201: Five Questions to Ask Before Buying a Mutual Fund

205: Gauging Risk and Return Together, Part 1

206: Gauging Risk and Return Together, Part 2

207: Examining a Stock Funds Portfolio, Part 1

208: Examining a Stock Funds Portfolio, Part 2

404: Style-Box-Specific versus Flexible Funds

506: Calculating Your Personal Rate of Return

Managers such as the team at Longleaf Partners (LLPFX) follow an absolute-value strategy. They dont compare a stocks price ratios with something else. Rather, they try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock.

Absolute-value managers determine a companys worth using a variety of factors, including the companys assets, balance sheet, and likely future earnings or cash flows. They may also study what private buyers have paid for similar companies.

At Longleaf, the managers look for companies that trade at discounts of 40% or more to the teams estimates of their intrinsic value, using discounted cash-flow analysis, asset values, or sales of comparable firms to determine the latter. The managers place much importance on the ability of a companys management to run the business on an operational level and to effectively allocate capital. They often take sizable positions, and the fund typically holds 20-25 names. The turnover rate is typically very low.

Because of this approach, the Longleaf portfolio isnt broadly diversified, and its concentrated approach means that trouble in a few top holdings can have a significant negative impact on returns. Indeed, for six of the past seven years (as of early 2011), the fund has landed in either the top decile or bottom decile of the large-blend category. However, over the long term (10- and 15-year periods), the fund lands solidly in the top 10% of its category.

This case study illustrates the patience required of investors in an absolute value fund. Because such a fund may look very different than the broad market, and its performance may deviate as a result, it can look very out of step over shorter time periods. Of course, some absolute value funds are better than others, but even the best absolute value funds can be misused by investors who cant stomach the rougher ride.

Learn how to invest like a pro with Morningstars Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.