This mutual fund has jumped 40% this year with a value strategy. Here's how its manager picks stocks

Published Sat, Oct 30 20219:34 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

Bill Smead could hardly have picked a scarier time to strike out on his own. The mutual fund manager started his own firm and the Smead Value Fund in mid-2007, just months before the stock market turned south and the financial crisis wiped out thousands of jobs in the industry. "We got slaughtered right out of the gates. Literally slaughtered. You almost have to be an optimist to be a value investor like we are, and it did not pay to be an optimist for those next 18 months," Smead said. However, Smead's shop is thriving more than a decade later, and he said that the rough start turned out out to be "blessing in disguise." "When you're a brand new company without a track record, the best possible thing to happen is to cause everybody's track record to get besmirched," he said. Since then, the track record for the Smead Value Fund has been superb, consistently beating its peers and earning a five-star rating from Morningstar. And this year, with the help of some contrarian bets and meme-stock good fortune, the fund's investor class shares have gained more than 40% — nearly doubling the S & P 500. Smead, who co-manages the fund with two other investors, leans on eight criteria when determining when to pick stocks. Those include a long history of profitability, strong free cash flow, high levels of insider ownership and shareholder friendliness. "We were working on the S and G of ESG long before anybody cared," he quipped. The currently hot way of searching for companies has a lot of overlap with a solid process for value investing, he said. "Good corporate governance results in good corporate success for a long time, and also causes you to be a good citizen at the same time," he said. "I'd say, in our portfolio, Amgen is a poster child for that. I joke to people that it not only fits all of our eight criteria to a T, but it might be the best company in the S & P 500 as measured by our eight criteria," he added. The veteran investor said there are four keys to beating the market: stock selection, timing, duration of holding the stock and fund concentration. For proper timing, Smead compared his team to a point guard in basketball, waiting for the play to develop. He pointed to buying American Express when the stock dipped following the end of a partnership with Costco in 2015 as an example. "We really prefer to buy into a traditionally strong growth company where things have gone haywire temporarily," he said. Selling at the right time For all of Smead's success over the years in the picking stocks, some of his best moves of 2020 is knowing when to sell. The fund had positions in Macerich and Discovery when both became swept up in the meme-stock frenzy earlier this year. The fund sold a lot of both when the prices spiked and have since started to buy back in as the shares have returned to earth. "At $62.50, Discovery was maniacal. We should have sold all of it," Smead said. The episode exemplified Smead's plan to sell when stocks get too popular. That is one of three reasons he sells, with the others being a broken economic moat or being "unlucky" with a pick, where the expected rally never occurs. A stock being too popular is as much a matter of speed of a move as total price. Smead said Discovery and Macerich weren't terribly overvalued by his calculations when his fund sold them but were clearly in a frenzy. "We weren't in them just as a trade. We wanted to own them for the next 10 years," he said. Contrarian bets The Smead Value Fund is highly concentrated compared to many other mutual funds, with fewer than 30 stocks in the portfolio at end of the third quarter. The fund is also overweight some areas that have fallen out of favor over the past decade, such as mall REITs. Smead said that the mall bets go along with similarly large positions in homebuilders as an argument that the market was underestimating the staying power of physical retail as millennials started families and moved to the suburbs. "Shopping is a relatively wonderful form of entertainment that also helps the economy work. And it's very social," he said. Arguably the biggest contrarian bet in Smead's arsenal is fossil fuels, with Continental Resources being the top holding at the end of the third quarter. Smead said the transition to clean energy will take longer than many expect, and the combination of inflation and more environmentally-conscious investors and executives should lead to outperformance for energy stocks in the years ahead. "Inflation is not a puppy dog, it's a wolverine. It's a mean animal. It will completely change what stocks are popular," he said.

People walk along Wall Street in the financial district of Manhattan on September 29, 2021 in New York City.

Spencer Platt | Getty Images

Bill Smead could hardly have picked a scarier time to strike out on his own.