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Buy the Unloved Funds

Here are where the bargains are in 2006.

Russel Kinnel, 01/17/2006

<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><EM>This article originally appeared in </EM><A href="http://corporate.morningstar.com/US/asp/subject.aspx?xmlfile=28.xml" target="_blank" >Morningstar FundInvestor</A><EM>, an award-winning newsletter that presents investment strategies and tracks 500 funds.</EM></P> <P>It's time once more for our annual look at good funds in out-of-favor places. However, I have made some changes to the way we choose our unloved funds.</P> <P>In the past, the funds we labeled as "unloved" were those categories that suffered the greatest outflows on a percentage basis. The problem with this technique is that small categories are much more likely to show large outflows on a percentage basis. Thus, niche sector categories tend to look more unpopular than broad core categories. For example, large growth has been the most out-of-favor category for years if you look at returns and outflows in dollar terms, but this group hasn't seen the percentage outflows of the sector categories flagged by our past studies.</P> <P>Moreover, returns of our buy-the-unloved strategy have lagged as the most popular categories enjoyed extended runs in recent years. If we hit a pivot point in the market and leadership turns, those figures could improve, but I think we can do better. The long-term returns of the strategy have been middling since we began tracking it in 1996, so I think it's had time to prove itself, and it hasn't done that.</P> <P>I'm adopting a more fundamentally driven strategy that should unearth winners that you can buy and put away for the long haul. To get there, I looked for categories that have lagged over the past three years and that are trading at a discount to fair value as judged by Morningstar stock analysts. The idea is to find an attractive pool in which to fish and then to pick a great angler who can make the most of it. Morningstar now covers more than 1,000 stocks, and our stock analysts estimate a fair value for each one. We roll these valuations up to see which parts of the U.S. style box are collectively trading at a discount to fair value. </P> <P>The next part of the process is choosing funds. I've continued the unloved theme by seeking out funds with small asset bases that haven't yet attracted investor attention. Thus, these funds should have at least three legs to stand on in coming years. They're run by talented managers, who are investing in areas with good values, and they're not hamstrung by unwieldy asset bases, so they should be able to make the most of their research. </P> <P>Of course, they also have all the other advantages we look for, such as ethical behavior evidenced by high Stewardship Grades, low costs, a strong record, and a sound strategy.</P> <P><STRONG>Where Are the Bargains?</STRONG></P> <P>The message of our stock analysts' fair value estimates is pretty clear. Large caps are more attractive than small and mid-caps. All three domestic large-cap categories are trading at discounts to fair value (large value, 9.1% discount; large blend, 5.9%; and large growth, 4.8%). Small and mid-caps are trading at premiums: mid-value, 2.4% premium; mid-blend, 6.5%; mid-growth, 14.3%; small value, 6.8%; small blend, 9.8%; and small growth, 8.2%.</P> <P>At the moment, value has a greater discount than growth, but the long drought in growth leads me to conclude that large caps are pretty attractive across the board.</P> <P>Although we don't have enough value estimates on non-U.S. stocks to come up with figures <BR>for foreign categories, I've included a couple of large-cap foreign funds as well because most valuation measures indicate they are selling at similar or lower valuations to U.S. large caps.</P> <P><STRONG>Large Value</STRONG></P> <P><STRONG>Harbor Large Cap Value</STRONG> <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>HILVX</MSTR:SECURITY></P> <P>This is an excellent, focused value fund that investors haven't discovered yet. Run by <BR>Jeff Shaw of Armstrong Shaw Associates since 2001, the fund has only about $800 million <BR>in assets. Shaw and company do traditional value analysis. They estimate a stock's intrinsic value and buy the ones that are trading at a discount of 30% or more. Shaw runs a concentrated, low-turnover portfolio. I like the fact that Amstrong Shaw has only one style and that Jeff Shaw is a majority owner. It means he is focused and not likely to leave the firm. (Interestingly, Armstrong Shaw was just added to the group running Vanguard Windsor II <MSTR:SECURITY>VWNTX</MSTR:SECURITY>.)</P> <P><STRONG>Masters' Select Value</STRONG> <MSTR:SECURITY>MSVFX</MSTR:SECURITY></P> <P>As with the other funds in the Masters' lineup, the story here is pretty straightforward. Outstanding managers run their own slices of a portfolio in a concentrated fashion. Put them together and you get style diversification without a sprawling portfolio.</P> <P>The managers here are Mason Hawkins, who comanages Longleaf funds, Bill Miller of Legg Mason, Bill Nygren of Oakmark Select, and Michael Embler of Franklin Mutual. The first three managers are pretty wide-ranging and tend to invest a fair amount in blend as well as value. Since inception in 2000, the fund has whipped 90% of its large-value peers, even though its blend bias has been a disadvantage. On the downside, the fund does have a meaningful stake in mid-caps.</P> <P><STRONG>ICAP Select Equity</STRONG> <MSTR:SECURITY>ICSLX</MSTR:SECURITY></P> <P>ICAP narrows a group of 450 large-cap U.S. and European names down to 50 by screening for stocks with attractive valuations, consistent-to-improving earnings, and catalysts for growth such as new product launches. Manager Rob Lyon further narrows this group by picking the 20 stocks with the most upside potential. It's a disciplined strategy that ICAP has executed beautifully.</P> <P><STRONG>Large Blend</STRONG></P> <P><STRONG>Vanguard Primecap Core</STRONG> <MSTR:SECURITY>VPCCX</MSTR:SECURITY></P> <P>Okay, I admit this fund's $1.1 billion asset base is a tad deceptive because there's a fair amount of overlap with the $27-billion Vanguard Primecap <MSTR:SECURITY>VPMCX</MSTR:SECURITY>, so maybe it isn't the most nimble fund around. However, it does offer outstanding management, low costs, and a good strategy, so I couldn't leave it out. Like Primecap, this fund makes contrarian plays on out-of-favor growth stocks, but it throws in a few more cyclical names than its bigger sibling.</P> <P><STRONG>Bridgeway Blue-Chip 35 Index</STRONG> <MSTR:SECURITY>BRLIX</MSTR:SECURITY></P> <P>If a portfolio is overrun with small-cap funds, you might consider righting your ship with this pure play on mega-caps. The fund tracks 35 of the largest-cap stocks in the U.S., and it charges just 0.15% for the service.</P> <P><STRONG>Large Growth</STRONG></P> <P><STRONG>T. Rowe Price New America Growth</STRONG> <MSTR:SECURITY>PRWAX</MSTR:SECURITY></P> <P>Manager Joe Milano is one of T. Rowe's rising stars. That this fund hasn't even reached $1 billion makes it especially attractive. His strategy is classic growth-at-a-reasonable-price. That makes the fund an excellent core growth holding. You get a slew of tech, health-care, and retail names in the portfolio, and so far Milano has produced good results. We're eager to see what he can do when growth stocks really run.</P> <P><STRONG>USAA Aggressive Growth</STRONG> <MSTR:SECURITY>USAUX</MSTR:SECURITY></P> <P>This fund is more of a pure play on large growth than the T. Rowe fund. With an average market cap of $39 billion and the able Tom Marsico at the helm, this looks like a great bet. I chose this one over Marsico's in-house funds because it charges about 25 basis points less than the Marsico funds. Don't let the fund's 2-star rating scare you off--Marsico has only been at the helm for the last three years, and he's done an excellent job over that stretch. The low star rating reflects poor performance from Marsico's predecessors.</P> <P><STRONG>Foreign Large Growth</STRONG></P> <P><STRONG>Harbor International Growth</STRONG> <MSTR:SECURITY>HIIGX</MSTR:SECURITY></P> <P>This is another fund that figures to be unknown for a while--a poor long-term record will do that. However, the poor part of the record was earned by a different firm. Since Jim Gendelman (of subadvisor Marsico Capital Management) took the helm the fund has performed well. Although his record here is brief, he has built a fine record at Marsico International Opportunities <MSTR:SECURITY>MIOFX</MSTR:SECURITY>. </P> <P>Gendelman runs a concentrated portfolio focused on attractive growth stocks, and he doesn't care much for whether that takes his country or sector weightings out of line with the MSCI EAFE. In short, it's a stock-picker's fund with a lot of upside. </P> <P><STRONG>Foreign Large Blend</STRONG></P> <P><STRONG>Fidelity Spartan International Index</STRONG> <MSTR:SECURITY>FSIIX</MSTR:SECURITY></P> <P>I admit it's a little dull, but since Fidelity cut expenses to 0.25% this fund has the look of a surefire winner. The average foreign large-blend fund charges an obscene 1.62%, so this fund starts the year with a 1.37 percentage point advantage over the competition. Yet it still has less than $2 billion in assets. If you like to focus your attention on domestic funds and want a basic foreign fund you can buy and put away for a long time, check this one out.</P> <P><STRONG>Foreign Large Value</STRONG></P> <P><STRONG>ICAP International</STRONG> <MSTR:SECURITY>ICEUX</MSTR:SECURITY></P> <P>Why not pick our International-Stock Manager of the Year?  The fund has just $154 million in it, so no need to worry about bloat. Rob Lyon and company do an outstanding job of unearthing good values overseas. Although their funds are small, ICAP has a lot of resources because it manages billions for institutional clients. Their approach is consistent, dependable, and they charge just 0.8%.</P> <P><STRONG>World Stock</STRONG></P> <P><STRONG>T. Rowe Price Global Stock</STRONG> <MSTR:SECURITY>PRGSX</MSTR:SECURITY></P> <P>This makes a great core holding for two reasons: its global mandate and Rob Gensler. Gensler is an excellent manager who produced strong returns at T. Rowe Price Media & Telecom-munications <MSTR:SECURITY>PRMTX</MSTR:SECURITY> before taking the helm at this fund. He applies a growth-at-a-reasonable-<BR>price strategy, which isn't all that original, but he just seems to do it better than most. I also like the fact that this fund's small $150 million asset base affords him plenty of flexibility. This looks like a fund you can buy and put away for many years.</P>

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