Finding Cheap Core Holdings

Equities' sharp, painful plunge has driven down stocks' valuations, but the recession has also taken a big bite out of profits. Consumer spending has dropped significantly, and consumer confidence may not rise to previous levels anytime soon. What's more, the financials crisis, brought on in part by excessive use of leverage, means companies are less likely to take on big debt loads to juice their profits in the near future. As a result, the economy may grow at a more modest pace over the intermediate to long term, which could in turn lead to more-muted returns for stocks than they have historically provided. In such a scenario, lower costs become more important.

We used Morningstar's Premium  Fund Screener to identify cheap, proven offerings run by veteran skippers that can serve as the foundation of an investor's portfolio. We screened for domestic- and international-stock funds (distinct portfolios only) that Morningstar's fund analysts believe can serve as core holdings, by using the Role in Portfolio, Fund Category, and Distinct Portfolio Only criteria. We also required the funds to not charge sales loads, be open to new investors, and be available for an initial investment of $10,000 or less. (These criteria can be found under Fees & Expenses, Closed to New Investment, and Minimum Initial Purchase, respectively.) Then using the Fund Manager Tenure, 10 Yr Return % Rank Category, and Fees & Expenses criteria, we narrowed the list down further to find funds with managers who have been on the job for at least a decade, who have generated top-third returns in their categories over that span, and that carry expense ratios of less than 0.8% (which puts them among the lowest quartile among domestic-stock funds).

 The screen returned the following funds as of May 18, 2009:

 DFA International (DFIVX)
 Dodge & Cox Stock (DODGX)
 Elfun Trusts (ELFNX) (This fund is available only to employees of  General Electric (GE).)
 Homestead Value (HOVLX)
 Vanguard LifeStrategy Growth (VASGX)

All five of these funds land in large-cap categories. The most expensive of the bunch, Homestead Value, charges 0.7%

Many investors probably know the story behind Dodge & Cox Stock , but this fund's merits bear repeating. Its team of nine portfolio managers boasts an average of 14 years' tenure on the fund (and 24 years at the firm, which has very low personnel turnover), and they're supported by a crack team of analysts. They ply a patient, fundamentally appealing brand of value investing, seeking out companies with solid management teams and competitive positions that are trading cheaply. (Such firms have often run into some sort of trouble.) The team has consistently applied this strategy, even when it's heavily out of favor. That has led to runs of underperformance at times, but investors have been greatly rewarded over the long haul. True, the team made a big mistake in jumping into financial firms such as  Fannie Mae (FNM) and Wachovia after their stocks had been hit hard in early 2008 (those companies later imploded), but we're confident they've learned from that error. Furthermore, the fund's 0.52% expense ratio gives it a big leg up over most of its large-value rivals.

Homestead Value deserves more attention from investors. This $400 million fund is another slow-moving value offering (portfolio turnover averages less than 15% annually) that likes fundamentally strong companies selling cheaply. But this fund is more willing (and able, due to its modest size) to scoop up smaller fry and companies in traditional growth-oriented sectors such as tech. The portfolio is also compact, with just 40-50 holdings. Its atypical look within the large-value category makes for streaky relative returns, and its concentrated portfolio has resulted in above-average volatility--but the fund has outpaced three fourths of its rivals over the past decade. And two of its three portfolio managers have been on board since the fund's 1990 inception.

No stand-alone index funds passed our performance screen, but Vanguard LifeStrategy Growth (which owns three Vanguard index funds and one actively managed fund) did. It invests 50% of its assets in  Vanguard Total Stock Market Index (VTSMX), 15% in  Vanguard Total International Stock Index (VGTSX) and 10% in  Vanguard Total Bond Market Index (VBMFX). The remaining 25% is stashed in  Vanguard Asset Allocation , which invests in the S&P 500 Index and the Barclays Long-Term Treasury Index in proportions that represent its outlook on future returns for stocks and bonds--thus, that fund can veer from 100% stocks to 100% bonds, and LifeStrategy Growth's equity weighting will vary from 65% to 90%. The fund lands in the large-blend category and has beaten 80% of its category peers over the past 10 years. However, its bond exposure has provided a strong tail wind over that span (since stocks have lagged). We wouldn't expect such strong relative performance in the future, but the fund is nonetheless a solid holding for investors looking for one-stop shopping.

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