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Buy the Unloved 2015

Going against the grain of flows can be a profitable strategy.

Russel Kinnel, 01/27/2015

This article was published in the January 2015 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Our annual "buy the unloved" strategy points you to unpopular Morningstar Categories that may be due for a rebound. Historically, it has pointed to more winners than losers. The idea is to buy funds from the three unloved categories and sell three from the loved. You then hold the unloved for three to five years. Starting from 1993 and rolling it forward, the strategy returned an annualized 10.3% for unloved funds versus 6.4% for loved funds. I wouldn't suggest making wholesale portfolio changes, but rather make these changes at the margins or simply use this as a guide for where to shop or what to avoid when looking for new funds.

Although the strategy has done well over the long haul, last year's picks are in a pretty big hole. Large growth was a great spot to invest, but the other two categories were precious-metals equity and natural-resources equity. Ugh.

In 2014, the three most redeemed equity categories were large growth, mid-growth, and small growth. That's interesting, given that large growth was quite strong and even mid-growth had pretty good returns. Nonetheless, all three still have appeal. I don't want to push my luck with large growth, so I'll focus on funds with Morningstar Risk ratings that are Below Average.

Jensen Quality Growth JENSX is probably the most contrarian option, as high quality has been out of favor in recent years. The managers seek out companies that have produced returns on equity of at least 15% for the past 10 years. Then they do discounted cash flow models and look for companies trading at a discount to their value. The result is a group of high-quality brand names with modest growth, such as PepsiCo PEP3M MMM, and Accenture ACN. The fund holds up nicely in downturns but tends to have pedestrian results in rallies.

Fidelity Contrafund FCNTX is more aggressive than the Jensen fund, but Will Danoff has been a very able manager in all environments. With an enormous asset base to command, Danoff invests more money in more companies than you might think possible to own while still producing good results. And he just keeps going and going. Danoff looks for companies with great products and strong management and aims to get ahead of the trend on both. He loves to attend meetings with company management, and of course scores of them come through Fidelity's offices every day. 

American Funds AMCAP AMCPX has been run with a steady hand over the years. Run by five managers and a pool of analysts, the fund looks for companies with competitive positions, above-average growth, and shares trading at modest valuations. (Today, there are 142 stocks in the portfolio and a distinct health-care bias.) What's impressive is the consistency of performance. The fund has outperformed in eight of the past 10 years and held up quite well in down markets in 2008 and 2011.

Vanguard Mid-Cap Growth VMGRX is a cheap way to get your mid-growth exposure. Assets are split between subadvisors Chartwell Investment Partners and William Blair. Ed Antoian of Chartwell and Robert Lanphier IV of William Blair have been with the fund since 2006. Since they came on board, the fund has matched the Russell Midcap Growth Index while beating peers by about 200 basis points a year. The fund hasn't yet lagged peers by a meaningful amount in any single year, while its years of outperformance, including 2014, have often been by margins of 300 basis points or more. 

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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