mutual funds using my criteria, so I might not be a great picker of money managers. I think I’m better positioned to evaluate money managers than are the vast majority of the people who write about funds, but there’s still a chance that I’ll be wrong. With that in mind, let me explain my system and then I’ll show you the results.

  When you’re looking for a good mutual fund, focus on performance: how much money will the fund make you? The people who rank funds to extrapolate from past performance try to give you a picture of how a fund might perform in the future. The smart ones who try to do this realize that recent performance is not a great indicator. The period being considered is just too short to get any kind of decent idea about a money manager’s prowess. Instead of using a fund’s results over the past year, what we usually do is look at its five-year and ten-year returns. That’s a long enough time to give you a pretty good idea about the fund manager’s abilities. That way we eliminate the hot funds that tend to burn out right when you put your money into them.

  My method is a variation of looking at past returns to assess a money manager’s abilities and predict how he or she will do in the future. Because I myself was a money manager, I have my own unique perspective that I believe makes my system better than any other that I’ve seen. I wanted to find funds that made money when the market was going down. The ability to make money in a down market is the true mark of a great manager. Some people think that you invest in an actively managed fund because you hope it will beat the S&P 500, or whatever benchmark you decide is relative. I don’t think that’s quite true. You don’t get a money manager in order to outperform the indexes every year, although that’s great if you do. You get a money manager in order to avoid declines. If you invest in an index fund, it goes down when the benchmark does down; there’s nothing to be done about it. But when you put your money in an actively managed fund, you expect your manager to sidestep at least some of those declines. Mutual funds with managers exist to protect your capital against downside risk. It’s not so important that they deliver additional upside. Anybody can make money in a bull market. You probably remember the late ’90s when everybody decided to be a so-called day trader and regular investors were making a killing left and right. It seemed as though stocks always went up, right? Well, in fact, that’s pretty close to the definition of a bull market. Stocks go up and it’s easy to make money. You don’t need a pro for that. You get a pro to make sure you’re still making money, or at least not losing it, when we’re in a bear market.

  With that in mind, I decided that I would weigh the performance of mutual fund managers in the off years, the years the market was down, more heavily than their performance in the good times. I think this method makes a lot of sense because it measures what you actually want in a money manager, or at least what you really should want in a money manager: someone who can hold off the downside. From the beginning of 2000 to the end of 2006, we had three bad years, 2000 to 2002, and four good ones, 2003 to 2006. I believe that the managers who outperformed in 2000, 2001, and 2002 deserve much more credit than the managers who outperformed in later years. If the S&P 500 is down double digits for the year and your mutual fund is up at all, let alone up double digits, you’ve got a good mutual fund. Over the long term, the fund managers who can make money in any kind of market will do a better job running your money than the guys who perform well only when times are good, or an index fund. If you don’t take big losses when the market’s hurting, then even if your gains are smaller when the market’s strong (this is just hypothetical; the vast majority of the funds and fund managers I’ve selected continued to beat the market from 2003 on), you’ll outperform over the long term. Consider what would’ve happened to you if you put $100 into a great low-cost S&P 500 index fund, the Vanguard 500, at the beginning of 2000. You were down 9.06 percent in 2000, another 12.02 percent in 2001, and then in 2002 you went down even further, by 22.15 percent. After three years of losses, that $100 would be down to $62.28. Then, in 2003, things turned around, and you would have been up 28.5 percent, which translates into a $17.74 gain. Suppose you had a good money manager who simply kept you from losing money from 2000 to 2002. Even if that manager underperformed the S&P 500 in 2003, he or she could still make you more money because a 20 percent gain, worse than the S&P 500 did in 2003, translates into a $20 win off a $100 base. Those who have more money make more money. That’s why preservation of capital is so important, and why you want a money manager who knows how to win when everyone else is losing.

  Here’s the nitty-gritty explanation of how I got my list of thirteen mutual fund managers with their mutual funds that I think are worth your time and money because I believe that they will, on average, outperform the benchmarks over the long term. First, I looked at only actively managed stock funds. There are two reasons for this: performance in a bond fund is a lot more uniform, and it’s really difficult to compare a fund that’s all stocks with a fund that’s a mix of stocks and bonds, an apples-to-oranges comparison. I wanted to build my mutual fund list on apples-to-apples comparisons. I have three lists: one for aggressive-growth funds, one for growth funds, and one for value funds. To some extent I think these categorizations are silly and unhelpful, but they’re already widely used. I wanted to produce fifty great mutual funds, but as it happened only thirteen met my criteria. I
could have loosened up my standards to generate a larger list, but I didn’t feel comfortable putting my seal of approval on funds that probably don’t deserve it. You have to admit: it is saying something about an industry when you set out to find fifty great products and you can’t. If we set out to find fifty great restaurants, we would probably have to start by cutting five hundred just to make the list manageable. But then again, that’s food; this is only money!

  I took lists of the fifty best-performing funds in each category for every year from 2000 to 2006. By the way, these are all diversified mutual funds, and any one of them could be a place for you to invest all of the money you want to put into stocks. Within these lists, I isolated the funds that made money in 2000, 2001, or 2002, or at least outperformed the market in these years and were among the best performing funds in their category at the time. These are the funds that made the core of my lists. Then I considered their performance from 2003 to the end of 2006 to rank the funds, excluding from my final lists any of the initial funds that did not perform well during this period. Because I believe that a fund’s performance is the manager’s, not the fund’s (even if a good manager is gracious and willing to give full credit to the team), I looked only at funds that had the same manager over this entire span of time. It would be unfair to give one manager credit for gains that the previous manager had actually racked up just because they were at the same mutual fund. I used data provided by some very helpful people at TheStreet.com Ratings, which is a great service that rates everything from stocks to funds to HMOs, and Morningstar to do my analysis.

  After this process I arrived at thirteen actively managed mutual funds that were up to my standards, or, I should say, that have managers who are up to my standards: five aggressive-growth fund managers, two growth fund managers, four value fund managers, and two honorable mentions. Because it’s not important to me how a fund performs within its category (I want to know only how it performs compared to the market), I didn’t try to come up with the same number of funds for each category. My method does not compare aggressive-growth funds only to other aggressive-growth funds, or value funds only to other value funds, but compares all funds against the market. My standards are objective. You don’t need to know the ten best funds in each category. You just want the best funds with the best fund managers.

  Before I dive into the list, I want to give you some pointers about mutual fund investing, because it’s a subject that confuses a lot of people. One mistake most mutual fund investors make is putting their money in too many funds. Ideally, you don’t want to spend hours and hours looking through funds to try to find the best five or six managers and “diversify” your mutual fund holdings across different fund categories. That’s the wrong move. You want a mutual fund because you don’t want to spend so much time thinking about where to invest your money. You want someone else to do that for you. With any advice in this book and the great fund managers I’ve picked out, you’re in good shape. So how many mutual funds should you actually own? If you can find one well-diversified fund—and the actively managed funds I’m giving you are all diversified by sector, meaning they don’t have too much concentration in any one industry—then the answer is one. I realize that makes some people a bit nervous, and there are certain situations and times when you would want to own more than one fund. For example, many of the funds on my list focus on small-cap stocks, and one is a micro-cap fund, which means that these funds own stocks of only small and tiny companies. You don’t want to put all of your eggs in one small-cap basket. So if you see a small-cap fund on this list that you really like, you shouldn’t invest all of your assets in it. Instead, give no more than half of your assets to any small-cap fund. If you like a fund that invests in large-cap stocks, big companies, you don’t need to diversify into a small-cap fund. The reason you should avoid exposing yourself 100 percent to small-cap stocks is that they’re inherently more risky than larger companies, although they also tend to have more upside.

  Remember, when you’re picking mutual funds, you still have to do research on the fund once you are in the fund. You can’t forget about it. You don’t have to follow it as closely as a stock, but if you are in too many funds, you will end up spending more time following them than you care to. If you want to diversify across different approaches—so that you own one aggressive-growth fund, one growth fund, and one value fund—you can, but I should caution you that these investing styles aren’t as important as the quality of the fund manager and the stocks your manager picks.

  In my list of funds, I’ve got everything you need to start being a great mutual fund investor. I’ve included the symbol for each fund so that you can look it up on any Internet site that you’d normally use to look up stocks. This is your one-stop shop for mutual fund investing. If you’re attracted to one of the funds I’ve picked, look it up and you’ll be able to see which brokerage houses sell that particular fund. You can either call one of those brokers or use their website to set up an account and invest in the fund of your choice, or you can talk to your own broker or access your broker’s website to see if they can help you.

  This is not just a list of funds with great managers. I’m also including my observations about who these funds would be good for: which funds would be best for young investors, which ones for older investors who are more conservative, which fund is the best one to give your mother-in-law (if you get along with her), which fund you should buy for your kids thanks to the Uniform Gifts to Minors Act—it’s all in there. (UGMA, by the way, is a law that lets you give assets like stocks and mutual funds to a minor, such as one of your children, without having to set up a trust fund. You just have to appoint a custodian for the money, which your child can access as soon as he or she turns 18 or 21, depending on your home state. You can give up to $12,000 in gifts a year to any one person without having to pay a gift tax. It used to be the case that UGMA was great because when you gave one of your kids stock or shares in a mutual fund, he or she would pay lower taxes on the gains, assuming that your kid doesn’t have nearly as much income as you do, or any income for that matter. Unfortunately, the rules have changed. In 2007, only $1,700 worth of a child’s unearned income can avoid being taxed at the same rate you, the child’s parents, pay. Still, $1,700 a year isn’t chump change, and if you want to give your children some exposure to mutual funds, the gift that truly keeps on giving, you should definitely take advantage of UGMA.)

  One last point before jumping into the list: many of you don’t have time to read through this whole list, or aren’t interested even though you want to make money. For you, I’m including a quick guide to being a good mutual fund manager that won’t take you more than a minute or two to read, right after I tell you about these great funds and great managers.

  These funds are all in roughly descending order, because they appeal to different investors. You can’t just say, “This fund is the best,” unless you take your age and risk tolerance into account. But to the extent that you can ignore those two factors, the best funds are at the top of the lists, becoming less great as you go down the lists.

  Aggressive-Growth Funds

  1. CGM Focus Fund (CGMFX), run by Ken Heebner. Heebner is one of the best, perhaps simply the best, mutual fund managers around. I think his style has a great deal in common with my style when I was at my hedge fund. Heebner’s returns are spectacular. His performance in 2000 and 2001 was simply awe-inspiring. His Focus Fund is all stocks, although he can invest in fixed-income instruments and he can short stocks in this fund, which gives him a big advantage. Heebner made a killing shorting tech stocks in 2000, which is exactly what I was doing at my hedge fund at the time. Very few mutual funds actually short stocks, even though many are allowed to. According to Morningstar, only forty funds that hold long positions also have more than 20 percent short exposure. Short-selling is when you borrow shares of a company, sell them, and then buy them back at a later date to return them to whoever lent you the shares. If your short is good,
the stock will go down after you sold it, allowing you to buy the same number of shares at a lower price and pocket the difference. Rather than buying low and selling high, shorting is when you sell high and then buy low. Most mutual funds won’t short stocks because it’s much more risky than simply buying. If you buy a stock, the worst that can happen is that it goes to $0 and you lose all of the money you invested in it. If you sell a stock short, you can have much bigger losses. You could short a stock, and then if it triples you’ll be down 200 percent on that trade. Heebner’s unique in that he’s willing to take on this risk, and he consistently shows that it’s worthwhile even if he is sometimes wrong.

  Heebner got into the great real estate market early and got out in 2005, because he could see that borrowers with wacky mortgages and poor credit would pull everything down. He made a big bet on copper in 2006 at the same time I was advocating owning copper producers on my show. The guy knows how to make money. He knows how to win. He likes a lot of the same stocks I do, but the proof is in the performance. Heebner’s CGM Focus was the best performing aggressive-growth fund in 2000, when it was up 53.93 percent, and again in 2001, when it was up 47.65 percent—keep in mind that the S&P 500 was down double digits in 2001—and he was number one again among aggressive-growth funds in 2005. Heebner has a record of outperforming when the market is taking a beating. Although he was down 17.79 percent in 2002, a rough year for everyone, he still came in ahead of the market. And he bounced right back with a stellar 66.46 percent return in 2003. Before the great tech bull market in the late ’90s, Heebner’s other funds were some of the best in the business, and he was producing similarly great returns, but he didn’t make a lot of money in the late ’90s, when everyone else was practically printing it. That’s because Heebner does his homework. This is a man who clearly has the right kind of work ethic and who relies on his research and his good judgment. He couldn’t get behind radically overvalued tech stocks in the late ’90s because he had no conviction in them. I was more cynical, but over the long term Heebner was right, and he made his investors a lot of money. This is not a fund that never goes down, and it’s not a fund that gives you the same consistently solid return every year. But Heebner does know how to make money, lots of it during the bad times, and though his returns vary wildly, most of them are wins, and really big wins at that. Heebner and CGM Focus are not for the faint of heart, but if you want to make a lot of money and you don’t mind risking losses every now and again, this is the mutual fund for you.