Ideas from Top Vanguard Managers

Some of the smartest and most experienced managers I've encountered work for Vanguard as subadvisors. Even inveterate indexers can use their insights for ideas or to set expectations for their portfolios. Here are some key takeaways from recent interviews with Vanguard subadvisors.

A Crapola Shoot
Most of the fund managers I've spoken with recently agree that the stock and bond markets' massive comebacks since March 2009 have been driven by what one Vanguard subadvisor charitably called "crapola." Ford Draper Jr., one of seven subadvisors on  Vanguard Explorer (VEXPX), only slightly exaggerated in a recent report to the shareholders of his own  Kalmar Growth-with-Value Small Cap  when he wrote that the rebound has been marked by massive relative outperformance of "lower quality/highly leveraged/smallest/lowest price/non-earning/most beaten down/highest beta/most economically sensitive stocks."

That could be the sour grapes of someone who has lagged in the rally, as Kalmar has. The data, however, back him up. Recent Morningstar fund research has shown funds owning the lowest-quality stocks bounced back much faster than those with the highest-quality holdings in 2009. Conversely, equity portfolios whose holdings had poorer average quality measures, such as higher debt/capital ratios and lower free cash-flow yields, did far worse last year than funds that scored better on those metrics. Similarly, Morningstar's individual stock data shows  unprofitable firms with dubious balance sheets and market positions have done better than profitable, financially sound companies with defensible competitive advantages in 2009. Smaller also has been better this year. The Morningstar Small Cap Index's 28% year-to-date return through Nov. 30, 2009, beats the 23% gain of the Morningstar Large Cap Index.

Quality for Sale
Consequently, the broad stock market's valuations aren't as cheap as they were in the first quarter of 2009. Managers I've spoken with recently, though, say there are still opportunities among high-quality stocks, meaning those with strong competitive advantages, or moats, and steady, predictable cash flow, earnings, and growth trajectories. Those sorts of steady-Eddie stocks don't go on sale often, but they've been attractively priced in the past year, said Don Kilbride, manager of  Vanguard Dividend Growth (VDIGX).

Kilbride's universe, which includes dividend-paying companies that can and will increase their payouts over time, has shrunk in the last two years as a global recession and frozen credit markets made companies more inclined to hoard capital instead of share it. Yet some market leaders that stayed profitable and financially healthy through the crisis reached once-in-a-lifetime prices. Kilbride, for example, bought personal hygiene company  Colgate-Palmolive (CL), whose average price/earnings ratio has hovered in the mid-20s for more than a decade, when its P/E was in the mid- to low teens. That's a good price for a global company selling products--toothpaste, shampoo, soap--that most people wouldn't forgo unless they fell into abject destitution.

Miracle on Wall Street
About a decade ago on "Louis Rukeyser's Wall Street" television program, the host asked  Vanguard Windsor II (VWNFX) manager Jim Barrow what it would take for him to own the likes of Microsoft. "A miracle," Barrow responded.

Miracles do happen. Barrow not only now owns  Microsoft (MSFT), but also  Intel (INTC), Nokia, and  IBM (IBM)--stocks that in the late 1990s were supposedly going to spend the next several decades wiping the floor with old-economy firms like Colgate-Palmolive. Barrow's reason for owning the tech bellwethers is not that he thinks they can still achieve the heroic growth rates many foresaw for them at the turn of the century. Instead he likes them because they look more like Colgate: They pay dividends, have strong balance sheets and cash flows, defend formidable market positions, and still boast steady, if unspectacular, growth prospects.

Similarly,  Vanguard Wellington (VWELX) manager Ed Bousa and  Vanguard Windsor (VWNDX) manager Jim Mordy recently bought  Cisco Systems  (CSCO). Telecom service providers have to upgrade their networks to accommodate growing demand for video and data over the Internet, and the network gear maker is situated to benefit, they said.

Pfizer's Pfundamentals
Investors have been worried about health-care stocks. Although the sector has gained money, it has been one of the relatively weaker sectors of the year so far and has some of the lowest valuations. That's partly because of the health-care reform debate. Longstanding worries about the patents, product pipelines, and liabilities of big pharmaceutical companies and some medical-device companies also persist.

Nevertheless, a lot of managers to whom I have recently listened argue that there are values in health care. I've heard many managers talk about  Pfizer (PFE), another one-time growth darling that has been a pariah this decade, falling 3% annualized over the 10 years ended Dec. 3, 2009. The drugmaker must integrate the recently acquired Wyeth and find a replacement for its cash-cow cholesterol drug Lipitor before its patent expires in two years. Although the market initially frowned on the Wyeth deal, several Wellington Management managers, notably Bousa, Kilbride, and Mordy, bought the company's shares after it cut its dividend earlier this year. They think it still has the free cash flow to resume growing its dividend from its new lower level and that Wyeth's complementary pipeline could take some of the sting out of losing exclusivity to Lipitor in 2011. It's arguably very cheap. Several of its valuation metrics, such as P/E ratio and dividend yield, are at historically attractive levels.

How Deep Is Your Moat
The arguments in favor of high-quality stocks seem compelling. Such stocks also still look relatively attractive to Morningstar stock analysts, who say there are still many wide-moat firms they cover that look undervalued enough to be compelling buys.

So, avoid chasing the returns of the low-quality, smaller-cap stocks that have rallied this year. That's where the high prices and risks are. Also, don't lose faith in the larger-cap, classic core holdings that have looked sluggish. They at least have less downside risk than more speculative fare that has run harder this year. If high-quality stocks don't already make up the foundation of your portfolio, it may not be too late to shore it up with a fund like Vanguard Dividend Growth, which Morningstar recently made a  Fund Analyst Pick in the large-cap blend category.

A version of this article ran in a previousVanguard Fund Family Report.

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