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Fund Spy

Buy the Unloved

Buying what others have been selling is a winning strategy.

A version of this article was originally published in the January 2018 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Contrarian thinking doesn't come naturally to most investors. Fund-flow patterns tell us they buy what's done well recently and sell what hasn't. This pattern can become self-reinforcing. Strong flows drive up stock prices, attracting more return-chasing investors and bidding up prices further.

Just as inflows beget more inflows, outflows beget more outflows. Eventually, popular stocks become too expensive and unpopular ones too cheap, and the process reverses itself. Investors who target the least popular areas of the market benefit when sentiment turns.

That's the idea behind Morningstar's "Buy the Unloved" strategy, which we introduced in 1994. This strategy involves investing equal sums in one fund from each of the three equity Morningstar Categories with the largest calendar-year outflows while avoiding those with the heaviest inflows.

We've tracked the results of the strategy through November 2017 by comparing the unloved categories' returns (as measured by the category average return) with those of the three most popular categories over subsequent three-year periods. After three years, we assume investors rebalance the proceeds into the three most unloved categories of the prior year, hold for another three years, and repeat the process. We also test the strategy's sensitivity to different start dates by measuring results beginning in subsequent calendar years.

Overall, the strategy has been successful. The unloved have beaten the loved by more than 5 percentage points annually from January 1994 through the end of November 2017. Adopting the strategy in later years also resulted in success. (See the exhibit below.) The unloved categories outperformed in 22 of the 24 periods we measured. (One of the periods, beginning just last year, is short. In the other, the four years beginning in 2014, the unloved categories lagged only modestly.) Moreover, favoring the unloved categories generally paid off within three-year rebalancing periods. Indeed, the unloved beat the loved in 77% of three-year periods.

Based on flows into open-end and exchange-traded funds (excluding funds of funds) through December 2017, the unloved categories for 2018 are large growth (an unloved category in every year since 2004), large value, and mid-value. In a repeat of 2017, the most-loved categories are large blend, foreign large blend, and diversified emerging markets. 

Below, we've identified Morningstar Medalists that we think are likely to fare well in markets favorable to their categories. With large growth tops in performance (or nearly so) among diversified equity categories over five- and 10-year periods, we paid special attention to each contender's valuation profiles. We tapped Morningstar's quantitative risk model, which uses equity analyst research to estimate fund portfolios' exposure to factors like valuation, valuation uncertainty (a measure of business stability), and economic moats (a measure of competitive advantage), to guide us. You'll find a summary of the funds' risk exposures in the exhibit below. 

Keep in mind that the "Buy the Unloved" strategy is best suited for the periphery of your portfolio. Implement it in the context of your long-term asset allocation. Consider these funds as ideas for redeploying capital away from your strong performers.

Large Growth
With no exposure to many of the stars of this year's rally, including  Apple (AAPL),    Amazon.com (AMZN), and  Facebook (FB),  ClearBridge Aggressive Growth (SHRAX) places in the large-growth category's 99th percentile for the year to date. The rally has left most large-growth portfolios looking relatively expensive, but this fund's holdings look cheap relative to the broad equity market, according to Morningstar's quantitative risk model. Indeed, the portfolio's concentration in cheaper stocks ranks highest among large-growth funds in the Morningstar 500. This fund, which has a Morningstar Analyst Rating of Silver, looks well positioned for when investors look for underappreciated growth stories--the sort that longtime lead manager Richie Freeman has identified again and again.

Silver-rated  Jensen Quality Growth's (JENSX) rigorous standards for quality make it look poky in sharp up markets, and 2017 was no exception. Management only invests in companies with at least 10 consecutive years of 15%-plus returns on equity--a criterion many of this year's big winners can't meet. The portfolio isn't as attractive on valuation grounds as its ClearBridge rival--as is typical, it trades at a premium--but heavy exposure to firms with economic moats, high business stability, and less-volatile stock prices should provide ballast in a down market. With the bull market entering its ninth year, downside protection holds extra appeal.

 Vanguard Primecap's (VPMCX) sizable tech stake helped it remain competitive in 2017, but in typical contrarian style, management has sliced its holdings in the year's biggest winners, leaving it with outsize exposure to less-expensive healthcare stocks. Morningstar's risk model suggests the portfolio looks cheap next to the broad market. The Gold-rated fund is closed to new investors, but  Primecap Odyssey Growth (POGRX), led by the same managers, remains open. That fund holds pricier, faster-growing stocks than its sibling, making it a purer growth play than our other recommendations in the category.

Large Value
With broad exposure to relatively cheap stocks, Silver-rated  Vanguard Value Index (VVIAX) stands to benefit from a value resurgence. The portfolio appears modestly undervalued according to our risk model, bolstering its appeal. Ultralow fees--not to mention active managers' difficulty besting it over the long haul--are the icing on the cake.

Because the Vanguard fund casts a wide net, it holds some stocks with weaker value characteristics. The same can't be said for Silver-rated  Invesco Comstock (ACSTX), which employs a deep-value style. The portfolio shows up as one of the most undervalued large-value funds in the M500. As is often true of deep-value approaches, it also scores poorly on quality measures like economic moat and valuation certainty. These characteristics court volatility, but the fund's veteran managers have made the ride worthwhile over the long haul.

Silver-rated  MFS Value (MEIAX) provides diversified value exposure with a higher-quality bent. Management looks for companies with durable franchises, a history of high returns on equity, and strong balance sheets. These preferences play out the portfolio's superior profitability, financial health, and concentration in stocks with economic moats. Traits like these usually don't come cheaply, but the portfolio trades at valuations comparable to the Vanguard Value Index. One negative: The fund's size limits its ability to seek bargains across the market-cap spectrum.

Mid-Value
 Harbor Mid Cap Value's (HIMVX) subadvisor LSV Asset Management uses a quantitative approach to identify unpopular mid-cap stocks selling at discounted valuations. With one of the category's lowest average price/earnings ratios, the portfolio aligns with management's focus on statistical cheapness. (It is also more concentrated in relatively cheap stocks as measured by our risk model.) Like many deep-value strategies, this fund has delivered streaky results, but we expect this Silver-rated offering's disciplined approach to thrive in mid-value rallies.

Bronze-rated  Hotchkis & Wiley Mid-Cap Value (HWMAX) relies upon traditional fundamental analysis to select deeply discounted stocks. On a price/earnings basis and as measured by our risk model, its portfolio trades even more cheaply than the Harbor fund. With ultralow price tags often comes plenty of business risk, and that's the case here. The fund is concentrated in stocks with low business stability and light on companies with economic moats. This profile can result in feast-or-famine performance in the short term, but patient investors have found it rewarding over the long haul.

Like Warren Buffett, Bronze-rated  Ariel Appreciation's (CAAPX) veteran managers look for high-quality companies trading on the cheap. Consistent with this strategy, the portfolio is relatively heavy on stocks with economic moats and discounted valuations. A tilt toward cyclical fare has spelled trouble in market downturns, but its high-quality profile gives it resilience to bounce back. Management will stick with winners as they appreciate into large-cap territory and the blend column of the Morningstar Style Box, but the current portfolio lands squarely in mid-value territory.  

Christopher Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.