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Homestead Value

With a rock-solid belief in their strategy, the managers of Homestead Value confidently go about their business.

Laura Lallos, 06/03/2009

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The economic crisis hasn't shaken the foundation of Homestead Value Fund HOVLX.

Indeed, the fund's longtime managers have been calmly conducting business as usual. The fund had no exposure to large-cap value disaster American International Group AIG, for one. Nor did the managers scramble to raise cash or make ill-timed forays into names such as Lehman Brothers, which seemed like an attractive value in early 2008, then collapsed later in the year. Granted, given its value focus, the fund was almost inevitably caught with a few financials duds, which triggered a higher turnover rate than usual, according to Mark Ashton, one of the fund's three comanagers. Nonetheless, turnover was less than 10% in 2008, compared with a large-cap value category average of nearly 70%.

"Although we make sure to maintain an open curiosity [about new investments], sometimes it's best to let things just percolate along," says Ashton, who came to Homestead Funds from Capital Research and Management in 1999. Indeed, the team's picks sometimes require patience. The team's investment process is "the exact opposite of that used by relative-strength or trend followers," says Peter Morris, who has run the fund with Stuart Teach since its 1990 inception. "Often, when we buy a stock, its relative strength is negative." The managers move deliberately, generally building positions slowly and selling gradually.

The team also plays confidently. This is a concentrated portfolio, with 45 holdings as of the end of 2008, and almost no cash. The managers may seek out companies in trouble, but they require sound balance sheets, healthy cash flow, and demonstrated strength in particular areas of business--and reason to anticipate a turnaround, such as a change in leadership. That fosters the possibility that "others might recognize the value for us," Ashton says, and acquire the company. Former holdings Wendy's International and IKON Office Solutions were bought out in 2008.

Distinctive Holdings
The idiosyncratic portfolio has a hardware stake nearly three times the large-cap value average. Hewlett-Packard HPQ, Dell DELL, Intel INTC, and Cisco CSCO made up 12.5% of assets at year-end. Ashton says that Hewlett-Packard was emblematic of what the team seeks in a value opportunity: a company with a sustainable advantage that is beset by temporary problems. "Bad news is a good place to start because it usually begets lower valuations," he says, laughing. The managers initiated the position in HP earlier this decade, when the company's PC business was crushed by competitors Dell and IBM IBM. The company was kept afloat by its strong printer, server, and IT businesses, however, and new management turned things around.

Dell, Intel, and Cisco were added as value opportunities arose in 2006 and 2007. Intel, for example, was under pressure from competitor Advanced Micro Devices AMD, but it makes the dual- and quad-core chips that customers have come to take for granted in their computers and handheld devices.

Ashton expects that these are investments for the long haul, as an improving economy expands the market for the companies' ever-advancing technologies. "One thing I've learned here is that not being in a hurry can yield benefits," Ashton says. "A traditional value shop would have let Hewlett-Packard go earlier in the story, but there is more to come. The acquisition of [IT service provider] EDS opens lots of doors."

At year-end, the fund was dominated by a 26% stake in health care, primarily pharmaceuticals, which fared relatively well in 2008. Morris says the companies' high dividend yields and strong balance sheets more than compensate for concerns such as patent expirations and increasing government regulations. Abbott Laboratories ABT, one of the best performers, bumped up against the fund's 5% limit for an individual holding, and Bristol-Myers Squibb BMY, Pfizer PFE, GlaxoSmithKline GSK, and Schering-Plough SGP were all in the top 10 at year-end. Ashton says that although the major pharmaceutical players "weren't run like 'real' companies in the past--they generated chemical compounds, then marketed them--they are now allocating capital much more efficiently." These are also global businesses with terrific growth prospects. Yet, despite yields that are well-above market, the stocks' price/earnings ratios remain below the S&P 500's.

Shedding Financials
In the more traditional value arena, the fund had 13% financials at year-end, which is significant but less than three fourths of the typical large-cap value stake.

"The current environment caused us to do something we don't normally do: sell stocks when they are down," Morris says. "Anyone who owns financials has had to average down." The managers made a timely sale of Washington Mutual WAMUQ in late 2007, because the bank was overconcentrated in aggressively packaged mortgages. "We sold in the midteens, so we fared well," Morris says. Over the past year, the managers also cleared out of Citigroup C, Genworth Financial GNW, and Fifth Third Bancorp FITB.

"We decided which financials had the wherewithal to withstand the buffeting of the economy in general," Ashton says. Keepers include the well-capitalized J.P. Morgan JPM, one of the fund's top 10 holdings, and Bank of America BAC. While the managers aren't adding to the fund's small position in the latter, they do expect benefits from its acquisition of Merrill Lynch, given the profitability of its retail brokerage.

The fund's largest insurance holding is Chubb Corp. CB, which boasts strong balance sheets and healthy operating cash flow. Its property and casualty insurance business is worlds away from the risky likes of AIG. Group disability insurer Unum Group UNM was a typical Homestead turnaround play, and new management had spurred a rebound before the stock was sideswiped by the falling market.

Mid-Cap Stakes
The portfolio is further distinguished by a large stake in mid-cap names, roughly one third of assets. The fund's $350 million asset base allows it to take advantage of names such as top-10 holding Parker Hannifin PH, which has outperformed its industry and the S&P 500 for the 10 years the fund has owned it. The manufacturing parts supplier "has a good record of getting larger [through acquisition] by looking for attractively priced assets, much as we do," Ashton says. "It also provides exposure to markets such as China and India, which is a conservative way for us to invest in such markets."

Other lesser-known names also seem tailor-made for the management team's long-term strategy. Defense contractor SAIC SAI, which went public several years ago, has shown strong, steady growth, "and yet it goes unnoticed," Morris says. The fund has owned another under-the-radar stock, label-manufacturer Avery Dennison AVY, on and off for 10 years.

The fund's investment in small-cap Office Depot ODP is an atypical contrast: After making money moving in and out of the stock several times over the past five years, the managers dumped the stake last year. "It blew up," Morris says. "There was bad planning, bad execution, and no turnaround, so this was a rare case where we did sell a whole stake over a short period of time."

Created for a Rural Coop
Despite the occasional misstep, this concentrated, low-cash portfolio has held up reasonably well in the current bear market (as it did from 2000 to 2002). It placed in the top half of the large-cap value category in 2008 and in the top third for the 12-month period through March 2009. Over the long term is where the fund has earned its stars, though: Through the five- and 10-year periods through March, it places in the top quartile of its category.

Better yet, when taxes are taken into the account, the fund's long-term category rankings rise to the top 20%. Morris notes that all the managers have significant stakes in the fund and are well aware of the tax consequences of active trading.

The fund has yet one more advantage, one that ensures it an edge over its peers in any market: a tiny 70-basis-point expense ratio. That is less than half the large-cap value norm--even though the fund's asset base is also well-below average. It is unusual for such a small fund company that doesn't enjoy the economies of scale of a Vanguard or a T. Rowe Price to keep shareholder costs so low.

All this raises the question of why a fund with a 15-year history of excellence under the same management team has not drawn more attention. "They are unknown because they aren't spending client money on wholesale marketing or advertising or fancy conference calls," says Dan Henken, a senior investment consultant who provides research for advisors associated with St. Paul, Minn.-based Securian Financial Group. "They don't come with all the pageantry." In fact, Homestead Funds was created in 1990 as an affordable investment resource for members of the nonprofit National Rural Electric Cooperative Association, and most of the company's assets still stem from that source.

Not a Pure Play
The fund does come with a caveat or two. The first is the above-average volatility that accompanies a concentrated, buy-and-hold portfolio with minimal cash. Henken says that his research team's quantitative screens allow managers to take active risk provided it is accompanied by outperformance. He frames the volatility within the perspective of the fund's low-turnover track record of sensible stock picks: "The managers see themselves as a fiduciary for NRECA and they are unlikely to take wild risks," he says.

The fund has not yet paid off for those who bought in on Henken's recommendation in January 2008, but he is unshaken: "It was a good move; we are happy and still confident in them."

Investors who can still stomach stocks may not be put off by some extra volatility, but someone looking to neatly fill the large-cap value segment of the style box might consider this portfolio insufficient. Not only is it concentrated and quirky, but it has less than 30% of its assets in pure large-value stocks, and its average market cap of $19 billion is on the small side for its category.

Advisor Jim Quandt, a senior partner with Fortune Financial in Minneapolis, Minn., believes that the fund's "low expenses, low turnover, and experienced management make it an exceptional find in this category." However, he considers the fund "a very nice complement to a more traditional large-value fund."

That said, management's long-term results make this a suitable core holding for any investor willing to take on equity risk. The fund is certainly a boon for NRECA members and for those without much money to invest upfront--but it deserves to be known as more than just a niche product.

Laura Lallos, a former Morningstar analyst and editor, is a frequent contributor to the magazine. 

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