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Finding American Funds with 5-Star Stock Portfolios

Uncover contrarian fund plays with our stock star rating.

Paul Herbert, 01/23/2006

<EM> <P><EM>Get mutual fund and stock information from our analyst team delivered to your e-mailbox every Tuesday. </EM><A href="http://advisor.morningstar.com/products/enews.asp" ><EM>Sign up for our free Investment Insights e-newsletter</EM></A><EM>.</EM></P> <P>Below is an excerpt from the January issue of Morningstar's <A href="http://corporate.morningstar.com/US/asp/subject.aspx?xmlfile=31.xml" target="_blank" >American Funds Fund Family Report</A>. </EM></P> <P>A lot of folks at least try to buy low and sell high when investing in stocks, but in my experience investors don't seem to take the same tack when buying mutual funds. Month after month, year after year, more and more money flows into the hottest funds in the hottest categories. (Though in recent years, assets have flocked to American Funds Growth Fund of America <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>AGTHX</MSTR:SECURITY>, which would be more accurately referred to as a hot fund in the coldest category.)</P> <P>In general, then, fund investors seem to operate according to the adage "The proof is in the pudding." This behavior persists despite a lack of meaningful evidence that above-average past performance tells you anything about how a fund will fare in the future.</P> <P>You might be thinking that I'm about to advocate investing in funds with the worst records. I'm not, though there are cases, when it makes sense to pay attention to the down and out.</P> <P>Instead, I'm going to suggest a different way of determining if a fund's portfolio is undervalued--by looking at the Morningstar Ratings of the individual stocks a fund holds. The stock ratings are assigned by our equity analysts and indicate whether a stock is over-, under-, or  fairly valued. To arrive at these measures, the analysts build cash-flow models for each company and make assessments of its long-term competitive advantages--<A href="http://quicktake.morningstar.com/DataDefs/StockMorningstarAnalysis.html#Moat" >economic moats</A>--and potential to withstand or fall victim to event risk--<A href="http://quicktake.morningstar.com/DataDefs/StockMorningstarAnalysis.html#Risk" >business risk</A>. You can think of a moat as a measure of a company's ability to keep rivals at bay. Often, one is created when a product or service has a market-share lead, patent protection, high customer switching costs, or a low-cost advantage. At the end of the day, each stock is assigned a moat and risk value, as well as an overall rating from 1 to 5 stars. Stocks earning 1 star are the most overvalued, and those with 5 stars are the most undervalued. </P> <P>To examine how the American funds stack up on these measures, I looked at each offering's most recent portfolio holdings and counted up the number of 4- and 5-star stocks, wide-moat stocks, and below-average business risk stocks. The idea is to identify those funds that are truly targeting high-quality businesses trading at inexpensive valuations. Since most of our stock team's efforts are focused on U.S. companies, I limited my evaluation to American's domestic-stock funds.</P> <P>See below for discussions of the three funds that looked stronger than the other American offerings in the same Morningstar categories on the basis of these criteria. For reference, in the S&P 500 Index, 23% of stocks land in 4- and 5-star territory; 35% of stocks have wide moats; and 22% of stocks have below-average risk.</P> <P><STRONG>American Funds Amcap</STRONG> <MSTR:SECURITY>AMCPX</MSTR:SECURITY><BR><STRONG>Category: Large Growth</STRONG></P> <P>I wouldn't necessarily expect growth funds to have as many highly rated stocks as value funds, but Amcap had the second-highest percentage of 4- and 5-star stocks (28%) of those I looked at in the American Funds lineup.</P> <P>This fund's broad mandate is to pursue "established growth companies with proven records of steady, above-average earnings and a growth rate faster than that of the general market." Broadly speaking, such companies haven't performed well in recent years, as smaller-cap and cyclical companies have been all the rage.</P> <P>The fund has been fond of companies such as Oracle <MSTR:SECURITY>ORCL</MSTR:SECURITY>, which has faced regulatory scrutiny over some of its recent acquisitions but possesses a database business that generates significant free cash flow. The stock garners a 5-star rating, wide economic moat, and is one of the fund's top 20 holdings.</P> <P>Other highly rated stocks such as First Data <MSTR:SECURITY>FDC</MSTR:SECURITY> pepper its list of principal holdings. Growth Fund of America has 23% of its portfolio in higher-rated stocks. It holds a bulky weighting in energy stocks, which have rocketed in recent years and generally sport fewer stars.</P> <P><STRONG>American Funds American Mutual</STRONG> <MSTR:SECURITY>AMRMX</MSTR:SECURITY><BR><STRONG>Category: Large Value</STRONG></P> <P>There was actually a tie in this group between American Mutual and  Investment Company of America <MSTR:SECURITY>AIVSX</MSTR:SECURITY>--with each fund parking 26% of its assets in 4- and 5-star stocks--but the former owns a greater percentage of stocks with below-average risk ratings.</P> <P>American Mutual places more emphasis on income and stability than most stock funds, and that has led it to hold firms such as Abbott Labs <MSTR:SECURITY>ABT</MSTR:SECURITY>, Coca-Cola <MSTR:SECURITY>KO</MSTR:SECURITY>, and  Microsoft <MSTR:SECURITY>MSFT</MSTR:SECURITY>. These stocks feature the lowest risk ratings because of their nearly ubiquitous brands and diversified product lines. Regulatory troubles could sideline these companies, but they've generally dealt with such scrutiny well in the past. And because these stocks haven't fared particularly well in recent years, each earns 4 or 5 stars.</P> <P>Investment Company, the firm's flagship offering, invests in blue-chip stocks, and names such as Walgreen <MSTR:SECURITY>WAG</MSTR:SECURITY>, AIG <MSTR:SECURITY>AIG</MSTR:SECURITY>, and  PepsiCo <MSTR:SECURITY>PEP</MSTR:SECURITY> are among its higher-rated choices. I was somewhat surprised to find that Washington Mutual Investors <MSTR:SECURITY>AWSHX</MSTR:SECURITY>, a large-value sibling of these funds, didn't own as many 4- and 5-star stocks, but it is somewhat comforting that it owns fewer 1- and 2-star names than its category siblings do.</P> <P><STRONG>American Funds American Balanced</STRONG> <MSTR:SECURITY>ABALX</MSTR:SECURITY><BR><STRONG>Category: Moderate Allocation</STRONG></P> <P>American Balanced owns higher percentages of 4- and 5-star stocks, wide-moat stocks, and stocks with below-average risk than any other offering in American's lineup. Thirty percent of its equity portfolio resides in stocks with 4 or 5 stars.</P> <P>The fund doesn't seem to have a strategy that's too distinct from the rest of the American Funds family--though its portfolio doesn't usually exhibit much of a bias toward growth or value stocks and often sports a higher average market cap. And the managers have certainly trolled the mega-cap waters for cheap names, including 5-star Wal-Mart <MSTR:SECURITY>WMT</MSTR:SECURITY>, which should continue to expand its margins and grow revenue at a double-digit clip in the next few years.</P> <P>Category peer Income Fund of America <MSTR:SECURITY>AMECX</MSTR:SECURITY> doesn't own as many higher-rated names, partly because it has bigger stakes in energy and utilities stocks, which have done very well lately.  </P> <P><STRONG>What This Means for You</STRONG></P> <P>The Morningstar Rating for stocks should be viewed as another arrow in your fund-evaluation quiver. It doesn't take the place of homing in on funds with low costs, experienced managers, and the ability to complement other holdings.</P> <P>But the star rating helps you to keep a watchful eye on the valuations of the stocks that your funds own, and to compare funds on the basis of how keenly the fund manager is paying attention to price and quality. If you're looking to add large-growth exposure to your portfolio, for instance, it makes sense to consider that Amcap appears to be focusing on inexpensive companies that can overcome threats from their rivals more than Growth Fund of America and New Economy <MSTR:SECURITY>ANEFX</MSTR:SECURITY> are.</P>

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