Those Bargain-Hunter Blues

The severe decline in residential-property prices blindsided Nygren. He says he expected a leveling off of prices -- the historic pattern in weak residential markets -- instead of a drop of 20% or more. "We got the housing-price outlook wrong, therefore we made mistakes in the mortgage business," he says. That's because so many loans to homeowners were made at dangerously high loan-to-value ratios, in defiance of Banking 101. Oakmark Select, a concentrated fund that holds about 20 stocks, was burned by its positions in Pulte Homes, Home Depot and H&R Block (the tax preparer wrecked a perfectly good business by an ill-considered diversification into the subprime- mortgage industry).

But the big whopper of a mistake was the fund's huge 15% allocation to Washington Mutual, the nation's largest thrift. WaMu held a portfolio of $200 billion in mortgages, says Nygren, who never guessed the bank would eventually book $20 billion in losses from mortgage holdings. The stock shed 90% of its value over the past year.

They got it right. Now let's look at two prominent value investors who have (mostly) coped with the market's duress. Steve Romick's FPA Crescent fund ( FPACX) returned 0.7% over the past year, while Bruce Berkowitz's Fairholme fund ( FAIRX) lost 1%. Both investors gave a wide berth to financials, loaded up on energy stocks (although Berkowitz recently cut back) and held a lot of cash.

In fairness, it should be noted that Crescent normally does not place more than 70% of its assets in stocks. Still, had Romick been less careful with his stock picks, the fund could easily have spilled red ink. "My returns have been generated as much by what we don't own as what we do," says Romick, who stopped buying financial stocks five years ago. He and his partner, Bob Rodriguez, manager of FPA Capital fund, have been remarkably prescient -- and vocal -- about the risks embedded in the U.S. financial sector.

Romick says many ostensible bargain hunters were fooled by the high returns on equity and other measures of profitability of U.S. banks. From 1996 to 2006, he says, those numbers were inflated by esoteric products and excess leverage, which should call for lower share values, not higher ones. "It was like a ten-year bubble for banks," he says.

Even after the recent collapse, Romick says, he's still not terribly interested in banks because rising inflation is bad for bank stocks. Plus, he figures that reduced leverage, greater regulatory scrutiny, more bad debts and fewer exotic products aren't a recipe for rising bank earnings.Berkowitz used to own financial stocks in the late 1980s and early '90s, when "you were able to understand who they were and what they owned." Today, he says, banks are so complex that "unless you're able to dig down into the underlying collateral," you don't know what you're buying.

Energy player. While Miller was betting against the oil sector, Berkowitz was loading up on low-cost energy producers, such as Canadian Natural Resources. Over the past few quarters he's booked a gusher of oil profits and moved the money into depressed health-care stocks, such as Pfizer and Wellpoint.

A value investor with an open and independent mind, Berkowitz is even doing the sacrilegious: paring his stake in Berkshire Hathaway. He says the law of large numbers is catching up with Berkshire, and that value-investing demigod Warren Buffett is spending more of his time on non-Berkshire activities.

Berkowitz also hews to a strategy of keeping a large pile of cash, in part to have ammunition to buy stocks when others are forced to dump them. "Cash is the equivalent of financial Valium," he says. "It keeps you cool, calm and collected."