What's the Biggest Fund Family Doing with Financials?

The financial services sector has dominated market news over the past 12 months, ever since the subprime-mortgage market imploded and kicked off a credit crunch. As a result, the fortunes of many mortgage lenders and banks--and even some financial firms that didn't previously appear vulnerable--have taken a dramatic turn for the worse. Over the 12 months ended March 25, 2008, the typical financials fund has lost 19%. That's substantially worse than any of Morningstar's domestic diversified stock-fund categories.

The turmoil in this sector, which still has the largest weighting of any sector in major market-cap-weighted indexes such as the S&P 500, may not be over. Some fund managers have told me that financials' valuations are now appealing on an absolute basis, but some skippers are concerned that further large write-downs as a result of losses on lower-quality loans could yet drive down earnings prospects and book values to an even greater degree. Thus, current price multiples could be quite misleading. Other managers, however, believe the vast majority of the subprime-related damage has been reported, at least in certain cases, and are beginning to wade into the sector.

Given financials' uncertain prospects, I think it's useful to examine what the sharp investing minds at American Funds are doing. The firm's funds generally boast excellent long-term performance and are run by a very large staff of experienced managers and analysts. In the March issue of the American Funds Fund Family Report, I took a broad look at how the funds' holdings had changed between December 2006 and 2007's end, according to regulatory filings. Below, I'll specifically discuss the moves that American's managers have made in this troubled sector.

Going Against the Grain
In general, American's skippers employ long-term approaches; portfolio turnover at the equity funds runs about 30% annually. Thus, there wasn't a lot of activity within the funds in 2007, as usual. However, many of American's managers are contrarian investors by nature, and the downturn in the financial sector presented them with apparent buying opportunities. Most of the equity funds previously held below-average stakes in financial stocks, because American's managers felt margins and profits were at unsustainably high levels. But as lenders and other financial firms were hit hard in 2007 by the implosion of subprime mortgages and the ensuing credit crunch, the managers began buying in that sector. For example, the funds' stake in  Citigroup (C) (which lost nearly half its value in 2007) jumped by one third, as measured by the number of shares they hold (though the position still declined as a percentage of the funds' assets), and their position in mortgage lender  Fannie Mae (FNM) increased by 40%. Also, the managers dramatically increased their stake in  Bank of America (BAC), which some observers feel has been overly punished in the subprime meltdown, given its seemingly limited exposure to lower-quality loans and its sizable deposit base. Finally, the funds bought a modest position in one of the most troubled names in the sector, mortgage lender  Countrywide Financial , which declined 78% in 2007. Not a single one of American's funds owned the stock at the end of 2006 (just before it hit the skids after a huge run). Although Countrywide has dropped another 28% in value for the year to date through March 25, 2008, the American Funds that own it, such as  American Funds Washington Mutual (AWSHX), have nevertheless held up well thus far.

The managers held fast, without buying or selling many shares, to some of the other firms that were pummeled last year, including insurer  American International Group (AIG) (which ran into trouble in its credit default swap business), lender  Washington Mutual (WM), and insurance broker  Marsh & McLennan (MMC) (which has been beset by regulatory issues). In fact, of the funds' 10 largest holdings in the sector in 2006, they added to their stakes in eight of those companies and trimmed their stakes in the other two only slightly. All told, the funds' financial stakes rose a bit on an absolute basis, despite very significant share-price depreciation.

Keep These Moves in Perspective
I think American Funds' contrarian stance amid the turmoil in this sector is noteworthy. The funds aren't known for diving into companies that carry a lot of downside risk--none of American's three large-value funds ( American Funds American Mutual (AMRMX),  American Funds Investment Company of America (AIVSX), and American Funds Washington Mutual) could be called deep-value offerings. Thus, the managers apparently believe that most of the recent and future bad news is priced into the stocks. Whether these moves pay off remains to be seen, of course, but we don't think that investors should be spooked by them. Not only does the investment staff have a long history of sound fundamental stock-picking, but the funds are broadly diversified across sectors and companies, thus reducing the impact of blowups.

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