Morningstar Advisor - Spring 2008 - 55

of what is a good management is one that has a good record. As soon as something goes wrong, the management is bad. We’re much more focused on the characteristics of the 22000 business. Because the reality is, if the business 19000 has good characteristics and the person running it fails, he or she is going to be 16000 replaced. The business isn’t going away. 13000 there’s something wrong. There’s no doubt that there’s something wrong. But when they start ignoring the valuation with the only objective of exiting, that’s when you can get yourself in some extraordinary opportunity sets, like what we’re seeing today. We have data that housing prices are declining. We have data that there is unusually high defaults, particularly in subprime mortgages. What we don’t have data on is what the ultimate losses are going to be in those pools. When no one knows what the ultimate losses are going to be, people make up numbers. When you’re making up numbers and all you see is the pricing declining and the delinquencies increasing, you tend to make up some wild numbers. KK: It can’t be easy for you to get your head John Hancock Classic Value Fund PZFVX $22K 19 16 13 03 04 05 06 07 08 S&P 500 managers out there. Where do you feel like you get your edge when you sit down and look at some of these names? RP: A lot of value investors look for a catalyst. KK: There are a number of other good value 10000 Category Large Value 1 Morningstar Rating QQ Minimum Investment $1,000 Expense Ratio (%) 1.28 5-Yr Anl Total Rtn (%) 9.86 5-Yr Anl Investor Rtn (%)* –1.47 5-Yr Anl TR % Rank Cat 88 Stewardship Grade V** The unfortunate reality of value investing is what creates value is deterioration. It’s unfortunate because we all know that if a business is deteriorating, it’s usually a bad idea to buy a stock. The problem is, if you wait for the “turn,” or the “revisions,” or the “catalyst,” or the “momentum,” or whatever Wall Street word you want to use, you rarely get a cheap price. I think you optimize the risk-reward trade-off by paying attention to the valuation and buying before the turn, or before you know when the turn is going to be. That’s very, very difficult for most people. It’s the art of all of this. We like to take advantage of an environment like we’re in today, particularly with financial stocks, where it’s more fear than fundamentals. Because you can do all the downside sensitivities you want, and the answer is you don’t really know how bad things are going to get. KK: Are you oversimplifying just a little bit by saying it’s more fear than fundamentals? There are fundamentals involved, too. RP: Sure, there are. There were some loose lending standards and credit spreads that were too narrow. That has obviously now unwound. Housing prices are in a decline, and people now want to bail out of financials. They want to bail out independent of the fundamentals. They want to bail out because they know around some of those situations. RP: It’s easy to try to come up with a downside understanding, I think. You never know the ultimate bottom, but you can take things like where the market is pricing subprime mortgage-backed securities, and back in to the loss rates that you have to assume in the subprime pool in order to get those trading prices. And they’re extreme. The loss rates inherent in the subprime ABX index for the ’06 and ’07 vintages imply loss rates in the high 20s. That’s possible but extremely unlikely, because when someone defaults on a mortgage, you get the house, and you get to sell the house. The recoveries so far on subprime first mortgages have been running in the 65-cents-on-the-dollar range—so 35% losses when you foreclose. To get to a 28% loss rate for the whole pool implies 80% default. *Dollar-weighted return that measures how the typical investor in the fund fared. **Stewardship Summary: This fund is supported by a corporate culture that’s increasingly investor-focused, but its Stewardship Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Grade is held back by middling fees. Apr-03Dec-03 Oct-04Jun-05 Apr-06Dec-06Aug-07 May-03Jan-04 Nov-04 Jul-05 May-06Jan-07Sep-07 Jun-03 Apr-04 Apr-05Dec-05Aug-06 May-07Jan-08 Jul-03 Jun-04 May-05Jan-06Sep-06 Jun-07Feb-08 Aug-03 Jul-04 Sep-03 Aug-04 Aug-05 Jun-06 Oct-03 Nov-03 Sep-05 Jul-06 Oct-05 Oct-06 Jul-07 Nov-05 Nov-06 Oct-07 Nov-07 Dec-07 Data as of March 31, 2008. Feb-04 Dec-04 May-04Jan-05 Sep-04 Feb-05 Feb-06 Feb-07 Apr-07 Now, I can sit here and say that seems ridiculous. The concept that 80% of the people who bought houses in ‘06 and ‘07 are going to mail the keys back to the bank because their house price went down seems far-fetched. Even though the media likes to write about the housekeeper buying an $800,000 house in California, we ignore that most of the borrowers in the subprime pool are mostly lower- to moderate-income people who had $225,000 mortgages, on average. They live in the house and weren’t planning on flipping it. They put some real money down, not zero down. If they get kicked out of their house because they don’t make the payments on their mortgage, they still have to move somewhere else. So the idea that you’re going to walk away from your life savings to save a few hundred dollars a month, or to avoid a situation where you may have negative equity in the home, seems to me unlikely. More people will do it than has been the case historically, no doubt about it, but the idea that you’re going to get to 80% of borrowers doing it seems ludicrous. KK: What’s it going to take to turn things around? RP: It’s going to take one of two things, which MorningstarAdvisor.com 55

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Morningstar Advisor - Spring 2008

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