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Funds That Look Cheaper Than the Market

This screen turns up solid funds with lower valuations than the S&P 500 Index.

Karin Anderson, 05/03/2010

Even with the stock market's retreat so far this year, the market still looks a bit rich according to some measures such as the cyclically adjusted price/earnings ratio, a favorite measure of economist Robert Schiller. Other investors argue that the market actually looks undervalued based on different measures, but most managers agree that the bargains of a year ago are gone and that it's been hard to gauge the quality of corporate earnings in the wake of the crisis. In such an environment, it makes sense to veer toward portfolios with a built-in margin of safety, or lower valuations than the market.

Morningstar Principia and Morningstar Office are great tools for casting a net for domestic funds whose holdings appear undervalued relative to the broader market. In this case, our screen is focused on mid-cap stock funds in addition to large-cap portfolios because a lot of go-anywhere funds that view the S&P 500 Index as their primary benchmark end up in the mid-cap categories by default. The following criteria are also important components of the screen. First, the screen limits the results to reasonably priced funds (those that levy 1% annually or less) that are open to new investments of $25,000 or less. The field is also narrowed to funds covered by Morningstar analysts.

Criteria:

Special Criteria = Distinct Portfolios Only
And ( Morningstar category = Large Value
Or Morningstar category = Large Blend
Or Morningstar category = Large Growth
Or Morningstar category = Mid Value
Or Morningstar category = Mid Blend
Or Morningstar category = Mid Growth )
And Audited expense ratio <= 1.00
And Purchase Constraints not = Closed-New Investment
And Minimum Initial Purchase < 25,000
And Analysis not = NA

To uncover the long-term winners, we limited the results to funds that ranked in the top quartile of their respective categories for the trailing 10-year period. To make sure that the current team is responsible for the solid record, manager tenure is set to 10 years or more.

And % Rank Cat 10 Yr <= 25
And Manager Tenure (Longest) >= 10

Last, the screen is set to pull funds that have lower forward-looking price/earnings, price/book, and price/cash-flow measures than those of the S&P 500 Index. We use the corresponding measures of the Vanguard 500 Index Investor VFINX as a proxy. (These measures can be verified by looking up the Vanguard fund in Morningstar Office or Morningstar Principia.)

And Price/Prospective Earnings <= 15
And Price/Prospective Book <= 2  
And Price/Prospective Cash <= 7

As of Feb. 16, the screen pulled eight results. Here are some that stand out.

Fidelity Low-Priced Stock FLPSX
While our proxy recently had a forward P/E multiple of 15, this mid-cap blend fund's was 12.4. And the fund's price/book and price/cash-flow measures, clocking in at 1.3 and 3.9, respectively, were roughly half the proxy's at last count. Manager Joel Tillinghast runs an eclectic portfolio with hundreds of holdings. His process involves using discounted cash-flow analysis to value firms and then buying when stocks are trading well below his fair value estimates. Over the long term, the fund's valuation measures have remained below that of the broader market, and its long-term record is topnotch.

Tillinghast has managed this fund since its 1989 inception. Not only is he one of the most experienced managers around, he is also one of the best. Tillinghast receives research support from a team of small-cap analysts (both in Boston and in Fidelity's international locations) and from Fidelity's industry analysts, but he does much of the research on his own.

Dodge & Cox Stock DODGX
Management zeros in on large-cap firms that look attractively priced on a variety of value measures. Recently, the fund sported a forward P/E of 13.6, price/book of 1.5, and price/ cash flow of 5. The team's valuation-conscious approach often leads it to beaten-down sectors, and the managers aren't afraid to load up. For example, the fund's 23% stake in health-care firms was nearly twice the S&P 500's at last count, in part because the team believes negative news on patent expirations is already priced in and health-care reform has become less likely. The fund's contrarian streak has gotten it in trouble at times, such as when it bought financials stocks going into 2008. The fund's process has produced a great record over the long term, though.

Fairholme FAIRX
Going his own way is the foundation of manager Bruce Berkowitz's success. Berkowitz has run this fund since its December 1999 inception, and he's successfully applied his Warren Buffett-style across the market- cap spectrum. As is typical, the fund's forward P/E of 12.7--as well as its price/book and price/cash-flow measures--is well below that of the broader market. In addition to a large stake in mid-cap stocks, his willingness to buy high-yielding senior debt and hold large cash stakes has also made this fund stand out from the crowd. Thanks to strong security selection, this large-blend fund has produced returns that handily outpace the index and the competition over the past decade.

The constant here is that Berkowitz remains opportunistic and moves quickly to remake his portfolio when he sees opportunity. Berkowitz's bold moves carry risk, but his strong record gives confidence he'll make them work.

Vanguard Windsor II VWNFX
Although five other subadvisors contribute to the fund's stock picks, Jim Barrow of Barrow, Hanley, Mewhinney & Strauss is responsible for roughly two thirds of its assets. He focuses on approximately 50 large-cap stocks that are attractively valued and sport above-average dividend yields. Indeed, the portfolio's forward P/E recently clocked in at 12.9, and its price/book and price/cash- flow measures at 1.8 and 5.9, respectively. But just because the fund has focused on more conservatively valued fare doesn't mean it will sit out every rally. For example, its 27% gain in 2009 beat out nearly three fourths of its large-value brethren, which was driven in part by larger-than-average stakes in industrial materials and hardware firms. Barrow has been largely responsible for the fund's strong record since its 1985 inception, and its dividend cushion should continue to provide ballast during bumpy markets.

Karin Anderson is a mutual fund analyst with Morningstar. 

Karin Anderson is a senior mutual fund analyst with Morningstar.
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