Some might consider Bill Nygren a turncoat. The manager of Oakmark Fund (OAKMX) is known to be a cautious value investor who buys the stocks of downtrodden, sometimes obscure companies. So why is his fund full of brand names -- Wal-Mart Stores (WMT), McDonald's (MCD), Citigroup (C)? "Today, you don't have to pay as much for growth or earnings consistency as you normally do," Nygren says. "So we're trading up."
Mutual-fund investors should take heed. Nygren and other top value managers believe that after four years in which cheap industrial, energy, small-bank, and real estate stocks have soared, the tide may be turning. Value stocks have grown expensive, and growth companies, if not cheap, are more reasonably priced than they've been in years.
You could hardly tell that from this year's top-performing funds. Across the board, value funds beat growth, and small-cap funds beat large-caps. Small-cap value funds, up 15.67%, did the best among domestic equity funds, which gained 9.05%. That's a slight improvement on the 8.52% total return earned by the Standard & Poor's (MHP) 500-stock index. (All returns are as of Dec. 10.) "Both value stocks and small-cap stocks have run so hard for so long that they are no longer investment opportunities," says Ben Inker, director of asset allocation at Grantham, Mayo Van Otterloo & Co., a Boston investment firm.
Growth-fund managers such as Bill D'Alonzo of Brandywine Blue Fund (BLUEX) agree that their universe of stocks are relatively cheap. But D'Alonzo won't invest in just any old blue chip. "It makes more sense to us to find a company that has a new catalyst for earnings growth than gamble on a well-known, mostly mature one that has fallen on hard times," he says. He's finding such catalysts at McDonald's Corp., which is now offering appetizing salads for adults and apples and milk as alternatives to french fries and soda for kids. D'Alonzo's Brandywine has triumphed this year, gaining 14.32%, compared with just 5.46% for the average large-cap growth fund.
Outside of blue chips, investment pros are finding some buys in popular categories. While oil stocks have soared, Dan Rice, manager of State Street Research (SSR) Global Resources Fund, which is up 40.60% this year, sees better prospects in other energy plays, especially coal stocks, which comprise 25% of his fund. "Coal prices have risen dramatically, but the supply of coal hasn't really increased," he says. That makes Rice think shares of coal miners such as Peabody Energy Corp. (BTU) and Consol Energy Inc. (CNX) could more than double.
Real estate investment trusts have risen consistently every year since the bear market began in 2000, and the average REIT fund gained 29.35% this year. Co-manager James S. Corl of Cohen & Steers Realty Focus Fund, up 36.94% year-to-date, says REITs on average have traded at a 4% or 5% premium to the value of their real estate holdings since 1987. Currently they're trading at an 8% premium, he says, making them slightly overvalued. Corl looks for REITs that trade at a discount to their properties. Among those is Host Marriott Corp. (HMT), which stands to benefit from higher occupancies and rising room rates.
What about technology funds? After a sharp rebound in 2003, they have sagged in 2004, gaining only 1.40%, though certain areas shined. "The two I like are the Internet and wireless data -- Yahoo! (YHOO), eBay (EBAY), Ericsson (ERICY)," says co-manager Walter Price of Pimco RCM Dresdner Global Technology Fund, one of the category's top performers this year, with a 15.48% gain. A bigger question mark hangs over the chip and hardware sectors, which are suffering from overcapacity. Price thinks inventory adjustments may depress earnings for six more months, but the stocks may rise sooner in anticipation of a recovery.
Managers of diversified funds aren't keen about tech. "There's increased competition and a lack of killer applications," says Edward P. Bousa, co-manager of the $33 billion Vanguard Wellington Fund, a balanced fund that can invest in almost any kind of stock or bond. "The sector needs some kind of great new product to spark demand." One of the few tech stocks he owns is Apple Computer Inc. (AAPL) because he believes the iPod digital music player is one of those great products.
Of greater interest to Bousa are foreign stocks; they account for 15% of his portfolio, high for what is primarily a U.S.-focused fund. Indeed, almost every manager BusinessWeek spoke to who had the flexibility to invest globally preferred stocks overseas, which have cheaper valuations and can benefit from a falling U.S. dollar. "I'm very confident that non-U.S. equities will beat U.S. ones over the next five years," says GMO's Inker. He is so confident that he's buying foreign stocks while short-selling U.S. equities in some of GMO's private accounts.
Manager Bernard R. Horn Jr. of the top-performing Polaris Global Value Fund (PGVFX), which has a 18.77% return so far this year, ranks entire stock markets of 44 countries by their relative valuations. The U.S., he says, is near the bottom. Poland tops the list, while Japan, China, Taiwan, Korea, Indonesia, and Hungary rank highly. He especially likes Japanese utility companies Tokyo Electric Power Co. (TKECF) and Kansai Electric Power Co., which have price-to-cash-flow ratios that are about half those of comparable U.S. utilities.
Emerging markets still offer the best bargains even though the funds have outperformed the S&P 500 for each of the past four years. Co-manager John Chisholm of Acadian Emerging Markets Fund, up 20.40% this year, figures the price-earnings multiples of emerging- markets stocks are 40% less, on average, than those of U.S. stocks. But he cautions that valuation alone isn't enough to prompt an investment. He also considers a country's interest rates, market volatility, and political corruption before buying stocks there. If any of those indicators are rising, as they are in Brazil, Mexico, and Pakistan, it's a red light. He's looking more favorably on Russia and Turkey.
Emerging-market bonds have done even better than the sector's stocks, earning double-digit gains each year since the debt crisis of 1998 and rising 10.55% in 2004. Whether the rally continues depends on the U.S., says Mohamed El-Erian, portfolio manager of the $1.7 billion Pimco Emerging Markets Bond Fund. If the dollar plummets and U.S. interest rates spike, he says, riskier investments such as emerging markets get slammed as investors flee to cash or gold. If the U.S. continues to muddle along with just a weak dollar, emerging-market bonds should continue to outperform lower-yielding U.S. Treasuries.
Certainly, the quest for yield has led bond investors to take on more risk. Average junk-bond yields have dropped from over 12% during the bear market to 7% today as yield-hungry buyers have poured billions into junk funds. Yet manager James Kelsoe of Regions Morgan Keegan Select High Income Bond Fund has been able to deliver a 9.8% current yield by investing in smaller, lesser-known bond issuers and by venturing out to more exotic investments such as collateralized home-equity loans and credit-card receivables. Kelsoe worries that interest rates on the new-issue high-yield bonds are only around three percentage points higher than Treasuries -- that's not enough extra return to compensate for the extra risk.
For this reason tax-free municipal bond funds may be a better bet. According to manager John Miller of the top-performing Nuveen High Yield Municipal Bond Fund, the average high-yield muni bond yields 6.6%. That translates into 10.1% for investors in the highest tax brackets. High-quality munis also look good relative to Treasuries. "You get 95% of a 10-year Treasury's yield on an AAA-rated muni bond of an equivalent maturity," Miller says, and it's tax-free.
Other than munis, attractive bond market opportunities are scarce. "I can't imagine any investor not doing better in a portfolio of high-quality equities than in bonds," says Oakmark's Nygren. Sure, that's a stock-fund manager talking, but looking into 2005 at least, many bond fund managers would probably agree.
By Lewis Braham