WSJ: DECEMBER 6, 2008 - Heebner the Contrarian

Fund Manager Bet Against Financials; Now, He's Buying.

By DIYA GULLAPALLI

After making a fortune betting against financial stocks until this summer, mutual-fund manager Ken Heebner is turning bullish on the sector.

Mr. Heebner, who runs one of last year's best-performing mutual funds, is sure banks and insurers will recover next year, thanks to Treasury Department and Federal Reserve efforts to bolster lending.

"A year from now, credit will be available because of the government's actions," said Mr. Heebner, who works at CGM Funds in Boston.

Only time will tell if he is right. Meanwhile, that switch has harmed his performance lately.
His CGM Focus fund, which for years has posted a string of market-beating returns, this year is lagging behind the Standard & Poor's 500-stock index by 11 percentage points. For only the second time in his 11-year tenure, he is in the red, off 52%. But the money manager, who often goes against prevailing trends, contends his plan eventually will pay off.

CGM Focus is famous for betting big on a few economic themes. This risk-loving fund often is at the top of its "large blend" fund category -- which buys both quickly expanding growth stocks and cheap value stocks -- but sometimes near the bottom, such as now and, most recently, in 2004.

For the most part, Mr. Heebner's track record is reassuring. Last year, CGM Focus was the No. 1 diversified U.S. stock mutual fund of more than 4,500 distinct offerings. Its 80% total return in 2007 dwarfed the S&P 500's 5.5% showing. The fund has one of the best 10-year records, returning 18% annually, while the S&P 500, after many gyrations, has returned to its 1998 level.

This fall, Mr. Heebner built a more than $1 billion combined position in Citigroup Inc. and Bank of America Corp. He has put $780 million in two Brazilian banks, Banco Bradesco SA and Banco Itau Holding Financiera SA, counting on U.S. actions to help lending abroad. CGM Focus's biggest holding through September was $552 million in Wells Fargo & Co.

About 40% of his $4.3 billion CGM Focus was in financial stocks as of Sept. 30, according to its portfolio report.

In determining which ones to buy, Mr. Heebner is leery of certain traditional earnings multiples that don't always best gauge affordability. So for banks he uses two other measures, which suggest they are at historically cheap levels and, because he feels strong rebounds are assured, are ripe for plucking.

One such metric is "price-to-tangible book value." For 20 big lenders, including Citigroup, Bank of America and Wells Fargo, this runs about 1.1 times, compared with 2.7 on average since 1990, according to a Goldman Sachs report. Tangible book value is the net worth of a company after stripping out intangible assets such as goodwill and patents. A lower ratio suggests a bank's stock is undervalued but can also suggest assets are overstated.

Citigroup has gotten much cheaper in the past six months. In June, the bank's market price was twice that of its tangible book value. As of Friday, its market value had sunk to less than its hard assets, a 0.96 ratio, Citigroup's lowest since 1990.

His second measure is the "price-to-preprovision earnings" ratio. For these 20 banks, it is 5.4 times compared with 12.2 times on average. Preprovision earnings exclude provision expenses for loan losses and measure banks' earnings power. A relatively low ratio can mean the market is underestimating the value of a bank's potential for profits. But a low ratio also can be warranted if the market believes a company hasn't provisioned enough for such losses.

Financial stocks have been relatively cheap for some time, and many fund managers got into them early, and paid for it dearly. Managers such as Oakmark Funds' Bill Nygren still held Washington Mutual Inc. earlier this summer. Regulators seized the firm in September and sold its banking operations to J.P. Morgan Chase & Co. His nearly $2 billion Oakmark Select Fund is down 43% this year, following a 14% slide in 2007.

Mr. Heebner's previous bearishness about financials was unequivocal. By last June, he had dumped shares of Goldman Sachs Group Inc., Morgan Stanley and Merrill Lynch & Co. because he was concerned their hedge-fund, private-equity and proprietary-trading businesses were using too much leverage.

He has shorted Countrywide Financial Corp., IndyMac Bancorp Inc., Wachovia and Washington Mutual because of their exposure to troubled mortgages. All four companies either have collapsed or been acquired since last year.

So it is all the more remarkable that Mr. Heebner, 68 years old, is changing his strategy. In September, when the government started taking steps to inject capital into banks and back troubled assets, he became convinced that confidence in credit markets would be restored and financial stocks would benefit.

He was further encouraged by consolidation within the sector, which he believes will bolster big banks over time. This includes Wells Fargo deciding to buy Wachovia and Bank of America acquiring Merrill Lynch this year.

For such companies, "in the next year, lending and deposit accumulation will be more profitable than ever before," he said.

Mr. Heebner knows his positions in financials could suffer more pain, as the recession brings more mortgage foreclosures and asset write-offs. He admits that the eruptions of bad news are sometimes disconcerting. Citigroup's announcement last month that the government will absorb as much as $249 billion in potential losses on real-estate loans and securities held by the bank "came out of the blue" and "I was scratching my head," said Mr. Heebner.

He is offsetting those bets with defensive picks. That includes Wal-Mart Stores Inc. and McDonald's Corp., bargain-oriented retailers that would both benefit as consumers rein in spending. Gold stocks such as Goldcorp Inc. and Barrick Gold Corp. represent another haven.

Mr. Heebner, who likes to trade frequently, likely has shuffled some of his financial stocks since September, but insists financials remain a top bet. For investors, one problem with Mr. Heebner is rapid portfolio turnover, which can generate capital-gains-tax liabilities.

Mr. Heebner trades his 25 to 30 stocks more frequently than other funds to reflect his latest ideas. While the average U.S. stock mutual fund turns over assets less than once a year, CGM Focus does so almost four times annually, according to fund tracker Morningstar Inc.

Mr. Heebner has been investing money for more than 30 years. In another counterintuitive move, Mr. Heebner is starting his first hedge fund. He is launching it through a private partnership he started in June called Wayfarer Capital LP. It is a more-difficult proposition in these times, when so many hedge-fund investors are pulling out.