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.

Funds with the biggest stakes in drugmakers include Washington Mutual AWSHX, American Balanced ABALX, American Mutual AMRMX, and Fundamental Investors ANCFX.

Mostly Tuning Out Media
Media stocks have also stunk lately after shining during the bull market. In the case of these companies, seemingly senseless mergers, accounting shenanigans, and overinvestment in the wrong areas have made owning and watching these stocks a waking nightmare since the market bubble burst.PAGEBREAK

For a number of years, Time Warner TWX--a firm that knows a thing or two about senseless mergers--was the firm's top holding. But CRM has been trimming its mammoth stake for a while now, including cutting it nearly in half last year. The firm's once-larger stakes in Viacom VIA.B, News Corp NWS, and Liberty are also smaller than they were a few years back. It seems that rather than sticking exclusively with traditional media players, CRM recently has been paying more attention to those media companies that make money over the Internet. Yahoo and eBay were among its bigger holdings for a couple of years, but in 2005 they took a backseat to Google GOOG, one of the firm's biggest winners and now one of its 10 largest positions overall. Its moves in this area have been pretty adept, though I wouldn't call them contrarian.

Funds with the biggest stakes in media include New Economy ANEFX, Growth Fund of America, Amcap AMCPX, and American Balanced.

More Than Just Citi
The expectation (and then the reality) of higher interest rates has been the elephant in the room for banks for a few years now, and it has kept investors from getting too excited about buying them. (The fear is that banks will have to increase the yields they offer customers on interest-bearing deposits faster than they can raise rates on the interest they receive loaning money.) Some of the big names have actually held up pretty well amid the concerns--these firms are well diversified, and some of the largest stocks jumped in 2003 and 2004 as the stock market rallied.

As The Journal pointed out, CRM more than doubled its bet on Citigroup in 2005 as the stock pretty much went nowhere for the year. The firm also reduced its exposure to stronger performers J.P. Morgan Chase JPM and Bank of America BAC. To me, this represents a pretty significant switch and a savvy upgrade to one of the most profitable companies around.

There was also some notable shuffling outside of those big names last year. The firm added Fifth Third Bancorp FITB, one of the sector's biggest laggards in 2005 (and a favorite of Morningstar's stock analysts). It also added to U.S. Bancorp USB, another slow performer, and cut back on Wachovia WB, which nearly kept pace with the S&P 500 last year. In all, I think the firm has gone against the grain in its approach to banks.

Funds with the biggest stakes in banks include Income Fund of America AMECX and Washington Mutual.

Other Downtrodden Areas
Just about every area of the large-cap universe--except the energy sector--had some losers last year, and American's bottom-fishing wasn't confined to pharma, media, and banks. It also added to its stakes in S&P 500 laggards Cisco Systems CSCO, Dell DELL, General Electric GE, Harley-Davidson HDI, IBM IBM, Oracle ORCL, Starbucks SBUX, Tyco International TYC, United Parcel Service UPS, and Wal-Mart Stores WMT. Not every loser deserved more attention--CRM lightened up on automakers, for instance. But in general, the firm added to its stakes in about two thirds of losing large caps, and reduced in less than one third of cases.

The Upshot
American Funds took in an estimated $79 billion in net inflows last year, so adding to stock positions was much more common than reducing--and that's true whether you're looking at holdings that trailed or trumped the S&P 500 in 2005. And I don't want to indicate that all of the firm's purchases were losers--it added to huge winners such as Google, Schlumberger SLB, Genentech DNA, and WellPoint WLP, too. But for the most part I would say that American is sticking close to its roots by placing its chips on stocks trading cheaply. Of course, time will tell if the funds can benefit from emphasizing any of the above areas--the nature, timing, and duration of broad recoveries isn't easy to handicap. But in the meantime, picking up cheap, dividend-paying stocks and holding on to them for the long term isn't a bad strategy.

Paul Herbert is a senior analyst with Morningstar.