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Buy the Unloved 2015

Going against the grain of flows can be a profitable strategy.

This article was published in the January 2015 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Our annual "buy the unloved" strategy points you to unpopular Morningstar Categories that may be due for a rebound. Historically, it has pointed to more winners than losers. The idea is to buy funds from the three unloved categories and sell three from the loved. You then hold the unloved for three to five years. Starting from 1993 and rolling it forward, the strategy returned an annualized 10.3% for unloved funds versus 6.4% for loved funds. I wouldn't suggest making wholesale portfolio changes, but rather make these changes at the margins or simply use this as a guide for where to shop or what to avoid when looking for new funds.

Although the strategy has done well over the long haul, last year's picks are in a pretty big hole. Large growth was a great spot to invest, but the other two categories were precious-metals equity and natural-resources equity. Ugh.

In 2014, the three most redeemed equity categories were large growth, mid-growth, and small growth. That's interesting, given that large growth was quite strong and even mid-growth had pretty good returns. Nonetheless, all three still have appeal. I don't want to push my luck with large growth, so I'll focus on funds with Morningstar Risk ratings that are Below Average.

 Jensen Quality Growth (JENSX) is probably the most contrarian option, as high quality has been out of favor in recent years. The managers seek out companies that have produced returns on equity of at least 15% for the past 10 years. Then they do discounted cash flow models and look for companies trading at a discount to their value. The result is a group of high-quality brand names with modest growth, such as  PepsiCo (PEP),  3M (MMM), and  Accenture (ACN). The fund holds up nicely in downturns but tends to have pedestrian results in rallies.

 Fidelity Contrafund (FCNTX) is more aggressive than the Jensen fund, but Will Danoff has been a very able manager in all environments. With an enormous asset base to command, Danoff invests more money in more companies than you might think possible to own while still producing good results. And he just keeps going and going. Danoff looks for companies with great products and strong management and aims to get ahead of the trend on both. He loves to attend meetings with company management, and of course scores of them come through Fidelity's offices every day. 

 American Funds AMCAP (AMCPX) has been run with a steady hand over the years. Run by five managers and a pool of analysts, the fund looks for companies with competitive positions, above-average growth, and shares trading at modest valuations. (Today, there are 142 stocks in the portfolio and a distinct health-care bias.) What's impressive is the consistency of performance. The fund has outperformed in eight of the past 10 years and held up quite well in down markets in 2008 and 2011.

 Vanguard Mid-Cap Growth (VMGRX) is a cheap way to get your mid-growth exposure. Assets are split between subadvisors Chartwell Investment Partners and William Blair. Ed Antoian of Chartwell and Robert Lanphier IV of William Blair have been with the fund since 2006. Since they came on board, the fund has matched the Russell Midcap Growth Index while beating peers by about 200 basis points a year. The fund hasn't yet lagged peers by a meaningful amount in any single year, while its years of outperformance, including 2014, have often been by margins of 300 basis points or more. 

 FPA Perennial (FPPFX) remains a strong pick even though one of its longtime managers has retired. Steve Geist stepped down at the end of 2014, but Eric Ende and recently promoted analyst Greg Herr are a good bet to keep things going. The strategy focuses on companies with a competitive advantage and low debt. It takes big bets in steady but boring growth businesses like  O'Reilly Automotive (ORLY), Signet Jewelers (SIG), and  Knight Transportation (KNX). Thus, you get some real individual stock risk tempered by the emphasis on steady businesses. Compared with most mid-growth funds, this one has a drastic underweighting in health care and tech. And because FPA funds without "Crescent" in the name continue to labor in obscurity, there's little chance this fund will suffer from asset bloat anytime soon.

 Akre Focus (AKREX) is another atypical growth fund worth investigating. Chuck Akre runs a focused steady-growth portfolio that rarely ventures into health care and technology. Akre buys "compounding machines" with high cash flow, strong management, and the ability to reinvest cash at a high rate of return. Instead of the  Apples (AAPL) and  Teslas (TSLA) common to growth funds, you see  MasterCard (MA),  American Tower (AMT), and  Danaher (DHR). Akre has built a great record here and previously at FBR Focus (now  Hennessy Focus (HFCSX)).

Small Growth
 Conestoga Small Cap (CCASX) really fits the unloved mold. The fund, which has a Morningstar Analyst Rating of Silver, had a great record until its pratfall in 2014 when several of its top tech stocks got whacked. The long-term returns here remain solid, though, and it seems appropriate to have one truly unloved fund with rebound potential.

 T. Rowe Price Diversified Small-Cap Growth (PRDSX) shows that quantitative funds can still deliver. Since 2008, many quant funds have had their circuits blow, but this fund has been a real steady performer. Manager Sudhir Nanda runs a low-turnover, diffuse portfolio that has produced strong results. Quant models crunch numbers on valuations, earnings quality, and financial health to produce a portfolio of more than 200 names.

 Meridian Growth (MERDX) has tremendous promise. Chad Meade and Brian Schaub are focused growth investors who built a brilliant record at  Janus Triton (JATTX). The duo looks for fast-growing companies with strong competitive advantages. The fund holds a mix of aggressive tech names like Cadence Design Systems (CDNS) alongside cheaper, steadier stocks like property manager  Jones Lang LaSalle (JLL). The MERDX share class is closed but (MRAGX) is open to new investors.

Avoid the Loved
What are the most-loved categories? Foreign large blend drew the highest flows in 2014, followed by large blend (U.S.) and conservative allocation. The strategy suggests dialing down exposure to these categories.

However, I'm not sure I'd go too far with that. All are core categories that you generally want to own through thick and thin.

So, I'm sharing the information for those who want to follow the strategy to the letter--but I wouldn't do it.

Historically, flows have followed performance, and that's why the strategy has been a winner. It leads you to relatively cheap asset classes and away from pricey ones. But since 2008, performance and flows have decoupled on the asset-class level even though they continue to be linked on a fund level.

Now flows are more linked to headlines. Since 2008, some people have taken a pessimistic (albeit incorrect) view of America's economy and looked to China as a superior bet. It hasn't worked that way the past five years, and it leaves us in the odd position of seeing the nature of fund flows change.

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Russel Kinnel has a position in the following securities mentioned above: JENSX. Find out about Morningstar’s editorial policies.