These Fine Funds Are Betting Heavily on Consumer-Defensive Stocks

After a red-hot first quarter, investors may be wondering what's next for stocks. Is there any upside left?

Although the companies under coverage at Morningstar are fairly valued, in aggregate, the most recent quarter-end insights from our stock analysts revealed optimism for stocks in our newly created consumer-defensive sector. That sector comprises companies that manufacture and sell products that consumers buy regardless of the economic climate: food, beverages, household and personal products, packaging, and tobacco. Additionally, certain retailers such as  Wal-Mart  (WMT) and companies that provide education and training services fall under the consumer-defensive umbrella.

Even though continued inflationary pressures and still-anemic wage growth could put pressure on consumers, our analysts expressed confidence that consumer packaged goods will continue to recover in 2011. And while consumer discretionary stocks have had a heyday during the past two years, our analysts foresee discretionary stocks taking a back seat to the consumer-defensive universe. Our analysts are particularly attracted to wide-moat consumer-defensive stocks--those that benefit from economies of scale, enjoy pricing power in at least some of their product categories, and have a foothold in emerging markets. Click here to read the full report on our outlook for the consumer-defensive sector.

 Colgate-Palmolive (CL) and  Procter & Gamble  (PG) are two consumer-defensive companies that currently earn Morningstar Ratings for stocks of 4 or 5 stars. (To see our full list of 4- and 5-star-rated stocks in the consumer-defensive sector,  click here.) To help unearth mutual funds that have positioned their portfolios to capture the potential upside of consumer-defensive sector stocks, we turned to the  Premium Fund Screener. First, we sifted through the domestic-stock universe for distinct share classes of diversified mutual funds that had overweighted the consumer-defensive sector by staking more than a 15.00% of their portfolios in it. (For comparison's sake, the S&P 500 Index has 10.73% in the consumer-defensive sector.)

To help ensure that a fund's consumer-defensive exposure wouldn't be fleeting, we screened out funds with more than 100% turnover. On the fees front, we eliminated load funds and sought offerings with expense ratios below the category average. We required that managers have helmed their fund for more than five years, and we capped the minimum initial purchase requirement at $5,000. Premium members can replicate the screen by  clicking here. We highlight three of our findings below.

 Dreyfus Appreciation (DGAGX)
This large-blend fund has long gravitated toward wide-moat mega-cap names within the consumer-goods realm, and the portfolio's 29% concentration in consumer-defensive stocks indicates that management's convictions have not wavered. Management's strong convictions translate well into their sell discipline. While they keep turnover ultralow, they sold  Transocean (RIG) after holding it for three years due to concerns about supply/demand in deep-water drilling; the stock eventually plummeted because of the Gulf oil spill. Using a disciplined strategy, management has generated a strong long-term record; low turnover also maximizes tax efficiency.

 Jensen (JENSX)
Like Dreyfus Appreciation, this is a concentrated fund (just 28 holdings) that operates under a highly disciplined investment strategy. Specifically, management requires that prospective holdings have earned a 15% return on equity for 10 consecutive years and also aims to buy them when they're trading below their estimates of fair value. Following this approach, the fund has generated compellingly consistent results over long time frames; through late 2010, it had beaten its peers in 74% of five-year rolling periods. Although the fund may lag during periods when speculative fare is in vogue, this steady-Eddie offering capably fits the bill as a core holding for conservative, risk-conscious investors.

 Yacktman Focused (YAFFX)
Managers Don Yacktman, Stephen Yacktman, and Jason Subotky favor wide-moat, blue-chip firms that generate plenty of free cash flow, have little debt, and are selling at a discount to their estimates of fair value. They've long found plenty of names fitting those criteria in the consumer-defensive sector; as of year-end 2010, the portfolio had a 36% stake there. The fund has generated excellent long-term returns and has also demonstrated remarkable resilience. When stocks tanked from late 2007 through early 2009, the fund lost roughly one third of its value, whereas the S&P 500 dropped by half. For investors who are able to withstand some of the short-term performance swings that come with concentrated funds, this fund is worthy of consideration.