Morningstar S Best Ideas for 2010

September 2011

The example illustrates how a seemingly Morningstar’s Best Ideas for 2010, great thing turns out to be a sucker’s bet, and 2011 and Beyond how a down trend can persist longer than expected. By William Parmenter, editor Another similar example, involved a mutual fund that in 2007 went up 74.4 percent Christine Benz, director of personal with assets of $5,460.5 million. In 2008 the finance for Morningstar, talked on Moningstar’s mutual fund dropped 55.7 percent and its assets Best Ideas for 2010, 2011 and Beyond at the Sept. declined to $4,110.7 million. 17 meeting of the Los Angeles chapter of the Moral, watch out for mutual funds that AAII at the Skirball Center. ascend like sky rockets, only to flame out, and Investors came to learn which areas of the descend even faster, farther, and longer than market are undervalued and which are overvalued, you would have imagined in your worst and how Morningstar translates research into nightmares. specific best ideas for mutual funds and sectors. Her second caveat was aimed at tactical The near-capacity audience was not asset allocation. Benz knocked it off the road, disappointed as she performed like a Benz— dismissing it as market timing. Professional elegant, reliable and authoritative. For the first money managers have not been able to deliver time in years, the AAII Los Angeles chapter gave positive results using tactical asset allocation. her the whole two-hour block for her presentation, She backed up her assertion with one hour for a power-point slide show, a break, evidence in a table that compared the results and one hour for question and answers. since 1992 to present, of the aggregate of Benz began with a couple of caveats on tactical asset allocation funds, with the results of what not to do. Two examples demonstrated the a benchmark, Vanguards Balanced Index mutual fallacy of performance chasing. fund. At the blow off of the tech bubble, a Of the tactical asset allocation technology mutual fund in 1999 went up 120.1 funds: 25 percent of them went broke, 22 percent and had $72.4 million in assets. In 2000 it percent outperformed in an up market, 35 went down 17.1 percent, though its assets increased to $118.9 million. In 2001, it went down 27.8 percent and its assets dropped to $69.1 Table of Contents million. In 2002, it went down for the third year Morningstars Best Ideas ………Christine Benz…..…..p.1 in a row, dropping 17.8 percent, with assets declining to $45.6 million. Education Nuggets……………..Dr. Don Gimpel……p.6

1 percent outperformed in a down market, 13 The most noteworthy observation of the percent did neither better or worse in an up or style box is that with the market selling off, all down market. Only 4 percent of them did better mutual funds are selling at a bargain, below fair overall. market value. The problem for tactical allocators (aka market timers) is to know when to get in and out Style Box: Fair Market Value of the market. Benz motored on to outlining what Large Large Large investors need to do to be successful: Value Blend Growth . 1) Investors need a long-term allocation .76 .83 84 strategy 2) Investors need to regularly rebalance. Mid cap Mid cap Mid cap 3) Investors need to focus on what they Value Blend Growth can control (bottom-up securities .91 .92 .97 selection), versus what they cannot control (macro factors). Small Small Small 4) Investors need to swim against the tide Value Blend Growth when initiating new positions in their N/A N/A N/A portfolio. In the next segment of her talk, Benz shone her headlights on the broad market. First she pointed out that the broad market has been Benz next trip was a cruise through moat undervalued since June through September, 2011. stock territory, shining her beams on three That is, stocks are selling at about a 15 percent categories of moats: none, narrow and wide. A discount now; or, otherwise stated, stocks are moat is a comparative advantage. selling at 85 percent of their fair market value. The idea of a moat takes meaning from The U.S. mutual fund universe is too the metaphor of a fortress with a moat around it. broad for meaningful detailed analysis, so Benz The fortress is the company brand that has to used the concept of Morningstar’s style box to defend itself in the marketplace. The moat, a dial down and discuss large cap, mid cap and relative monopoly, protected by patent, by small cap mutual funds in terms of their fair branding, marketing skill, a charismatic CEO, a market value. unique product, a lack of competitors, or An examination of the table, below, shows colossal scale, gives the fortress protection in that large value mutual funds are the best value, at the marketplace. 76 percent of their fair market value. Large cap No-moat stocks are trading at .87 of their mutual funds are a relatively better value (with an fair value, trading roughly in line with the average of .81) than are mid cap mutual funds broader market. Examples of these companies (with an average value of .93). are Eastman Kodak, Brinker International, As one would expect, value stocks Abercrombie and Fitch and E-Trade Financial. (average of .84) are a better value than are growth Most companies covered by analysts have no stocks (average value of (.91). The worst value is moat. mid cap growth at .97 of fair valuation. The N/A Narrow-moat companies were trading notation in the small cap mutual fund boxes at .86 of their fair value in September. stands for not applicable, as the universe of small Examples of these companies included: Allstate, cap mutual funds was too small to generate Charles Schwab, Coach, and General Mills. statistically significant results. Wide-moat companies are the cheapest of the three moat bands, selling at .85 of their 2 fair value. Wide moat companies include: Altria, PRFDX, T. Rowe Price Equity Income Black Rock, Google, Harley-Davidson and Wal- (YTD, -4.46%) Mart. VWELX, Vanguard Wellington Income In the case of the three moat bands the Fund, (YTD, +.09) difference between the highest .87 (no-moat (The posted year-to-date (YTD) figure is companies) and lowest .85 (wide-moat for Sept.23, 2011.) companies), was .02, which is probably Large cap stock recommendations: statistically insignificant. ABT, Abbott Laboratories (Last Trade Nevertheless it is instructive to make a or LT) $50.96) couple of comments about the concepts of moats AMAT, Applied Materials Inc. (LT and fair value. Fair value of a company is $10.59). determined by cash flows: sales, earnings, profits, XOM, Exxon Mobil Corp. (LT $69.31). and their rates, evenness and sustainability. Fair (The last trade, LT, was on Sept. 23, value is based on a consensus of analysts 2011.) opinions. Other things being equal, investors would favor buying wide-moat stocks, because these companies can better defend their comparative Los Angeles County Meeting Schedule advantage and brand. Wide-moat companies lost less in 2008. Westside Computer Group – Don Gimpel, (310) 276-9875 [email protected]. Veterans of Foreign Wars Memorial Wide-moat companies show their mettle in down Bldg. Culver Blvd. and Overland Avenue, Culver City. The group markets when their share price drops less. will meet at 10:30 a.m., Saturday, Oct. 1. Topic: 13 Winning Mutual Funds The UltraFS 11 group will not meet at 9 a.m. on the Avoiding losses is more than half the battle in same day. Its next meeting TBA. stock investing. Pasadena Group – Will meet at 7 p.m. Oct. 18, at Pasadena Main The no-moat companies recovered the Library, in the David Wright Auditorium, at 285 E. Walnut St., most, outperforming in the 2009 recovery. Pasadena. (Meets third Tuesday of the month, except for August and December.) Topic TBA. Voluntary contribution of $2. Contact, Benz cruised on to her next topic, Ivan Wong at (626) 446-2486, [email protected]. Morningstar’s best ideas for equity investors. She Mutual Fund Group – Meeting at 10:30 a.m., Nov. 5. For more covered areas that look relatively cheap right now, information, contact Gunter Hagen (310) 457-7404, or Bill English including large cap mutual funds, large cap (310) 472-7762. [email protected]. Meetings are free to the public. stocks, sectors, financials, international, and bonds. Stock Selection Group —Norm Langhout, (310) 391-6430, [email protected]. Meeting at 7 p.m. , Oct. 26, using IBD, (She did not discuss the picks individually. CANSLIM stock selection method , at Fairview Library, 2101 To research them, go to www.finance.yahoo.com Ocean Park Blvd., Santa Monica. The group meets the fourth Wednesday of the month. and examine charts, news and information about the mutual funds, stocks and bonds.) Los Angeles Chapter, Skirball Center at 9 a.m, Sat. Oct. 15. Speakers and topic TBA. In the category of large cap mutual funds, she recommended: Desert (Palm Springs area) Group Usually meets from 10 a.m. to noon, second Saturday of the month at Sunset View Club House, JENSX, The Jensen Portfolio Inc. Class Sun City, Palm Desert. No meetings will be held until October, (YTD -3.91%) 2011. For more information, contact Patricia Gammino, [email protected]. or at (760) 485-6161. DGAGX, Dreyfus Appreciation Fund, Inc. (YTD +3.39%) Option Special Interest Group, meets online on first and third Tuesday of the month at 7:30 p.m. Get instructions on how to VDIGX, Vanguard Dividend Growth Fund participate at www.aaiilosangeles.org. ; click on subgroups, and (YTD +2.21%) get information from the Options Special Interest Group. Group leader is Robert Morgan at [email protected]. SEQUX Sequoia Fund (YTD +7.03%) VIG, Vanguard Dividend Appreciation ETF (YTD, +.4%) 3 Taking a look at sectors provides another government-backed bond funds. Beware of lens for examing the market. Relatively cheap junk bond funds, as spreads have narrowed to sectors and their fair market valuations include: four percentage points, the rule-of-thumb sell Economically sensitive: communication point. services, .85; energy, .83; industrials, .83; and Motoring on to her talks finish line, technology, .91. Benz addressed her best ideas for personal Cyclical: basic materials, .86; consumer finance. Noting that we dodged a bullet in cyclical, .88; financial services, .78; and real 2010, she cautioned that we should prepare for estate, 1.01. rising tax rates by doing the following: Defensive: consumer defensive, .98; Go Roth; IRA conversion is a great utilities, 1.00; and health, .84. opportunity; also consider Roth 401(k) The best ideas for sector investments contributions, if eligible. include those in the sectors of energy, financials Manage for tax efficiency. and international. Check to see if munis offer after-tax Energy: Vanguard Energy ETF (VDE) returns better than comparable taxable bond with a fair market value of .79; Vanguard Energy funds (Benz’s favorite firm for munis is mutual fund, an actively managed fund (VGENX; Fidelity.) ExxonMobil (XOM); Kinder Morgan Do not overload on dividend-paying Management (KMR); and Schlumberger (SLB). stocks in your taxable accounts. What if taxes Financials: iShares Global Financials go up? (IXG); Davis Financial mutual fund (RPFGX); Prepare for inflation, by doing the Bank of New York Mellon (BK); Blackrock following: (BLK); and Western Union (WU). Shop frugally for food and energy, as International, in general international they are in the forefront of inflation. funds are in line with fair value: Dodge and Cox Retirees need to be especially mindful of International, (DODFX); Harbor International, inflation, since many of them have their (HIINX); and Vanguard International Value investments in fixed-rate investments, and are (VTRIX). not eligible for COLAs. Turning toward bonds, Benz cautioned TIPS can help hedge against inflation, about reaching for yield, and to be mindful of the but space out your purchases. Favorite fund: possibility of a rise in interest rates. Regarding Vanguard Inflation-Protected Securities bond funds, delegate to an active manager with a (VIPSX). flexible strategy. Commodities and stocks are reasonable Favorite bond funds: Harbor Bond ways to hedge, but watch out for the extreme (HABDX); Harbor Unconstrained Bond; volatility of commodities. (HAUBX); Metropolitan West Total Return Concluding her power-point (MWTRX); and Dodge and Cox Income presentation, Benz invited audience members to (DODIX). obtain a free, one-month trial of Morningstar’s Don’t forget about inflation protected Premium Service, by emailing her at bonds. But, note that a rate hike could wipe out [email protected]. yield on nominal bonds. Harbor Real Return The 22 slides of Benz’s presentation is (HARRX); or Vanguard Inflation Protected posted at the AAII Los Angeles chapter website Securities. Consider floating rate funds, such as at www.aaiilosangeles.org. After going to the Fidelity Floating Rate High Income (FFRHX). home page, click on “presenter’s slides” in the Avoid long-term bonds and bond funds. lefthand rail column, then click on Devote a slice of your bond portfolio to dividend- Morningstar’s Best Ideas for 2011 and Beyond. paying stocks. Lighten up on Treasuries and other 4 Benz is director of personal finance and Gold and silver are not evaluated by senior columnist for Morningstar.com. She is the Morningstar. You would have to look at good author of two books on personal finance. mining stocks. The gold stampede gave Benz Employed by Morningstar since 1993, she has pause. It does not seem like a time to get in. served in various roles, including director of Buy junk bonds when the spread mutual fund analysis, editor of various between government bonds and junk bonds hits publications, and as an analyst and editor. She eight percent; sell when the spread narrows to has a bachelors degree in political science from four percent. Currently the spread is five the University of Illinois at Urbana-Champaign. percent, so it is not a time to buy junk bonds. She is the author of Thirty-Minute Money Junk bonds got crushed in the sharp Solutions: A Step-by-Step Guide to Managing economic downturn of 2008. Junk bonds loose Your Finances (John Wiley and Sons, 2010), and, money in down market movements. author of the second edition of the Morningstar Vanguard and Fidelity tend to stick to Guide to Mutual Funds: Five-Star Strategies for higher quality companies. The risk and return Success (John Wiley and Sons, 2005). might not be as much as from other mutual fund After a brief break, the audience companies, but the stability is greater. reconvened for a wide-ranging question-and- Morningstar has access to corporate and answer session with Benz. mutual funds management when doing Concerning Morningstar’s one to five star evaluations. There is no momentum basis in rating system, Benz said they are meant to be an Morningstar’s evaluations. aptitude test for stocks, and are based on fair On expense ratios, Benz said that value. expense ratios matter less in volatile markets, (Fair value decimal ratios are computed by such as emerging markets. Some mutual funds dividing price by a fair value rating, e.g. an $8.5 charge a high expense ratio, because they are price divided by a $10 fair value rating, gives a putting their profit in there. Start up funds fair value of .85. Such a stock is cheap.) without a large investor base have high expense For stocks, a one-star rating means it is ratios, because they are putting their costs on the selling way over fair value, and a five-star rating investors. means the stock is selling at a bargain price. Emerging markets and mid-cap funds For mutual funds, the star rating system is are good places for actively managed funds. an achievement test, with one star as the lowest Large-cap U.S. and international funds are good rating. Five stars is the top rating, reserved for the places to have passive management, according top ten percent of mutual funds. No future rating to Ibbotson Research. is indicated in star ratings on mutual funds. For Bogle.com is a good source for both stocks and mutual funds, the star ratings are strategies (for example tax management), but changed once per month. can be a little extreme on index funds. Morningstar does not spend much time on Fairmark.com is another good and helpful country outlooks. It does employ 275 analysts investment site. globally, more than some mutual fund companies. Morningstar has been tracking fund Closed-end funds might be a superior flows for the last one and a half years. Google product for some asset classes when fund Morningstar fund flows. Investors want to managers do not want to deal with in and out follow investor behavior to see what is driving flows of investor money. it. ETFs can be even more tax efficient than Benz prefers Vanguard (low cost funds) some equity mutual funds; ETFs can be more over iShares ( more costly). nimble than mutual funds. Mutual funds might comprise 20 percent of the stock investing universe, Benz said. So it 5 is unlikely that the large index funds have enough Gimpel is planning the meeting around weight to influence the market. distributing the table to the audience and Fundamental indexing has not been around reviewing and discussing the data. a long time. The question is how does it perform And, by the way, the UltraFS User group over market cycles. Capitalization indexing has will not be holding a meeting at 9 a.m. Oct. 1. been around a long time, and it is cheaper. Its next meeting is to be announced.

Education Nuggets

By William Parmenter, editor Orange County AAII Announcements

Dr. Don Gimpel referred to mutual funds The Orange County AAII chapter heard that reliably return 10 percent compounded Matthew McCall talk on Economic Indicators, interest, during his five minutes of investor the Market and ETFs on Sept. 17. education at the Sept. 17 meeting of the Los In October the chapter will not have a Angeles Chapter of the AAII at the Skirball meeting. Center. In November Herb Farrington will give a Gimpel called these funds ”set it and talk updating federal and state income tax. The forget it” mutual funds. These are funds that have time and date are to be announced. at least a 10-year history, and have a risk less than For more information about the Orange half of that of the S&P 500. The funds have to be County chapter of AAII and their meetings, go easily available with no loads, and small initial to [email protected]. investments. Gimpel screened 5,000 mutual funds Note to Pro Forma Contributors: looking for funds that met his criteria. He found 13 of them, and entered the information on a Please have your copy emailed to the table. editor by the fifth of the month. Letters and Do these funds have names? comments are welcome. If you want to email an Well, yeah, but to find them out, and get article about the financial system will have a the table, you have to go the Computerized chance to appear in print and inform Pro Forma Investing Special Interest Group meeting at 10:30 readers. a.m., Saturday, Oct. 1 at the Culver City Veteran’s Book reviews are welcome. Mail disks Memorial Complex on the southwest corner of to: 319 Walnut Ave., Apt. 2, Long Beach, CA. Overland Avenue and Culver Boulevard in Culver 90802, or use email to send copy to the editor at City. [email protected]., or call (562)-437- 2412.

6 Pro Forma

Pro Forma Editor William Parmenter Pro Forma Editor, Emeritus Orvis Adams

SIG GROUP CHAIRMEN

IBD Meet-up/ AAII CANSLIM Norman Langhout Mutual Fund Group Gunter Hagen Options Group Robert Morgan Pasadena Group Ivan Wong Palm Springs Group Patti Gammino San Fernando Valley Group Evan Press Westside Computer Group Don Gimpel

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