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November 2009 Mutual Fund Red Flags

Are these portfolios getting too pricey?

Greg Carlson, 11/17/2009

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.

Between the latter stages of the recent bear market (stocks began falling precipitously in mid-2008) and the massive rebound beginning on March 9, 2009, stocks' valuations have gyrated wildly. Where do funds stand now? The market is still well below the highs reached in October 2007 as well as the start of the mid-2008 slide (the S&P 500 is down roughly 12% from June 30, 2008, through Oct. 20, 2009). And yet, we found funds that have seen the average price/earnings ratios of their holdings increase substantially since June 2008. True, P/E ratios aren't a foolproof measure of valuation, but these increases can tip investors off that the funds' holdings may now be on the pricey side. Below, we take a closer look at the three funds that saw the biggest rise in their average P/E ratios.

FPA Paramount FPRAX
This fund lands in Morningstar's mid-growth category, but it's hardly a typical mid-growth fund. Managers Eric Ende and Steve Geist like small- and mid-cap firms that are arguably higher-quality in nature: They look for high returns on capital and healthy balance sheets, as well as modest valuations. The fund will own some rapid growers, but it also holds companies with slower and steadier revenue streams, such as makers of consumer staples. The fund's average P/E ratio jumped from just under 16 in June 2008 to 23.5 in September 2009--a 47% increase--despite the fact that the fund lost 7% over that span. The managers made few changes to the portfolio over that span, but they did sell a few holdings trading at modest absolute valuations for firms that now sport higher price multiples (such as animal hospital operator VCA Antech WOOF). In addition, the sturdier companies that the fund typically owns were, generally speaking, trading at historically low levels in mid-2008 compared with more economically sensitive fare such as energy and industrials. Given the fund's solid relative performance in both the bear market and the rebound, it may be due to cool a bit--although we're not concerned about its long-term prospects.

Longtime manager Charles Akre left this fund in August 2009 to start his own firm and was replaced by a trio of managers who had served as analysts on the fund. However, that's not the reason that the fund's average P/E ratio jumped from 20.2 in June 2008 to 29.7 by September 2009--indeed, the fund didn't buy or sell any stocks during the quarter in which Akre left. However, changes have been made to the portfolio since mid-2008. In particular, the fund dumped several energy holdings such as Penn Virginia PVA in 2008's third quarter--a time when the profits of many energy companies were peaking along with the price of oil, and thus their P/E ratios (because of the firms' high fixed costs) were modest on an absolute basis. (Much of the proceeds from these sales have been kept in cash.) Also, this fund (like FPA Paramount) tends to hold hefty stakes in sturdier firms--management favors those that generate at least a 20% return on equity--which have seen their valuations rise over the past 15 months. It held up extremely well in the bear market but has lagged a bit in the ensuing rally.

Ameristock AMSTX
This fund's portfolio is compact, with just 25-35 holdings, and chock-full of the market's behemoths. Nicholas Gerber, who's managed the fund since its 1995 inception, only considers stocks with a market capitalization of at least $15 billion. He favors companies that pay out hefty dividends and trade at cheap valuations or out-of-favor growth stocks that have stumbled a bit. The fund, like the two above, tends to own well-established firms, and its average P/E ratio has jumped substantially--from 14 in June 2008 to 20.4 in September 2009, a 46% increase. Chalk this up in part to the aforementioned appreciation of steady-Eddie fare over that span. But also, the fund has sold companies with lower absolute valuations, such as Bank of America BAC and Citigroup C, for those with more attractive earnings growth potential and higher multiples such as Cisco Systems CSCO.

Greg Carlson is a mutual fund analyst with Morningstar.

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