Contrarian Buying at American Funds

In this article from the April 2006 issue of Morningstar's Fund Family Report on American Funds, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities, I looked at the funds' approaches to various out-of-favor areas of the large-cap landscape. To review a risk-free trial issue of our Fund Family Report on American Funds, click here. Fund Family Reports on Vanguard and Fidelity are also available.

American Funds' managers--even its growth skippers--have gained a reputation for sticking their necks out to buy stocks others are ignoring. There are countless examples of names that American's managers picked up when others were pessimistic. An article in The Wall Street Journal in early April indicated that American had been buying up shares of Citigroup C. I've pointed out how they smartly favored Lowe's LOW over Home Depot HD earlier in this decade. It turned out that there was money to be made in focusing on homeowners' wants in addition to contractors' needs, and Lowe's seized that opportunity.

I'd like to take a closer look at what the firm sees when it looks through today's bargain bin. Focusing on whether American seems to be sticking to its contrarian roots, even as its organization grows and changes, will provide an idea of how the funds may perform in the years ahead.

Specifically, I started with a list of U.S. stocks with market caps greater than $10 billion that failed to beat the S&P 500 Index's 4.9% gain in 2005. Then I looked at whether and by how much the firm either added or reduced its stakes in those firms. I focused on large caps because Capital Research & Management (CRM), advisor to the American funds, typically traffics in bigger stocks, and I paid particular attention to the firm's attitude toward stocks from certain lagging areas of the market, including big pharma, media conglomerates, and mega-cap banks.

Picking and Choosing among Drug Stocks
There have been plenty of pickings for penurious investors among drugmakers in recent years. The group was one of the strongest performers in the 1990s, but more recently the market has been focusing on these companies' warts, such as bloated cost structures and glaring unanswered regulatory and safety questions. In recent years, American's funds--in particular its growth offerings such as Growth Fund of America AGTHX--have largely avoided the area, and that's been to their benefit. (However, American's value funds have been buying drug stocks, mirroring what we're seeing across the fund universe.)

It appears that these stocks got cheap enough for American to be enticed to a greater degree last year.

Seven of the eight largest U.S. drugmakers trailed the S&P 500 in 2005, and CRM added significantly to its stakes in five of these companies--Abbott Labs ABT, Eli Lilly LLY, Johnson & Johnson JNJ, Merck MRK, and Schering-Plough SGP. It left its stake in Bristol-Myers Squibb BMY relatively unchanged and cut back its Pfizer PFE holdings.

Many argue that these companies offer a pretty compelling combination of low valuations, strong profitability, and ship-shape financial positions. It appears that some folks at American may be starting to agree.