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March 2010 Mutual Fund Red Flags

Can these funds navigate through a 'new normal'?

Greg Carlson, 03/23/2010

Can These Funds Navigate Through a 'New Normal'?

Mutual funds have been buffeted by the economy's fortunes more than usual in the past several years-- particularly those that invest heavily in companies that have few (if any) competitive advantages. If economic growth proves to be sluggish in the near future (a real possibility as the ability to take on leverage is much more limited after the excesses of 2003-07) or dips again, these funds' holdings could struggle as investors favor companies with more-dependable revenue streams. Morningstar's equity analysts assign a moat rating to companies based on their assessment of the firms' competitive advantages. So we took a look at the average moat ratings of funds' holdings; we highlight the following three funds that sport very low average moat ratings.

Brandywine BRWIX
This all-cap growth fund's managers aren't particularly interested in companies' long-term fortunes. They attempt to identify reasonably valued firms that will see accelerating profits before others find them and continuously replace holdings with new ones that offer more promise. (Its disciplined approach is one reason this is a mid-growth Analyst Pick.) Thus, they don't really consider long-term competitive advantages when picking stocks--and companies that experience quick bursts in profits can be less steady-Eddie in nature. For example, the fund's top holding at 2009's end was deep-discount retailer Dollar Tree DLTR, which has little to differentiate itself from other retailers in this niche other than its sheer size.

It's not too surprising, then, that the fund's holdings have an average moat rating of "minimal." That's Morningstar's second-lowest average moat-rating designation for funds (after "none"). Because of the fund's high-turnover approach, it probably won't hold these particular stocks for very long, but their characteristics are typical of the managers' picks. It's worth noting that, although firms with low moat ratings can be more volatile in nature, this fund actually doesn't bounce around as much as its typical mid-growth peer. Its broad diversification and short holding periods limit its exposure to the varying fortunes of any particular company.

Fidelity Mid-Cap Stock FMCSX
Shep Perkins, who's managed this fund for five years, has often favored economically sensitive fare, such as energy and industrial firms (which often have few competitive advantages), during his tenure. That has been especially true the past couple of years, which helps explain the fund's poor showing in the October 2007-March 2009 bear market, as well as its outsized gains in the ensuing rally. He's trimmed some of his more cyclical picks as they've run up in price in favor of relatively stable companies, but the average moat rating of its holdings was still firmly in the "minimal" category at the end of 2009. Indeed, four of the fund's five largest holdings--TW telecom TWTC, insurer Genworth Financial GNW, electronics maker Flextronics FLEX, and clothing maker Hanesbrands HBI--are deemed by Morningstar's equity analysts to have no moat. Perkins has generated a solid record at this fund, but it remains to be seen how he might fare during a slow-growth environment.

Fidelity Value FDVLX
This fund's presence on the list isn't a surprise to us. Longtime skipper Rich Fentin seeks out companies that look cheap relative to their historical valuations and their peers, as well as their cash flows and earnings. He's often owned a sizable stake in industrial firms, though he has more recently owned a clutch of tech firms, which are often quite sensitive to the fortunes of the economy, too. And the fund's forays into banks several years ago, many of which possess only modest competitive advantages, if any, proved disastrous when the financials sector blew up in 2008. (The fund managed a sizable rebound in 2009, but its long-term record is still tarnished.) Its top holdings at the end of last year included few companies with no moat at all (tech-equipment distributor Avnet AVT is one), but the average moat rating across its hundreds of holdings is still "minimal."

Greg Carlson is a mutual fund analyst with Morningstar.

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