3 Funds for a Fairly Valued Market

Investors looking to put money to work in the market today are probably scratching their heads. Wherever they look, the risks appear to outweigh the rewards.

Sinking money into cash for more than a few months promises a near-certain loss of purchasing power, once inflation is factored in. Meanwhile, bond yields look shrimpy, too, especially when you consider that bond investors are walking a tightrope. By venturing into long-term bonds, they risk getting stung by rising interest rates, whereas lower-credit-quality bonds could fall if the economy unexpectedly weakens. 

The dearth of compelling alternatives helps explain why, over the past five-plus years, stocks have been referred to as "the least bad option" (or, in the words of PIMCO's Bill Gross, as "the least dirty shirt"). 

But with U.S. stocks gaining, on average, 16% over the past five years and 20% over the past three years, many investors are quite reasonably questioning how much upside is left for stocks. After bouncing around below fair value for much of 2011 and 2012, the stocks in Morningstar's coverage universe, in aggregate, are trading slightly above our analysts' estimates of their worth today. 

Stocks don't look catastrophically expensive, but full valuations suggests that savvy investors putting money to work today should consider picking their spots--downplaying dramatically overvalued areas and tilting toward those with greater upside potential. Technology stocks look notably pricey today, based on the sector view of our Market Fair Value graph, whereas stocks in the basic materials and, especially, the energy sectors appear to be the most reasonably priced. (To find the fair market value of a given sector using our graph, click on the "Sector" tab found in the left-hand navigation.) Meanwhile, companies with wide moats, meaning that their businesses have lasting competitive advantages, also appear to be a touch more attractively value than narrow- and no-moat companies today. That syncs up with Grantham, Mayo, Van Otterloo, & Co.'s most recent seven-year asset-class forecast, which anticipates decent, if unspectacular, 2.2% real returns from U.S. high-quality stocks and negative real returns from other U.S. equities over the next seven years. 

Stock investors can use our  Premium Stock Screener to home in on individual equities that have wide moats and still-reasonable valuations. While there are currently no 5-star wide-moat stocks (meaning that they're both cheap and have high-quality businesses), 10 companies currently rate at least 4 stars and have both wide moats and low fair value uncertainty ratings, including  Coca-Cola (KO),  Procter & Gamble (PG), and  ExxonMobil (XOM).

To help unearth mutual funds that are similarly focused on high-quality, reasonably priced firms, I turned to our  Premium Mutual Fund Screener. I searched for equity funds with a preponderance of their portfolios tilted toward stocks with wide moat ratings. (Our calculation is asset-weighted, meaning that big positions in a portfolio take up a greater weight in the calculation than do smaller positions.) To help ensure that those high-quality companies are coming in at reasonable prices, I screened for average price/earnings ratios below that of the broad market. To confirm that the funds themselves are up to snuff, I screened for those with Medalist ratings, meaning that our analysts think they're likely to outperform their peers thanks to some combination of a sensible strategy, talented staff, or low costs, among other factors. Because some otherwise-worthy funds ( BBH Core Select  and  FMI Large Cap (FMIHX)) have limited access in recent years, I also screened for offerings that are still open to new retail investors. The result was an extremely short list of funds that look promising from a variety of angles. To view the output of the screen or tweak it to suit your own specifications, click  here. Below are profiles of three of the funds that made the cut.

One commonality among the funds on the list--in addition to their wide-moat portfolios and Medalist standing--is that they've exhibited lukewarm performance over the past few years as smaller, more speculative firms have thrived. By the same token, they have historically held their ground better than their peers in market sell-offs. That suggests that even if you're not inclined to add a high-quality, wide-moat fund to your portfolio, you should at least have patience with those holdings that have similar characteristics and have demonstrated a similar performance pattern. 

 Clearbridge Appreciation (SHAPX)
Category: Large Blend | Analyst Rating: Bronze
The managers of this advisor-sold large-blend fund focus on high-quality firms trading at a discount, and their portfolio's statistics are a testament to that approach. Nearly 55% of the fund's most recently available portfolio landed in wide-moat stocks, according to  Morningstar's Premium Details portfolio statistics. And the fund's average price/earnings ratio is below that of both broad market index funds and S&P 500 trackers. Management's focus on quality and valuations has tended to mute gains in buoyant markets: It lagged its peers in 2009 and 2013, for example. But the fund's downside capture ratios relative to the S&P 500 tend to be even lower than its upside capture ratios, suggesting that the fund has provided an acceptable trade-off for risk-averse equity investors. 

 Dreyfus Appreciation (DGAGX)
Category: Large Blend | Analyst Rating: Silver
This mega-cap fund stakes a whopping 66% of its portfolio in wide-moat firms. And while the managers will let their winners ride--turnover is an ultra-low 6%--they're sensitive to valuations when building new positions in the portfolio. The portfolio's price/earnings ratio is lower than that of the Russell 1000 Index and the large-blend category average, and management has a sizable overweighting in the energy sector, which Morningstar analysts think is the cheapest major industry currently. While many of its holdings also take up big positions in the S&P 500 Index, analyst David Kathman notes that the fund's active share--a measure of how different a portfolio is from its market benchmark--demonstrates that it's not a closet index tracker. 

 Wintergreen
Category: World Stock | Analyst Rating: Bronze
This world-stock fund puts a global spin on the high-quality, valuation-conscious approach featured in the aforementioned portfolios. With the latitude to hold cash and venture heavily overseas, it's a true go-anywhere fund. That flexibility is particularly attractive in the current environment, when no single market or sector looks especially cheap. Close to 70% of its portfolio is staked in wide-moat firms, an outgrowth of manager David Winters' focus on companies with high returns on equity and low debt levels. Those criteria have, for much of the fund's life, led to outsized weightings in foreign stocks relative to other world-stock funds; Winters has often found more companies fitting his criteria in developed Europe and especially Asia than he has in the U.S. The fund's expense ratio--1.85% for the retail shares--is the one major knock against it.

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