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How to Handle Three Strong Performing American Funds

What should you do if you own one or more of these sizzling funds?

Paul Herbert, 10/16/2006

Below is an article from the August issue of the Morningstar Fund Family Report on American Funds, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. To review a risk-free trial issue, click here. Fund Family Reports on Fidelity and Vanguard are also available.

Returns and asset figures reflect the most-recently available information as of early August.

A couple of months ago, I wrote a piece in the newsletter about whether it was a good idea to buy, sell, or hold the three American funds that have been trailing their Morningstar categories during the past several years. My aim was to remind readers that it isn't always a good idea to sell weak performers or, in the case of New World NEWFX, to point out that a fund's absolute returns are often more important than its percentile rankings.

This time around, I'll review offerings from American that have really shone recently. Why would you want to change your stance on one of these star performers if you already own one? Because while it may seem natural to assume that a hot streak is evidence of staying power, a run of great performance could instead indicate that a fund's valuations are on the high side and that the securities in its portfolio could be due to cool off. For instance, during most of this decade, funds that have preferred riskier stocks and bonds--including small- and mid-cap stocks, high-yield bonds, and securities with revenues closely tied to commodity-price movements--have usually prospered.

Current valuations rely on a continuation of all of the trends we've seen in the recent past, though, which may or may not transpire.

How do you separate funds that will continue to post strong results from those that could be pricey and may have had too much of a helping hand from the market's passing preferences? By delving into specific elements of funds' portfolios, and, in particular, by paying attention to how they have been approaching the lesser-quality investments that have been soaring recently. Plus, because the funds discussed below have been the lineup's best relative performers, and American has been successful at translating solid results into inflows, it also makes sense to examine whether asset size may now be an impediment.

Bond Fund of America ABNDX
Category: Intermediate-Term Bond
Three-Year Return (% Rank in Category): 5.19% (4)
Five-Year Return (% Rank in Category): 5.71% (4)

This fund certainly has taken on some risk to achieve its fine relative returns, and I can envision some rougher times ahead for it.

Buying corporate bonds, including high-yield bonds, is nothing new for American Funds. At this flagship offering, that has meant sticking about half of assets into the corporate sector, while the typical fund in the intermediate-term bond category allocates less than one third of its portfolio to these issues. But there are some signs of upcoming trials for corporate bonds, as their valuations are looking quite rich these days, and according to some managers, their financial conditions have also begun to weaken.

Although American's managers have experience and savvy that would pay off in a downdraft, the fund's hefty weighting in the sector would be a stiff headwind if the credit markets weakened. To be clear, I'm not saying I think the fund's performance in a credit-unfriendly market will mirror its 1998-2002 ride, when it frequently visited the category's bottom reaches as lower-quality fare, in particular, struggled. It doesn't devote as much attention to high-yield debt as it did back then.

Nonetheless, now is as good a time as any to make sure that your bond portfolio has a balanced approach, which would mean holding less-credit-sensitive funds, such as Intermediate Bond Fund of America AIBAX, in addition to more assertive funds like this one. Intermediate Bond Fund offers a relatively plump yield today because short-term rates have been rising for the past two years.PAGEBREAK

Growth Fund of America AGTHX
Category: Large Growth
Three-Year Return (% Rank in Category): 13.92% (3)
Five-Year Return (% Rank in Category): 5.23% (4)

Growth Fund of America continues to shine, but I'm going to keep sounding cautious tones about the now-$144-billion fund.

I'm worried about two things here.

For one, while the fund's eye for value has been apparent in some moves, such as its additions to its positions in cheap technology stocks Microsoft MSFT, Cisco Systems CSCO, and Oracle ORCL during the past year, the fund's portfolio doesn't appear to be very well positioned for the rebound in the type of beaten-down large-cap growth names that appear to be the cheapest right now. I looked at the star ratings, economic moat (competitive advantage) ratings, and business-risk ratings that Morningstar's equity analysts come up with for the fund's holdings and for Morningstar's large-growth stock universe. While the differences were slight, it was clear that Growth Fund of America owned fewer 4- and 5-star, wide-moat, below-average-risk stocks than the universe did. To bring it back to one of the points I made above, the fund's stakes in energy and materials companies, whose fortunes are tied to prices of raw materials, are much higher than the universe's, and those stocks warrant lower ratings because our analysts believe most of these stocks have run up too far relative to where they think those underlying prices are headed.

Second, the fund's size puts pressure on the processes that have helped it succeed in the past. I worry that the recent division of investment staff at the fund's advisor could strain communication among decision-makers. In all, I'd cut back here because I still think sibling Amcap AMCPX is a better vehicle for playing a large-cap rebound.

Income Fund of America AMECX
Category: Moderate Allocation
Three-Year Return (% Rank in Category): 12.98% (5)
Five-Year Return (% Rank in Category): 8.66% (4)

A number of factors have enabled this income-seeking fund to perform well during the past few years.

First, it has emphasized cheap dividend-paying stocks, which was a huge help during the bear market. Second, the fund has preferred high-yield bonds to higher-quality credits, which have aided its cause as junkier issues have rallied since late 2002. Third, its managers have been willing to venture into overseas stocks and bonds, which have provided a boost throughout the whole period.

That it has been able to rely on many sources to drive it forward makes me confident that it stands a good chance to sustain its run. That's not the only reason I'm excited about it, though; its focus on yield helps it to provide relatively even showings over time, and some opportunistic moves by its bosses, such as moving into higher-quality blue-chip stocks, set it up to prosper when those stocks come back to life. I'm not saying the fund's profile means it is immune to problems: In 2005, for example, factors such as a strengthening dollar and struggling auto and food stocks contributed to a poor finish. Plus, like Bond Fund of America, this offering would struggle if lower-quality corporate bonds did. And, there's no doubt that it doesn't have a fighting chance in an all-out growth rally.

But overall, I think there's plenty to like here. Its nearly $67-billion asset store is a lot to lug around, but the fact that the fund may invest in bonds and place up to 30% of its portfolio abroad creates some breathing room. I don't see any reason for most investors to change their position here.

Paul Herbert is a senior analyst with Morningstar.

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