The mad genius of mutual funds
Ken Heebner is a maverick manager with an amazing history of making big winning bets on stocks and sectors.
(FORTUNE Magazine) - What does it take to be an investing genius? For starters, you've got to have the guts to go against the herd. And that's a quality Ken Heebner of CGM Funds displayed as far back as college. As an undergrad at Amherst in the early 1960s, Heebner participated in a psychology-class experiment that was supposed to demonstrate how easily people can be swayed by the views of others. Heebner was asked for his impression of a painting and then ushered to another room where an "expert" offered an opposing viewpoint. Then Heebner was asked once again what he thought of the painting. Says Heebner: "They told me afterward that I was the only one who showed no evidence that other people's opinions had any effect whatsoever on what I thought."
That independent streak has helped make Heebner one of the most successful - and original - investors of his time. In an era when most fund managers seem more concerned with beating indexes than beating paths to glory, Heebner isn't afraid to follow his instincts. He makes big bets on companies and sectors, pulls the plug quickly when conditions change, and dares to short blue chips like Dell (Charts) or Wal-Mart (Charts) that he deems overvalued.
When Heebner is wrong, he'll grossly underperform the market (though outright yearly losses at CGM Realty and CGM Focus, his biggest funds, have been rare). But when he's right, the gains are astronomical. CGM funds aren't for everyone, especially investors who crave predictability. Morningstar, the fund research firm, goes so far as to label his style "too gutsy to be practical," although that strikes us as unfair. Gutsiness has always been integral to investing greatness.
And there's no question Heebner is one of the all-time greats. Today he manages $6.6 billion, most of it in four CGM mutual funds: his flagship Capital Development (now closed to new investors), Focus, Realty, and Mutual, which holds a mix of stocks and bonds. Realty has the best three-year, five-year, and ten-year returns in its Morningstar peer group. Focus has returned 30.5% annually over the past three years. And while Legg Mason's Bill Miller may be the fund world's brightest star, Heebner's Capital Development fund has actually outpaced Miller's Value fund since the latter debuted in 1982. Going back further, in the 30 years since Heebner took over the fund in 1976, Capital Development has trounced the S&P 500, gaining an average of 17.2% a year, vs. 12.8% for the index.
Best of all, Heebner is getting better with age. His last six years have been stellar as well as redemptive, coming on the heels of the late-'90s bull market that flummoxed the tech-averse Heebner. Focus, his biggest fund, returned just 3.5% in 1998, vs. 28.6% for Standard & Poor's 500. Realty lost 21.2% that year. But he's been on a roll since 2000, with a series of remarkably prescient calls. In 2000 he made a bundle short-selling tech and telecom stocks. In 2001 he made a huge - and hugely profitable - bet on homebuilder stocks, which soared over the next three years.
Yet despite the fact that he became a vocal cheerleader for the sector, he never fell in love with his winners as so many investors do. Just as the housing boom neared its peak, he grew worried about the proliferation of what he termed "funny-money mortgages." Heebner ruthlessly unloaded every homebuilder share he owned by early 2005 and plowed the proceeds into energy stocks - even in the Realty fund - right before oil prices took off.
Then, in late 2005, he doubled down on commodities with a big bet on copper, the price of which has risen 67% year to date. "Ken is one of the best big-picture thinkers I've known," says his friend Chuck Clough, the former Merrill Lynch chief investment strategist. "He does the research, and he's got the courage of his convictions."
FORTUNE senior writer Jon Birger recently caught up with Heebner for a wide-ranging talk on the stock market, the art of investing, his aversion to vacations, and why, at age 65, he has no plans to retire.
Your investment style is quirky. How do you define it?
I've never done a good job answering that question, and that's probably why there are people better at selling themselves than I am. I've made the most money when my strategy was something few people agreed with. My huge outperformance occurs when I find one of these very contrarian strategies - something supported by a lot of deep analysis - and implement it in a concentrated way in the portfolio. Like investing in oil in 2004, when everyone thought it was going back to $25 a barrel. Or buying savings-and-loans in 1982, back when interest rates were 15%. I wish I could find one every year, but I can't.
CGM funds aren't real popular with 401(k) plans or pension consultants. [According to Schwab, only one of the 750 401(k) plans it administers offers CGM funds.] Does this bother you?
People get scared when they see how my returns vary. The consultants don't want you straying that far from the benchmarks. That's a problem for me, because I don't pay attention to benchmarks.
Are you surprised your bet on copper has paid off so well?
It's gone up more than I thought it would, but there's a real supply-demand imbalance. Copper goes into the infrastructure of all developing nations, of which India and China are the most publicized but not the only ones. Copper production hasn't been able to grow fast enough to keep pace with demand. When you look around the world today, the earliest we can see incremental new production coming online is 2009 or 2010.
Now one of the things that usually happens when the price of a commodity rises like this is you get demand destruction. But in the case of copper, 75% of its use is for wiring, and there aren't good substitutes. Aluminum and silver have superior conductivity, but silver is much too expensive, and aluminum isn't practical, because it's bulky. So you're not seeing demand destruction in copper, and when you don't have demand destruction, prices keep going up.
I look at the prevailing expectations. There is nobody I know of who's forecasting that the price is going to stay this high [$3.54 a pound in early June]. The consensus estimates are for a sharp decline down to around $1.50 a pound.
Which you actually see as bullish.
Yes. It encourages me because I have reasons why I think it won't go down. That said, I don't have same level of conviction as I did last year.
When we discussed copper last fall, you clearly knew a lot more about the supply outlook than most commodity analysts. Copper production is water-intensive, and you mentioned water has been in increasingly short supply in some mining regions in Chile [the world's leading producer]. Where do you get such good info?
Even today, no one else is interested in the water issue in Chile. You call the companies up, and they tell you there's no problem - the reason is, they're trying to buy water rights and don't want to lose leverage. So if all you do is talk to management, you're going to hear there's no problem. But I talked to a mining engineer from one of the companies [operating in Chile], and he started out saying, "We don't have a water problem, we get 700 liters per second from our mine in the southern part of the country." But then he mentioned how those guys up north, they get only four or five liters per second. I go, Really? He says, "Yeah they have to go 200 kilometers to get water." Was it that way two years ago? "No."
One of your colleagues told me you read a lot of obscure trade publications like China Metals Weekly.
It's all about looking for an investable advantage. Given the interest in China, you'd think that a publication that reported prices in China every week in five different regions would be on everybody's reading list, at least if you're interested in commodities. But it wasn't. I'd be talking to a steel analyst, and he'd say the price of steel in China was X, and I knew it was Y. I knew the price of steel in China was going up a lot, which is why I was in steel stocks. My judgment is that the Chinese price is the swing price in the global steel market.
With AMD, you've got a company that for most of the past 20 years seemed to exist only because Intel felt it needed a competitor rather than face the Justice Department. But new management has come in, and AMD now is ahead of Intel in terms of providing the architecture that users want as well as chips that use less power ... which is why they're gaining share at a pretty rapid rate.
Why are your forays into tech so rare?
It's a business where change is very rapid. Even if you identify a competitive advantage, it can disappear quickly. Also, what I look for when I'm investing is some piece of data that I can use to monitor what's going on. If it's a retailer, it's same-store sales. If it's a commodities producer, it's the price of the commodity. The numbers are murkier with technology companies.
Did you learn anything from the late '90s?
The people who did the best during that period were those who bought overvalued stocks, held them till they were obscenely overvalued, and sold before they collapsed. I don't know how to do that. I need some sort of framework where I can say the valuation is this and if the earnings do that, the stock will be strong.
My big mistake was that I decided to try to keep clients happy by staying with the trend. I bought some of the stocks like Cisco. I thought the stocks were overvalued, but I bought them anyway to try to have better performance. What happened is that I would always be a nervous holder. The stocks would go down, and I'd sell them at a loss because I lacked conviction. I was better off never owning them at all.
You own a lot of hotel REITs right now in your Realty fund.
After 9/11, construction of new hotels came to a screeching halt, but a year after 9/11, the economy was back on track. Leisure travel was rising, as was business travel. A supply/ demand imbalance developed, and you're seeing the result of that now. Revenue per available room is growing at double-digit rates some weeks. That's creating a surge in hotel-company profits.
Are you still bullish on energy?
I remain positive. We are seeing the greatest global economic boom in my 40 years of investing. You'd have to go back to the 19th century, when the Industrial Revolution was rolling through the West, for something comparable. Today the mature economies like Japan, the U.S., and Europe are growing. China and India continue to roll forward at high rates. Then you've got smaller economies in Eastern Europe, Asia, and Latin America growing rapidly too. All this is leading toward outsized growth in demand for industrial raw materials and also oil.
With oil, we're looking at adding 1.5 million barrels a day of incremental demand, and when I look around the world and factor in natural declines in major oilfields in Saudi Arabia and elsewhere, I have trouble finding 1.5 million barrels a day in incremental supply.
Their pipe is used in very tough environments. The big market is deep offshore wells. So you've got volume growth as offshore drilling expands, and these guys have been aggressive about raising prices based on the fact that there's a shortage of what they're selling.
Are you worried about what higher interest rates, courtesy of the Federal Reserve, could do to demand for commodities?
It's an interesting question. If the monetary authorities push rates so high they precipitate a recession, it would be a real worry. But I don't see that happening. In the U.S., the Fed is debating whether they need to slow growth [to curb inflation]. Everywhere else in the world there is no sign whatsoever that [central banks] intend to diminish the growth rate.
But won't reverberations from Fed rate hikes here be felt everywhere if U.S. consumers start cutting back?
It's my belief that for the first time the U.S. is relatively unimportant in the global demand picture. Indigenous demand has grown in countries all around the world. So if we slow down it will not have a material impact on the rest of the world's growth rate. Of course, you'll probably see some nervousness in the market if the Fed keeps pushing rates up.
I hear you don't take vacations.
The last full week I took off was probably in the 1980s, although I do take a Friday off here or there to go sailing. I don't need a vacation to relax. The stock market relaxes me.
I'm guessing then that retirement is out of the question.