Concentrated bets help bring Tilson to No. 1

Whitney Tilson and Glenn Tongue rely on three stocks to make their Tilson Focus Fund the top-performing mutual fund of its kind in the U.S.

The Tilson fund has 37 percent of its assets split among McDonald's, Berkshire Hathaway and Microsoft.

Only nine of 2,530 equity funds tracked by Morningstar have such a large proportion of their money in so few stocks.

"It's not that we're gunslingers," said Tilson, who runs T2 Partners LLC in New York with Tongue. "We reduce risks by concentrating our fund in the stocks we know the best and have the highest degree of conviction in."

Tilson's fund rose 25 percent this year, as of Dec. 1, the highest return of 925 equity funds tracked by industry research firm Lipper that can invest in companies of any size.

The gain beat the 14 percent advance of the Standard & Poor's 500 Index and the average 13 percent increase of U.S. stock funds. One reason for the fund's success is it has only $13 million of assets.

Tilson and Tongue buy stocks they think are trading at least 30 percent below what they estimate the companies are worth. In all, T2 Partners oversees about $150 million for clients.

Concentrated mutual funds are risky because all it takes is a decline in one of Tilson's stock holdings to hurt returns, said Russel Kinnel, director of mutual-fund research at Morningstar in Chicago. With a concentrated fund, "you're upping the ante on the manager's skill," he said.

The $9.6 billion Janus Twenty Fund, which limits investments to about 20 stocks, fell at an average annual rate of 28.5 percent in the three-year stretch ended Dec. 31, 2002, compared with the 15.5 percent slide of the S&P 500 in the same period.

The typical U.S. fund holds 85 stocks and has $508 million of assets, according to Morningstar. Seventy-one percent of Tilson Focus is in 10 stocks.

The Tilson fund, opened in March 2005, currently holds 25 stocks, 16 of which "are of a size that matter," Tongue said.

Unlike T2 Partners' hedge fund, the mutual fund doesn't engage in short selling to capitalize on stock prices that the managers expect to decline.

Tilson was recently named to SmartMoney's "Power 30," a list that includes Berkshire's Warren Buffett, the world's second-richest person, and Bill Miller, whose $20 billion Legg Mason Value Trust topped the S&P 500 for 15 consecutive years.

McDonald's, the world's largest restaurant company, is the biggest holding in the Tilson Focus Fund, representing 13 percent of the fund's assets, followed by Berkshire Hathaway and Microsoft.

"When we started our fund, those were our biggest positions, and for eight months, those stocks went nowhere," Tilson said. "Now we look like geniuses. That's just the way investing is when you run a concentrated portfolio."

Shares of Microsoft are undervalued, Tilson said. They don't adequately reflect the company's $36 billion stock-repurchase program or the earnings boost from the release of Windows Vista, the newest version of the company's operating system.

"It's a no-brainer," Tilson said.

The fund's one-year Sharpe ratio is 1.58, compared with 1.19 for its peers, according to Morningstar. The greater a fund's Sharpe ratio, the better its risk-adjusted performance.

The fund's management fee of 1.5 percent increases to as much as 1.95 percent of assets when returns meet certain benchmarks. It falls to as low as 1.05 percent when the fund loses money.