Saturday, July 14, 2012

A Comparison of 4 low cost core mutual funds

Recently, I worked on a project where I evaluated 4 mutual funds. Those funds were comprised of Dodge & Cox Stock Fund, Yacktman Services, T. Rowe Price Equity Income Fund, and American Funds Washington Mutual. In putting this together, I also created a comparison spreadsheet with all of the various investment statistical metrics of the four funds I was comparing so I could view them side by side. I may add that at a later date as my HTML skill improves. Of note is I ignored management fees, since all are very reasonable in that regard. Yacktman does charge a 2% redemption fee if sold within 60 days of the initial investment, but for an investor buying a mutual fund, this should never be an issue.

What follows is the written summary of that analysis.

Fund Comparison and Recommendation

I have reviewed 4 funds in the Large Cap (3 Value, 1 Blend) category, and have selected the Yacktman Service Fund (YACKX) as the lead choice.

Yacktman Fund is classified as "Large Blend" by Morningstar, and yet it performs similar to a Large Cap Value Fund, with a much lower beta of .76 than the category average of 1.04. The defensive nature combined with lower risk metrics of its holdings, makes it an appropriate core holding in any portfolio. When examining the history and future prospects of this fund, there's not much to dislike about it. This fund, to use a baseball analogy, knocks it out of the park on so many levels. For me, as an analyst, one of the primary things that jumps out is the downside capture ratio, which beats the 3 other funds on a 1, 3, 5, and 10 year timeframe. While the fund may not capture all the upside movement in a bull market (as is typically a characteristic of a Value fund), its clear that not capturing 100% of the downside move is more important. To use a behavioral finance term, Prospect theory, states that investors give much more value to what they lose than what they gain. As shown by the bear market decile rank of 3, Yacktman clearly understands this and manages the fund accordingly.

As shown by the relative underweighting in financials and volatile energy sectors, Yacktman is invested defensively, while at the same time, not terribly conservative, as shown by the 16% allocation to technology (roughly in line with the S&P, but slightly underweighted on a relative basis), something I would agree with. The tech names in the fund are solid names such as Microsoft, Cisco, and Hewlett Packard, a company selling at book value, and a potential turn around story that investors are getting paid a nice 2.6% dividend to wait for. It should also be noted that it is only in recent years that Yacktman began investing in technology. Does this sound like another famous investor we know? In doing so, one can surmise that Yacktman views certain companies in the technology sector have greatly reduced technology risk (no pun intended) and are trading at depressed multiples with good consistent cash flows.

The number of holdings in this fund is 43, so not over or under diversified, in my view. While the top 10 holdings do represent 54% of the portfolio, four of them are defensive (Coke, Pepsi, Sysco, Proctor and Gamble). But Yacktman is not afraid to get aggressive, as shown by the blistering 59% return in 2009. Don Yacktman has mentioned in several interviews that he usually prefers high quality, as current portfolio reflects, but in 2009 it made more sense to buy lower quality because it was so ridiculously cheap. This shows how innovative and flexible management is.

Lastly, Yacktman has averaged 15% in cash over the last 10 years, indicating they don't feel the need to always be fully invested, which again speaks to flexibility. This likely is in large part why they are only capturing 75% of the S&P 500 downside moves, on average. For these reasons, Yacktman Service is my top pick.

The table below will show the weightings in various sectors in each fund, which I will discuss in more detail.

Sector Weightings Yacktman
Dodge & Cox
T. Rowe Price
Equity Income
American Funds
Wash Mutual
Basic Materials 0.00% 2.011% 6.66% 1.84%
Consumer Cyclical 17.29% 10.77% 11.03% 10.43%
Financial Services 7.80% 20.5% 20.67% 10.35%
Real Estate 0.00% 0.00% 0.51% 0.00%
Communication Services 2.12% 9.21% 5.09% 6.12%
Energy 4.02% 6.99% 12.85% 14.00%
Industrials 0.00% 9.30% 13.52% 21.03%
Technology 15.89% 19.41% 8.87% 9.01%
Consumer Defensive 36.35% 2.53% 7.08% 8.88%
Healthcare 16.53% 19.28% 7.03% 12.71%
Utilities 0.00% 0.00% 6.69% 5.63%

As of 3/31/12     
Source: Morningstar                                        

As for the other funds, here's where they may be better choices under different assumptions. American Funds Washington Mutual is a solid 5 star rated and Gold rated (a new rating system designed to predict future prospects) fund by Morningstar. The fund buys stable, high quality franchises that pay dividends. This fund, by its very nature, performs well in down markets, as shown by its top 10% ranking over the past year while its competitors lost 5.5%. From Morningstar" At least 95% of the portfolio must be invested in dividend payers, and those companies, at a minimum, must have paid their dividends for the past five years and earned them for eight out of the past 10 years." Currently, the fund is underweight financials and overweight materials and industrials relative to its category. This would imply that the fund manager still believes the U.S. economy is in early recovery and sees a stronger economy ahead. If we're in for another "lost decade", then these are the types of companies that should be able to eke out a nominal return and pay a dividend. The fund manager believes the companies its invested in can absorb economic setbacks and therefore has taken larger bets on companies providing goods and services that people want and need. These companies are able to raise dividends, and therefore well positioned going forward. Of note, all of the managers have at least $100k or more of personal money invested in the fund. If, as a company, we want to select a pure value fund, my second choice would be American Funds Washington Mutual, with its below average risk and above average return characteristics and similar profile to Yacktman on the same measures.

Dodge and Cox had its worst year ever in 2008, likely affecting its Morningstar Rating of 3 stars (a historical-based rating). Staying true to its value style, the fund buys out of favor companies. However, in doing so, the fund has an above average risk profile, as indicated by the relatively high standard deviation, as well as the highest downside capture ratio of these 4 funds (i.e.: a negative). With nervous investors, this is not something one likes to see. Additionally, it owns up to 20% in foreign stocks, and area an investor can get access to in other ways. As stated in their annual report, Dodge and Cox thinks foreign equities are compelling at 10-12 times projected next year's earnings. The top 2 holdings are Wells Fargo and Capital one, representing approximately 8.5% of the portfolio. Specifically, Charles Pohl, the fund manager, sees higher capital ratios, better liquidity, declining credit losses, low valuations, and consolidation in the industry.

Of particular note is Dodge and Cox 20% allocation to technology, showing that it likes companies with strong balance sheets and arguably stronger fundamentals vs. other sectors. Last year the Fund added to Hewlett Packard and is taking a bet that the bulk of HPs revenues coming from overseas will be a positive for future growth. HP is the funds 4th largest holding, and proof that it is as contrarian as ever. The typical time horizon is 3-5 years. Many of the managers have significant investments in the funds they manage, always good to see.

T. Rowe Price Equity Income Fund is rated 3 stars by Morningstar, but also has a Gold rating. Dividends are not the primary driver in this fund. With a trailing 12 month yield of 1.95%, it lags the S&P Index and its peers in this measure. Due to its cyclical nature of investments, this fund may underperform in the short term, but has been in the top third of its category over a 10 year period. While not making a sector bet on Financials, it is betting on cyclicals. I would rather see an overweight in Morningstar rated "Sensitive" sectors, meaning sectors that will fluctuate with the overall economy, but not severely so. This would include communication services, energy, industrials, and technology. This fund also has over 100 holdings and typically has a low cash position of 3-5%. Again, the fund manager here has his own money invested in the fund, more than $1 million.

All of these fund managers are bottom up managers, meaning they are more concerned about the individual company strength and ability to weather economic downturns, but without taking a view on the economy per say.

In an up market, I would expect American Funds Washington Mutual and Yacktman Services to lag the S&P 500 (although Yacktman crushed the S&P 500 return in 2009) and in a down market both of these funds should perform better than the S&P 500. The idea being that both of these funds make up their underperformance in up markets with the outperformance in down markets.

Dodge and Cox Stock fund has severely lagged in recent years in both up and down markets, with the exception of 2009. In its defense, many of the contrarian picks take longer to work out, so one truly needs a longer term view with this fund. Time smooths out the bumps in performance. Lastly, T.Rowe Price Equity Income Fund will likely lag in racier markets, but should perform better in down markets. However, history shows that this fund performs about in line with its peers over the short to intermediate term, only doing much better over a 15 year time period by only capturing 79% of the downside vs. 91% for the category.

While all four of these funds have a very sound process for value investing, again, my top pick is Yacktman Service Fund.

Monday, May 14, 2012

Artisan Value Fund: A Solid Core Portfolio Holding

I had the unique opportunity last week to sit down with one of the managers of the Artisan Value Fund, George Sertl. The management team is comprised of 3 managers, 2 of which have worked together since 1989. They are Scott Satterwhite and James Kieffer. Sertl joined Artisan in 2000 as a part of the U.S. Value team, which also manages the Mid Cap and Small Cap Value Funds, both of which are closed to new investors. While each of the managers brings 20 plus years of experience, none of them is older than their early fifties, meaning they will likely be with Artisan for many years to come.

The Value Fund started in March of 2006. This is the only fund of the 3 they manage which is open to new investors, and one I believe represents a compelling investment opportunity. The fund invests in stocks with a market cap of $2 billion and up. By design, this captures equities in the Mid Cap space as well. This is an important point, as 23% of the fund's holdings are under $10 billion in market cap. I believe this is an important point when comparing to a benchmark such as the Russell 1000, as the lower average market cap would tend to exhibit higher earnings growth potential. However, the fund is true to its value style on a number of metrics, including P/E, Price/Book, Price/Sales (approximately half that of the Russell 1000 Index), and dividend yield (2.41% vs 2.07 for the Russell 1000). While the appropriate benchmark for comparison is the Russell 1000 Value, the long-term earnings growth rate in the portfolio at 11.1%, is actually higher than that of the blended Russell 1000 Index of 10.27%. This is a function of the lower market cap bias, as well as the stock picking methodology of the team.

Compared to its peers, the fund invests in a fewer number of equities (typically 30-40), currently 33. Typically, the largest position it will represent no greater than 5% of the portfolio. For example, the fund recently trimmed its position in Apple, as the stock had doubled since it initially purchased. The managers still consider Apple attractive, but felt it was prudent to lock in profits. Not only did they lock in a large profit, but they were sensitive to tax consequences, waiting an additional week from when they made the decision, resulting in a long term capital gain.

The Value Fund's time horizon is typically 2-5 years when they make a purchase. However, if any holding approaches what they consider to be fair value before then, they will either reduce it or sell the entire position.

Investment Philosophy:

The Value Fund has what they refer to as 3 margin of safety criteria:

1. Attractive Valuation: Look for equities selling at a discount to their estimates of market values. This can mean a discount to book value, discount to normal price/free cash flow, P/E, etc. They are typically companies with low expectations in the marketplace and a favorable risk/reward.
2. Sound Financial Condition: Does the company have financial flexibility, meaning can they borrow at a reasonable rate, buy back stock, etc.
3. Attractive Business Economics: Can the company grow the business, preferably organically. How healthy is free cash flow? Can they buy back stock to enhance shareholder value in a major economic downturn?

The Value Fund doesn't necessarily look for a "catalyst" for the stocks they buy. They believe that pricing itself can take care of that over time. Additionally, they allow 2-5 years for this to happen, as the market tends to be inefficient in this timeframe, and therefore, patience is important in exploiting business value inefficiencies.

The opportunistic nature of Artisan Value can be seen in its overweight of certain sectors. In fact, they do not attempt to closely match the weightings of the various sectors of the benchmark index. As a bottom up manager, Artisan invests in sectors where they see value.

Below is a comparison of the fund holdings to the various Large Cap Russell Indices

Sector Weightings Artisan Value
% Stocks
Russell 1000
Russell 1000
Basic Materials 0.00% 3.31% 1.92% 4.59%
Consumer Cyclical 2.12% 10.66% 8.36% 12.82%
Financial Services 27.22% 13.10% 23.34% 3.22%
Real Estate 2.65% 2.68% 3.74% 1.72%
Communication Services 2.71% 4.28% 5.51% 3.16%
Energy 15.45% 10.67% 11.53% 9.66%
Industrials 4.22% 12.28% 10.32% 14.09%
Technology 29.7% 17.99% 7.73% 27.69%
Consumer Defensive 11.13% 10.51% 8.34% 12.85%
Healthcare 4.79% 11.10% 12.31% 10.16%
Utilities 0.00% 3.41% 6.90% 0.06%

As of 3/31/12
Source: Morningstar

Interestingly, the fund has a strong overweight in financials, with nearly 4% greater than that of the Russell 1000 Value Index. However, its important to note that BNY Mellon is the only bank stock in the top 25 holdings. I believe this is in large part due to the fact that BNY derives a large portion of its earnings in products and services such as asset management, wealth management, and advisory services. One of Bank Of New York’s main competitors in the capital markets industry is Goldman Sachs, which the fund purchased late last year as it approached cash value. They have a large position in property and casualty companies, as they purchased what they consider to be "best of breed" companies which were selling at or near book value. Berkshire Hathaway, for example, is a diversified financial services conglomerate, which also has retail operations, railroads (Burlington Northern), utilities, and energy distributors. Soon after they initiated a position in September 2011, Warren Buffett announced that the company would start a buyback. Three of the top 10 holdings are financials (Berkshire Hathaway, Progressive, and Western Union). Western Union, which is a specialty finance company that provides domestic and international money transfer services.

The fund also has a large overweight to technology companies (4 out of the top 10 holdings), as they have found several companies with great free cash flow, undemanding valuations, and some of the strongest balance sheets around. As you can see in the above table, the technology sector weightings more closely resemble the Russell 1000 Growth Index. Still, they have a 2% higher weighting vs. that index. As previously mentioned, Apple is the largest holding, however, the fund has taken substantial profits and reduced the position. But again, the approach is mainly "bottom-up", meaning a de-emphasis the significance of economic and market cycles, and instead, focusing on the analysis of individual companies. The Technology sector just happens to be where they are currently seeing the most value over the intermediate term.

Artisan Value is the type of fund which will tend to do better in "risk off" markets where investors are nervous and seeking "safer" stocks to purchase. The fund's only notable misstep came in 2008, when it was overexposed to bank stocks. However, it righted the ship in 2009, outperforming its benchmark by a whopping 16%. Last year, it also substantially outperformed by 5%. Because of its opportunistic nature, it also outperformed the Russell 1000 in those years. Lipper ranks it in the top 6% for 1 year performance, 15% in 3 year, and 38% for 5 year. Were it not for the bank bet in 2008, I'm certain it would be in the top quartile for all 3 time periods. This fund is a solid core holding in any portfolio.

DDIC Investment update

In my first blog post in early October 2011, I recommended purchasing DDI Corp, a small technology company that provides printed circuit board engineering and manufacturing serices. At the time, the stock was selling at about $7 per share and yielding 5.5%. In early April, Viasystems agreed to purchase DDI Corp for $13 per share. Anyone who happened to read my post on DDI Corp and purchased the stock made nearly a 100% return in 6 months. Not bad.