These Funds Are Counting on Undervalued Sectors

The market's strong, if sometimes wobbly, performance so far this year has left most stock sectors priced at or above our equity analysts' fair value estimates--but not all. Basic materials and energy stocks remain cheap, our analysts say, in part because of concerns about softening demand in Europe and China and a potential glut in global oil supplies (click the following links to read our analysts' latest quarterly outlooks for basic materials and energy). 

Yet positive developments, such as growth in U.S. construction and increases in natural gas prices, could help offset these concerns and improve valuations for these sectors. And if that happens, or if fears about these sectors prove to be overblown, a handful of quality funds are positioned to take advantage.

You may recall that last week we looked at diversified equity funds that are overweight in overvalued sectors of the market. The idea was to identify funds that could be headed for trouble if some of their key holdings begin to head south. This week, we look at funds that are overweight in undervalued sectors, and in particular those led by management teams with proven track records. Whether making sector bets, choosing stocks that appear attractive based on fundamentals, or simply executing a consistent value-oriented approach, a good manager knows how to take advantage of what the market is offering--in this case discounts on companies in the basic materials and energy sectors that appear to be worth more than their current stock prices would indicate.

For investors interested in sector funds that focus on these areas of the market, quality options include  Vanguard Energy (VGENX), a Gold-rated fund run by a seasoned management team, and  RS Global Natural Resources (RSNRX), a Silver-rated fund that primarily invests in both sectors. (Some investors will pay a load, or sales charge, to buy shares in the RS fund.) Those looking for exchange-traded funds that invest in these sectors might consider Morningstar analyst favorites
 Vanguard Energy ETF (VDE) or  iShares S&P Global Materials (MXI).

For investors who prefer diversified stock funds that tilt toward these sectors, we used Morningstar's  Premium Fund Screener tool to search for funds with energy and basic materials weightings that are at least 10 percentage points above those found in  Vanguard Total Stock Market Index (VITSX), a proxy for the U.S. stock market. To ensure reasonable costs and quality management, we included only funds with Morningstar Analyst Ratings of Bronze or better. We applied the Distinct Portfolio screen to avoid duplicate share classes and screened out funds that are closed to new investors and those that charge loads. Premium Members can see the list  here.

It should come as no great surprise that our list of funds includes only value and blend funds--in other words, those investing at least part of their portfolios in stocks that appear to be undervalued. It also should come as no surprise that some funds on the list have been poor performers in recent years given the fact that basic materials and energy stocks have underperformed. Below is a sampling of funds on the list.

 Artisan Value (ARTLX)
This large-value fund has overweightings in not only energy stocks (23% of the portfolio) but tech (21%) and financials (24%), and to a lesser extent basic materials (8%), as well. The fund's veteran management team seeks out companies with good business models and healthy balance sheets that trade at significant discounts to the team's estimated value of those stocks. Top holdings in the concentrated portfolio of around 30 names include Samsung preferred shares,
 Apple (AAPL), and  Apache (APA), a midsized oil and gas company. The fund showed good timing in reducing its energy stake in early 2008, thus avoiding the plunge in oil prices later that year. But its bet on bank stocks around the same time turned out to be a bad idea. Morningstar fund analyst Greg Carlson says the fund is currently re-evaluating its approach to the energy sector in the wake of the poor performance of its energy stocks in 2012, a year in which the fund trailed about two thirds of its large-value peers.  

 Royce Micro-Cap (RYOTX)
Investing in some of the smallest publicly traded companies, with average market cap of its holdings at $363 million, this micro-cap fund holds 14% of its portfolio in basic materials companies and invests 21% of assets in non-U.S. stocks. The fund's managers favor companies with balance sheet quality, high returns on invested capital, and earnings stability, and they only buy stocks trading at 30%-50% discounts of their assessment of the companies' worth. Performance since 2011 has been poor compared with its mostly small-cap-focused peers, but Morningstar analyst Karin Anderson says the managers' strong stock-picking has made the fund a long-term winner relative to the competition. The fund's 1.47% expense ratio is above-average for a small-cap, no-load fund. 

 Wells Fargo Advantage Small Cap Value
Investing 25% of its portfolio in energy stocks and 14% in basic materials (mostly mining) puts this fund well over the small-blend category average for both sectors. About one fourth of assets are invested in non-U.S. companies, and its largest single holding is Australian energy company InterOil , which makes up 11% of the portfolio. Management takes what Morningstar analyst Dan Culloton calls a flexible value approach, seeking out stocks that look cheap relative to their intrinsic values and have good growth prospects for the coming three years. Managers also may look for contrarian opportunities. Despite the fund's bottom-quartile returns each of the past three years, Culloton cites the track record of long-time manager Charles Rinaldi and his disciplined process as reasons to believe in this fund. At 1.33%, annual expenses are above-average for a small-cap, no-load fund.

Portfolio data as of March 31 for Artisan Value and Royce Micro-Cap and as of April 30 for Wells Fargo Advantage Small Cap Value.