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January 2010 Mutual Fund Red Flags

There's steep price for no growth in these portfolios.

Michael Breen, 01/19/2010

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

In the recent recession, many firms have preserved profit margins and returns on equity by aggressively cutting costs in the face of stagnant or shrinking sales. But that's not a recipe for long-term success: You can't perpetually trim your way to prosperity. At some point the top line needs to rebound or profitability will shrink.

Funds aren't immune. Many have made big gains in 2009 as profits at their holdings have shrunk less than expected, sending share prices soaring. Some may even continue winning by owning firms with declining sales, but buying right is crucial. If a stock is cheap enough, shrinking less than expected may still be rewarded by the market. But those paying abovemarket multiples for firms that have been losing sales face a tougher road. If sales don't bounce back, profits will get a haircut, and the market will punish the shares or inflate their price/earning ratios--or both.

Below are a few portfolios with higher P/E ratios than the S&P 500 whose current holdings are solidly profitable but, on a weighted basis, have had declining revenues. A few clunkers in each portfolio influence the numbers, and the past isn't prologue, so there's no need for panic. But these funds have a risk that others don't, and they bear watching.

Fidelity Contrafund FCNTX, Fidelity Magellan FMAGX, and Fidelity Growth Discovery FDSVX are three large-growth funds with small positions in a number of firms with negative sales trends. Each also has good-size bets on a few firms that need to turn around their top lines. For Contrafund, it's investment banker Goldman Sachs GS and Corning GLW, a maker of specialty glass. Magellan owns both as well and also holds a set of depressed cyclicals, including homebuilders Lennar LEN, Ryland RYL, and KB Home KBH. Growth Discovery has a more tech-heavy portfolio and holds such names as Internet security firm VeriSign VRSN and semiconductor equipment maker ASML Holdings ASML.PAGEBREAK

Contrafund is the least worrisome. Manager Will Danoff has proved over time he can pull the right levers, and he's not afraid to cut firms that don't live up to his expectations. His portfolio's net margin and return on equity are also well above the S&P 500's, giving him wiggle room. Profitability levels at Magellan and Growth Discovery are much lower, and shrinking cash flows at many of its holdings pose another challenge. They bear watching.

It's no surprise that Marsico 21st Century MXXIX owns a few firms facing challenges. Manager Cory Gilchrist buys three types of companies: rapid growers, steady growers, and those suffering near-term setbacks where he sees promise. A few holdings, such as financials Jefferies Group JEF and Goldman Sachs GS, along with Ford Motor F, Anheuser-Busch InBev ABI, and CBS Corp. CBS, have dragged down the fund's sales-growth rate. The fund struggled in 2008 and is lagging again in this year's rally. Gilchrist has won out over time, but this portfolio's P/E of 24.1 is well above the market's and decreases the margin for error.

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