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Three Great Funds for a Low-Return World

If the S&P 500 is overvalued, these are prudent alternatives.

Last week on Morningstar.com there was an article postulating that the S&P 500 index was "egregiously overvalued." Morningstar stock analyst Curt Morrison, relying heavily on long-term studies of equity markets, came to this conclusion by examining several traditional building blocks of the stock market's historical return--inflation, dividends, and real capital appreciation (earnings). He estimates that earnings growth will have to hit 5.4%, an unusually high number, to justify the index's current level. Right now, Morrison prefers cash to this basket of large-cap stocks.

Morningstar fund analysts like myself hear and read such views pretty frequently. This past summer at Morningstar's annual conference, Bob Rodriguez, manager of  FPA Capital (FPPTX), touted cash over all other assets. Jeremy Grantham of Grantham Mayo Van Otterloo & Co.--who seems to always think everything but timber is overpriced--gleefully predicted doom. We talk to managers almost daily and, especially after a sharp bull rally like the one in 2003, we hear nasty forecasts of low-return environments and a lack of buying opportunities. Yet a lot of us, myself included, continue to hold the  Vanguard 500 (VFINX) index fund.

Stand Your Ground
There are three reasons for holding strong in the face of such pronouncements. First, while a lot of solid thought and research goes into them, they can still be wrong. The formulas could be flawed, price/earning ratios may not fall to historical norms, or the forward-looking expectations (inflation, for instance) could turn out to be off the mark. One need not even figure out how the theory might be wrong, it only matters that it could be. Second, even if you believe the premise, the supposedly prudent response--not owning large-cap stocks--seems extreme, even imprudent. Finally, even if you do get out of stocks (or certain kinds of stocks) at the right time, you also have to get back in at the right time, which is incredibly difficult to do. In other words: I'm not betting my retirement that the naysayers are correct.

Of course, it should be obvious that there are options besides owning an S&P 500 index fund or cash. If one is convinced by the central conclusion--that large-caps are pricey--how might one remain invested but protected? We can turn to Morningstar's  Premium Fund Screener to identify mutual funds that have a better profile than the S&P 500 index given Morrison's key measures.

Finding the Diamonds
First, we'll establish a universe of funds with equity styleboxes only in large-caps and domestic stocks. We'll also request distinct portfolios so we only see one share class of each fund. Then we turn to the argument against the S&P 500. Morrison argues that too high a price is being paid for firms' earnings, so we'll request that the funds' portfolio have a price/earnings ratio that's below the index's. Also, the historically low-dividend rate is a problem, so we'll demand that our funds have a trailing 12-month yield that surpasses the S&P 500's 1.71% rate--and note that there's extra care here given that this yield is post-expenses, not pre-expenses. In order to ensure that a fund's yield doesn't come from bonds, we'll demand that the fund's assets be 90% U.S. stocks. Since this is a buy list, we don't want closed funds. And we never want expensive funds--especially if we're going to be in a low-return world, so we'll cap the expense ratio at 1%.

As of November 19, this search yields 20 funds. Click  here to view them.

Not surprisingly, most of the funds that make the list are large-value funds. It's also not surprising that some of these funds are highly appreciated by Morningstar's fund analysts and would make fine portfolio anchors. Here's some details on three of them.

A dividend-focused offering,  Vanguard Equity-Income (VEIPX) has posted the second-highest yield of the funds that passed our screen. That's due, in part, to Vanguard's trademark: a tiny expense ratio, which lets those dividends flow through to share owners. Three different management teams have three different strategies for finding stocks with solid payouts, so owners can rest assured that the fund doesn't simply chase one kind of firm. The fund focuses on the very largest firms, so its relative returns--that is, those compared with peers--can fluctuate based on how well mega-caps perform in a given time period.

Fund analyst Christine Benz notes that  Vanguard Windsor II (VWNFX) is "a topnotch choice for what's shaping up to be an era of low expectations." That's because of the focus on true-value fare and dividends. This fund doesn't home in on dividends quite as much as Vanguard Equity-Income, which is one reason why the fund's relative returns don't shift as much as its sibling's. The portfolio's price/earnings ratio is 14.3, which is 17% lower than the S&P 500 index's, making a nice cushion should valuation multiples contract.

While both Vanguard funds do use quantitative methods in small doses,  American Century Income and Growth (BIGRX) uses them extensively. The whole plan here is to take measured bets against the S&P 500 index to create a portfolio that's like the bogy but leans heavily toward value. Its models specifically seek low valuations and solid dividends. While its expense ratio isn't quite as low as the Vanguard funds', the low cost of 0.69% allows a nifty 1.9% yield to end up in investors' pockets.