These Bull-Market Laggards Are Worth a Look

Since bottoming out three years ago to date on Friday, the stock market has staged quite a comeback. The S&P 500 is up more than 100% since March 9, 2009, making many stocks' and stock funds' three-year annualized returns appear downright rosy. Of course, in stocks the rule "what goes up must come down" sometimes gets turned on its head. Companies and sectors that are beaten-down the most in a market collapse, such as during 2008 and early 2009, eventually have more room to run once the economy and market turn positive again.

Take, for example, real estate and financials stocks, both of which took a pounding amid the bursting of the housing bubble and the credit crisis that followed. Yet, today real estate and financials stocks have three-year annualized returns of 50% and 36%, respectively, versus the S&P 500 average of 28%. (For a discussion of which stock fund categories have performed best and worst in the three years since the market bottom, click here.)

By contrast, stocks and funds with more defensive characteristics, which held up reasonably well in the down market, now might be showing less impressive three-year returns. For example,  American Century Equity Income (TWEAX), a large-value fund with a conservative profile that typically holds about 20% of assets in convertible bonds, limited its losses in 2008 to 20%, compared with a 37% loss for the S&P 500. In the three years since the market bottom, the fund has returned about 18% annually on average. Not bad, but still nearly 10 points less per year than the S&P 500's return.

Despite its relative underperformance since the market bottom, the fund carries a Morningstar Analyst Rating of Silver, meaning Morningstar's analysts believe it has important advantages that could help it outperform its peers in the years ahead.

To find other quality funds that have underperformed since the market bottom, we turned to Morningstar's  Premium Fund Screener tool and searched for no-load domestic-stock funds in the bottom quartile in performance--meaning they have returned less than 24.2% annually each of the past three years--but with Gold or Silver analyst ratings. Premium users can click  here to run the screen themselves. Here are a few of the funds we found.

 Sound Shore (SSHFX)(
)This large-value fund kept pace with the market throughout the 2009 recovery only to fall behind in 2010. It then suffered through a disastrous 2011, losing 6.2% and lagging the market by more than 8 percentage points. Underperformance by financials such as  Citigroup (C) and tech stocks, including  Microsoft (MSFT), didn't help. The fund's longtime management team targets beaten-down stocks with strong fundamentals selling at discounts. Despite a disappointing two years, the fund has delivered consistent long-term performance, narrowly beating the market during the trailing 10- and 15-year periods; it also offers strong stewardship and a sensible process. So far in 2012, the fund has returned a robust 10.5%, 3 points ahead of the market.

 Osterweis (OSTFX)(
)After beating the market by more than 4 percentage points in both 2008 and 2009, this fund lagged by more than 2 points the following year and by more than 6 points last year. Health care and energy make up about 40% of the fund's all-cap portfolio. The fund's managers look for stocks selling at attractive prices but with good growth potential. They also tend to keep an unusually large cash position--currently about 10% of assets--a strategy that has helped the fund outperform in bear markets but can cause it to lag during rallies. Morningstar analyst Dan Culloton likes the seasoned management team and their willingness to run a portfolio that looks quite a bit different than their peers'; the fund's 10-year average annual return of 6.5% outpaces the market's return by nearly 3 points. 

 Vanguard Health Care (VGHCX) (
)This behemoth--with $21.7 billion in assets, it dwarfs its competition--held up far better than its peers during the bear market; its 18.5% loss in 2008 was 5 percentage points smaller than the category average and beat the market by a whopping 18.5 points. The fund lagged in 2009 and 2010 before delivering a strong 2011, with an 11.5% gain, well ahead of the 7.7% for the category. Given its size, it's not surprising that large drugmakers such as  Merck (MRK) and  Pfizer (PFE) dominate the portfolio, making up as much as 60% of its holdings. The fund's managers favor a value-oriented approach, and turnover is minimal at just 9.0%. With an expense ratio of just 0.35%, this fund has a built-in advantage over its actively managed competitors, which average of about 1.5% in fees; it's also cheaper than some health-care exchange-traded funds. This fund's 10-year average return of about 7.0% is in the top quartile for the category, and its 15-year average return of 11.8% puts it in the top 1.0% for the group. Morningstar analyst Chris Davis also likes the fund's fundamentals, noting that the team here averages 24 years' worth of experience and that they've had success uncovering drug and health-services picks that went on to outperform.

Performance data as of March 7, 2012.