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Fund Spy: Morningstar Medalist Edition

Buy the Unloved 2016

Picks in three categories for the contrarian investor.

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It's time for our annual "Buy the Unloved" report.

This is a strategy that we have tracked for more than 20 years, and it has proved to be surprisingly resilient. It's really a pretty basic contrarian strategy driven by mutual fund flows. The idea is to look at calendar-year mutual fund flows by Morningstar Category and go in the opposite direction.

The strategy says you buy funds in the three most redeemed categories and sell funds from the three most heavily purchased, then hold on for three or five years. Both time periods work well. Essentially, you use flows to point you to the most undervalued investment classes. Going back to 1994, the unloved have beaten the loved in all but one three-year period. On average, the unloved have beaten the loved by 377 basis points annualized.

I use flows for open-end funds and exchange-traded funds, but exclude funds of funds. The unloved categories for 2015 are pretty similar to those for 2014: large blend, large growth, and large value. That was a good signal last year, as large caps beat small caps, and large growth was particularly strong.

Here are a few good choices in each of the unloved categories.

Large Blend
 Vanguard Total Stock Market Index (VTSAX) is one of the best low-cost options, and it can simplify investing given how widely dispersed the portfolio is. If you are looking for a more contrarian active strategy, consider  Oakmark (OAKMX) and  AMG Yacktman (YACKX). Both have excellent stock-pickers with the potential for tremendous outperformance.

 T. Rowe Price Dividend Growth (PRDGX) plays the role of Goldilocks here with a still active but milder strategy of investing in companies with solid growth prospects and healthy balance sheets that are capable of boosting dividend payouts.

Large Growth
For large-growth funds, I always plug Primecap, but you know that, so here are three non-Primecap funds that are well worth a look.  T. Rowe Price Blue Chip Growth (TRBCX) is a real gem. Veteran manager Larry Puglia seeks out companies with high returns on capital and sustainable earnings. He's used that strategy to produce pleasingly consistent performance. A more contrarian-focused play would be the small  RiverPark/Wedgewood (RWGFX) run by David Rolfe. Rolfe has a good long-term track record, but his energy holdings have held the fund back lately.

If you want a growth fund that can play defense, consider  Jensen Quality Growth (JENSX). The fund buys high-quality companies that tend to hold up well in recessions.

Large Value
 Sound Shore (SSHFX) shows that focused portfolios don't have to be high-risk. Management only owns 40 stocks, but it limits individual positions to no more than 3.5%. It also avoids deep-value stocks, which tend to be higher risk as well as higher reward. Rather, it favors stocks that have shown some signs of recovery and have strong competitive positions. The end result is a fairly consistent portfolio and performance. Its desire for companies with competitive positions has led it away from materials and energy and into financials, tech, and healthcare. Harry Burn III and Gibbs Kane Jr. have been running the fund since 1985, and comanager John DeGulis was named manager in 2003 but has been with the firm since 1996.

At  American Century Value (TWVLX), Phil Davidson and team look for companies with defensible franchises whose shares are in the cheapest third of the S&P 500. His fondness for yield also leads him to some of the oil majors.  Exxon Mobil (XOM),  Chevron (CVX), and  Occidental Petroleum (OXY) are among its top holdings.

Feeling really contrarian? How about a good value fund with overweightings in energy and materials?  Artisan Value (ARTLX) has 12% in materials and 13% in energy. Needless to say, recent returns are lousy. Still, the team's longer track record at other funds shows this is a decent bet for a rebound. The team looks for cheap stocks but wants solid business models. Unfortunately, the cheap have gotten cheaper, as the likes of  Apache (APA), Goldcorp, and  Devon Energy (DVN) have been crushed. But that also means they could produce big gains with just a little good news. I would note, though, that we lowered the fund's Morningstar Analyst Rating to Bronze from Silver because of Scott Satterwhite's planned retirement in 2016.

Sell the Loved
On the flip side, foreign large-blend, Europe, and healthcare are the most loved categories. The Europe influx is particularly interesting. Nearly all the inflows came into dollar-hedged European ETFs, because Europe started a program of quantitative easing at the same time that it was apparent the U.S. Federal Reserve's next move would be to hike rates. Thus, investors interested in Europe were worried that a rising dollar would undermine any gains in equities. (Very few open-end Europe funds hedge their currency exposure.) So, I suppose this is a signal to bet against the dollar as much it is to bet against Europe.

I consider the "Buy the Unloved" strategy a good guide to contrarian ideas, but I wouldn't suggest overhauling your portfolio based on it. You don't want to veer from your overall, long-term plan. Just use this strategy at the margins and as a healthy reality check to make you reconsider buying the most popular categories and rethink selling a fund from an unpopular area. 

For a list of the open-end funds we cover, click here.
For a list of the closed-end funds we cover, click here.
For a list of the exchange-traded funds we cover, click here.
For information on the Morningstar Analyst Ratings, click here.

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