By Christine Benz |
One of the key most important aspects of successfully investing in actively managed stock funds is to make sure you understand their strategies. Doing so will help you understand your holdings' performance (including the inevitable weak patches), employ funds that are complementary rather than redundant, and understand whether a manager has begun to drift from a strategy that served him well in the past.
What follows is a field guide to some of the key strategies that active managers employ.
Shades of Value Value strategies divide (roughly) into the relative-value and absolute-value camps. However, some value-oriented fund managers place a premium on companies with high dividend yields.
Relative Value Fund managers practicing relative-value strategies favor stocks that look cheap relative to some yardstick, including the stock's historical price, the historic valuation norms for the company's industry, or the broad market. For example, the team at Morningstar Analyst Pick
Sound Shore (SSHFX) looks for companies that are trading cheaply relative to their historic price multiples. Relative-value funds have a decent shot of delivering strong performance in a variety of market conditions--not just when truly cheap stocks are in demand. For example, although technology stocks soared in the late 1990s, leaving many value funds on the sidelines, certain relative-value funds actually performed reasonably well during that stretch because they had delved into tech names they considered cheap within that sector, which was pricey overall. The key drawback to the relative-value approach is that these funds might also have more exposure to volatile growth stocks.
Absolute Value Managers such as those in charge of the Oakmark family of funds,
Third Avenue Value's (TAVFX) Marty Whitman and Ian Lapey, and the team at Longleaf Partners (LLPFX) follow absolute-value strategies and are typically considered stricter value practitioners than the relative-value set. Absolute-value managers don't compare a stock's price ratios with that company's historic norms, those of other companies, or the market. Instead, they try to figure out what a company is truly worth, and they want to pay less than that figure for the stock. Absolute-value managers determine a company's worth using several factors, often looking at the company's assets, balance sheet, and growth prospects. They also study what private buyers have paid for similar companies. As a general rule of thumb, absolute-value managers often focus on companies in traditional value sectors, including financials firms, basic-materials and manufacturing companies, and energy firms. But some of these funds will also venture into traditional growth sectors--including technology, health care, and retail--if they find a company they think is selling at a discount to what it's truly worth.
In general, if you own an absolute-value fund, be prepared to wait out some dry spells and don't expect your fund to move in lockstep with a broad market index such as the S&P 500. Managers who follow strict value strategies tend to be a determined lot, and they're generally not swayed by market fads. It can take a while for an extremely undervalued stock to pay off, particularly if it's in a segment of the market that's badly out of favor. Over long time periods, however, absolute-value strategies have often helped funds deliver strong long-term returns.
Income-Oriented Value Another subset of value funds are those that focus on companies with above-average or even high dividend yields. Such funds might also use absolute- or relative-value strategies in addition to seeking stocks with high income payouts. For example, Jim Barrow, who runs the largest share of assets at
Vanguard Windsor II (VWNFX), focuses on high-dividend-paying stocks with low price/earnings ratios. Managers tend to look for stocks with high dividend yields for a few reasons. First, fund managers may consider a company's ability to pay out part of its earnings in the form a dividend to be an important sign of financial strength. Other income-oriented managers might consider a high dividend yield to be a good sign of a cheap stock. (A company's dividend yield is calculated by dividing its dividend by its stock price, so if a company's share price is declining, it's dividend yield will invariably be on the rise.) Finally, some value managers focus on dividend-paying stocks because they're catering to investors who are looking to their mutual funds for a regular income stream. This last group is a declining subset of stock funds, however, largely because most common stocks deliver little in the way of income these days.
Shades of Growth In contrast with their value-oriented counterparts, most growth managers are more interested in a company's earnings or revenues and a stock's potential for price appreciation than they are in finding a bargain. In general, growth funds will have much higher price ratios than value funds. That's because growth managers believe that if a company has what it takes to create high-quality products and services, investors will be willing to pay a higher and higher price for it in the future.
Growth-style strategies generally work better when investors are concerned about economic weakness. Manufacturing and basic-materials stocks will suffer when economic growth slumps, but companies with steadier growth generally hold up better. That's because market participants usually believe that if a company has a nifty product or service, it has the potential to grow regardless of what the broad economy is doing.
It's worth noting that growth-fund managers, like their value-oriented counterparts, practice different styles. Those styles will affect how the fund performs--and how risky it is.
Earnings-Driven The majority of growth managers use earnings-driven strategies, which means they use a company's earnings growth as their yardstick for determining how quickly the company is growing. If a company's earnings aren't growing significantly faster than those of the average company in its sector or the market as a whole, these managers aren't interested.
Within this earnings-driven bunch, earnings-momentum managers are by far the most daring. You might say their mantra is "Buy high, sell higher." Momentum investors buy rapidly growing companies they believe are capable of delivering an earnings surprise, such as higher-than-expected earnings or other favorable news that will drive the stock's price higher. These managers will likely sell a stock when its net income (based on earnings that are reported every quarter) slows. That can be the harbinger of a later earnings disappointment--a negative earnings surprise--that will drive the stock's price down.
Earnings-momentum managers typically pay little heed to the price of a stock. Instead, they focus on trying to identify companies with accelerating earnings, as well as catching upswings in stocks that have already shown price gains. These funds, therefore, can feature a lot of expensive stocks as long as earnings continue to increase at a rapid rate. American Century's lineup has several funds that use earnings momentum as a component of their strategies.
Revenue-Driven Not all growth stocks have earnings. In particular, stocks of younger companies such as Groupon might not produce earnings for years because they're spending more than they're taking in. Some growth managers will buy companies without earnings if the companies generate strong revenue. (Revenues are simply a company's sales; earnings are profits after costs are covered.) Because there is no guarantee when firms without earnings will turn a profit or if they ever will (think of the many Internet companies that went under in 2000), this approach can be risky, risky, risky.
Blue-Chip GrowthMore moderate earnings-growth-oriented managers look for companies growing in a slow but steady fashion. The slow-and-steady group has historically included such blue-chip stocks as
Wal-Mart (WMT) and Procter & Gamble (PG). As long as these stocks continue to post decent earnings, the managers tend to hold on to them. Steady-growth funds often have more modest price ratios than other growth-oriented funds and often fare relatively well in slow economic environments because they favor companies that aren't dependent on economic growth for their success. Funds known for following this moderate-earnings-growth strategy include Aston/Montag & Caldwell Growth (MCGFX) and Dreyfus Appreciation (DGAGX). Shades of Blend Although some of the best-known mutual fund managers use either growth or value approaches, a giant group of fund managers is content to split the difference between these two investment strategies. We say such managers are using blend strategies because their approaches combine both value and growth styles. The blend group is home to pure index funds and indexlike funds, but it's also home to bold stock-pickers' funds such as
Legg Mason Value (LMVTX) and Selected American (SLADX). If you're not sure whether the value or growth style of investing appeals to you, most blend funds are a good way to hedge your bets. That's because value and growth investment styles tend to swing in and out of favor. But if you own a blend fund, you improve your chances of having something in your portfolio that's working well no matter what. That all-weather appeal is partly what makes blend funds such popular choices for the core holdings in investors' portfolios.
GARPWithin the blend category, the most common management style is the so-called growth-at-a-reasonable-price approach, or GARP. Managers who seek growth at a reasonable price try to strike a balance between strong earnings and good value. Some managers in this group find moderately priced growth stocks by buying stocks that high-growth investors have rejected. Often, these companies have reported disappointing earnings or other bad news, and their stock prices may have dropped excessively as investors overreacted by dumping shares. GARP managers also look for companies that Wall Street analysts and other investors have ignored or overlooked and that are therefore still selling cheaply. As with value investors, GARP investors try to find companies that are only temporarily down-and-out and that have some sort of factor in the works (commonly called a catalyst) that seems likely to spark future growth.
Dividend GrowthDividend-growth funds blend aspects of both growth and value investment styles. Like income-oriented value funds, their managers want their companies to pat dividend yields. However, they're not seeking yields that are high in absolute terms, which can be a signal that a company is struggling. Rather, they like it when a firm has a history of increasing its dividend over a period of a few years or more, because it's an indication that the company is fundamentally strong and has growth potential.
Vanguard Dividend Growth (VDIGX) is a prime example of a fund that employs such a strategy. 
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