Behind the Oceanstone Fund’s long run as a Lipper Leader

August 29, 2011

When an equity mutual fund receives Lipper’s highest rating of five for consistently superior, risk-adjusted three-year performance — along with other funds in the top 20 percent of its category—it may catch your attention.

When it gets that five rating consistently for 21 months — a record that Lipper’s research services head, Tom Roseen, calls “rare and worth a look” — you may be ready to plunk down some money.

But do your research first. The fund that currently holds this esteem is the Oceanstone Fund, a $15.5 million no-load, multi-cap value fund, which received its first five when it turned three (and became eligible) in November 2009 and its most recent five in July.

Its significance: Risk-adjusted performance reflects the volatility level its manager incurred to achieve it, and consistently superior risk-adjusted performance implies returns that are up more in up markets, and down less in down markets, than those of peer funds.

(Note the power of adjustments for risk, which can produce high ratings for consistency even when annual total returns fluctuated between negative 10 percent in 2008 and positive 264 percent in 2009.)

Not surprisingly, Lipper has also been rating Oceanstone a five for total returns and a four for capital preservation.
High Lipper ratings, of course, would not alone constitute a recommendation — even if you ignore its one’s for low tax efficiency (because of taxable capital gains distributions resulting from portfolio turnover) and high (1.8 percent) annual expenses. Neither would Morningstar’s five stars for risk-adjusted performance.

Such ratings can, however, be a cue to check whether a fund is suitable.

Oceanstone’s prospectus and shareholder report shed light on the fund, but they also leave important questions about performance and stock selection unanswered. (Go to or call Mutual Shareholder Services, transfer agent, at 1-800-988-6290.)

Investment objective:
Capital appreciation

James J. Wang of Carlsbad, California, is portfolio manager, president, and controlling shareholder of Oceanstone Capital Management, the investment adviser firm formed in 2006, six months before the fund. His previous experience was as investment adviser to individuals and small businesses, 2003-2006. (He has not responded to requests for an interview or faxed questions.)

Investment strategy:
Wang’s general strategy, popular with managers who take above-average risks to seek above-average appreciation, has been:

  • To invest only in stocks — of small- and mid-cap companies and, to a lesser extent, of less risky large-caps.
  • To go up to 100 percent cash as a defensive measure when necessary. Except when fully invested in 2009, he kept about 10 percent to 40 percent in cash.
  • To concentrate in few (15 to 30) stocks and engage in “active and frequent trading,” which can increase transaction costs and trigger taxable capital gains distributions.  He turned over the portfolio at rates of over 400 percent in Fiscal Years (FY) 2008 and 2009, ending June 30.

Style preference:
A comparison of Oceanstone’s November 2010 prospectus with earlier versions — to understand whether Wang preferred growth or value stocks — resulted in a discovery: He apparently switched style emphasis from growth to value in 2009.

The 2010 prospectus’ clues: He introduced a preference for “stocks … that (he) believes are undervalued “and omitted key phrases, such as “growth at reasonable price,” “favorable long-term future growth prospect,” and “favorable short-term future growth prospect.” The word, “undervalued,” appeared four times; “growth,” not once.

In Oceanstone’s annual report for FY 2009, Wang had indicated the change earlier: “With so many undervalued stocks in the U.S. stock market during this period, the Fund found some of them. Now the Fund continues to search for the undervalued stocks …”

Lipper, which bases its classification system on three years of shareholder reports’ portfolio data, reclassified the fund in April from “core,” a combination of growth and value, to “value” (and from mid-cap to multi-cap.)

Morningstar has Oceanstone in its small-cap value category, also based on three years of portfolio data, but a recent “snapshot” put it in mid-cap.

Stock selection: The 2010 prospectus tried to describe how Wang picks “undervalued stocks as compared to their intrinsic values,” but erred when it began: “To determine a stock’s intrinsic value (IV), the Fund uses the equation: IV=IV/E x E,” (in which) E is the stock’s earnings per share for its trailing 4 quarters … ”

The equation, previously used in the June 2009 annual, is clearly misstated: multiplying the first E by the second leaves you, unhelpfully, with IV = IV, and wondering what he intended to say.

With little or none of the SEC-required annual report discussions of “the factors that materially affected the Fund’s performance … including the relevant market conditions and the investment strategies and techniques used … ,” it’s not easy to understand how the fund outperformed peers. (No market sector or stock is mentioned in Wang’s first four annual report letters.)

Compare the portfolios of March 31, 2009 and June 30, 2009, and you can see how stunning performance by some stocks must have contributed to the 134 percent return of 2009’s second quarter, Oceanstone’s best.

Three of the top five June 30 holdings, whose positions Wang kept throughout the period — Dollar Thrifty, Sonic Automotive and Avis Budget — were up 1,103 percent, 535 percent, and 521 percent. Fuqi International, whose position he enlarged during the three months, was up 341 percent.

Value or growth stocks, correct equation or not, can Oceanstone keep up the pace?

Wang makes no promises. “We don’t know when or where … investment opportunities (in undervalued stocks) will develop,” he wrote in the 2010 annual. “It is difficult to identify them and easy to be wrong.”

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