Injecting Some Growth to the Portfolios

Investors aren’t making too many mistakes these days. That means we have to search harder to find profitable investment ideas with a margin of safety.

The most frequent mistake investors make is to misprice investments. In the typical investment cycle, investors buy whatever has been rising. This pushes the price of that asset to an unsustainable, overvalued level until there are no more buyers. Likewise, cheap investments are ignored by most investors until their prices start to increase.

Because of this cycle, it was easy in the late 1990s to see that growth stocks were overvalued while value stocks and real estate investment trusts were screaming values. More recently, we ventured into international stocks and bonds when they were attractively priced, and we sold the REITs after a fantastic five-year run.

Now, most types of stocks are fairly valued, and about equally valued. In our May 2005 visit I showed you a chart revealing that the price-earnings ratios of growth and value stocks are converging. In fact, almost any way you want to slice the stock market, today valuations of different types of stocks are very similar. The valuation gaps between all different types of stocks are historically narrow. There also is not much of a difference when U. S. stocks are compared to international and emerging market stocks.

REITs appear to be fairly valued and are near their peak historic values by some measures. We might add them to the Managed Portfolios later this year or early in 2006, but for now they do not carry enough of a margin of safety for me.

Since 2000, prices have sharply declined for assets that were overvalued. Those that were undervalued back then have had their valuations rise. In short, the valuations of most investment assets are converging.

That doesn’t mean we are without investment opportunities. We will delve into a new idea in this visit, and will review the assets already in the portfolios.

Sector and Balanced Managed Portfolios

There is cash to be invested in these portfolios and a good place to invest some of it.

Many stocks are priced at levels they first reached in the 1998-2000 period. Yet, because corporate earnings continue to grow at a good rate, earnings for many of these companies are much higher than when stocks were at their peaks. Since there are no major differences between the valuations of different types of stocks, searching for major valuation differences is not the way to identify mutual funds to buy at this stage of the investment cycle.

Instead, the best way to invest in U.S. stocks now is to buy stocks of companies with strong earnings growth that is sustainable. Since such stocks generally are selling at the same valuation levels as other stocks, the fast-growing companies are bargains. There is no incentive to buy other stocks when those with fast-growing earnings are selling at similar valuations. U.S. growth stocks offer the best risk-return trade off in the world’s equity markets.

Relative valuations are not the only reason growth stock funds should be part of your Managed Portfolio now. Growth stocks tend to perform very well after the Fed stops tightening. That is likely to happen sometime in the second half of this year, and we do not want to be on the sidelines when investors get the word.

But do not buy just any growth fund. There are wide differences in the performances of growth stock funds. Some managers still are waiting for the return of the tech stock boom. Others do not pay attention to valuations, while others are not good at analyzing businesses. Also, avoid small growth stock funds. These are the most volatile and risky stocks and rarely earn returns that are worth the risk.

My choice for our portfolios is Chase Growth. This low-expense, no-load fund has several unique features that make it ideal for us.

The fund is run by Derwood S. Chase, Jr. and David B. Scott. Chase has been in the investment business since 1957. Most of today’s growth fund managers were born well after that. The fund searches for the best value and opportunity among stocks with growing earnings.

Chase Growth is not a mega fund. Its moderate size enables it to shift among stocks and sectors as it sees opportunities. It does not worry about affecting the markets the way growth funds from Fidelity, Janus, and Vanguard do. Chase also can invest in mid-size growth companies in a meaningful way, which the larger funds cannot do. It also is able to focus on its best ideas, a trait I look for. It owns less than 50 stocks and has almost a third of the fund in its top 10 holdings.

Chase examines the fundamentals of a business to ensure the earnings growth is likely to continue. Unlike many growth stock funds, Chase considers a stock’s selling price and valuation in its buy and sell decisions. This helped the fund significantly in the rough growth stock market since 1999. The fund lagged the top growth funds a bit in the bull market, but it handily outperformed the average growth fund in the bear market. It is one of the few growth funds to lose less than 15% in both 2001 and 2002.

If growth stocks really take off, Chase will earn solid gains but might very well trail the hottest growth funds. If the stock market enters a rockier period than I anticipate, the fund will hold up much better than other growth stock offerings. It is the kind of margin-of-safety trade off I like. Add Chase Growth to your portfolio. (The fund charges a 2% redemption fee for shares held less than 60 days.) The fund is available through most of the NTF broker programs.

If you cannot buy Chase Growth, there are several good substitutes. Consider Fidelity Contrafund, Price Growth Stock, and Vanguard Morgan Growth. A more risky option is Needham Growth.

Chase Growth will complement other funds in the portfolio that look for a small number of specific stocks to buy. This stock-specific approach is the best approach in today’s markets.

Oakmark Fund has some similarities to Chase Growth. Each fund is looking for good businesses that are selling at good prices. The difference is that Oakmark looks for value first, while Chase looks for growth first. Oakmark’s managers recently said that at today’s valuations it is difficult to find many great companies selling at bargain prices. Since it anticipates strong earnings growth to continue for the next year or more, Oakmark is looking for the best businesses it can find for the portfolio instead of looking first for value.

The fund owns a number of great companies that used to be considered growth stocks: The Gap, Home Depot, Harley-Davidson, Walt Disney, Kohl’s, and Viacom among them. Oakmark believes the growth stories for these companies are intact, and that they are solid investments at today’s prices.

Another portion of our portfolios is taking the stock-specific approach in what has been the sweet spot of world markets for a few years: small international value stocks. Third Avenue International Value and Tocqueville International Value take different approaches to finding bargains in small to mid-size companies around the world.

Third Avenue, which we added in the June visit, seems to find extraordinary bargains in companies no one else has heard of or that no one wants to buy. The great advantage of the Third Avenue approach is that the fund rarely has a strong correlation to market indexes. For example, it is up about 5% for 2005 while most stock markets are down. The fund also rose while the dollar was gaining against other currencies, showing that the fund does not need a weak dollar to show profits for U.S. investors.

Tocqueville takes a more traditional approach, searching the world’s markets for small, growing companies that are selling at discounts to their growth rates. It invests in both developed and emerging markets. It recently had about half its assets in Europe and almost 40% in Asia. The fund is fairly concentrated, owning about 60 stocks with 25% of the fund in its top 10 holdings. It also has a gain for this year, though it is well below its highs of March 2005. This is a rare no-load, low expense fund in this asset class.

Because of strong recent returns in both of these funds, they could close to new investors soon.

We added PIMCO Commodity Real Return to the portfolio last month. So far, it is well above its May low. If the economy grows as I expect, we should see gains in commodity prices and in this fund. Because of its holdings in Treasury Inflation Protected Securities, the fund also has benefited from the sharp drop in interest rates. I anticipate holding this fund for a while, but it always is nice to see a good gain right after our purchase.

Hussman Strategic Growth continues to occupy a sizeable portion of these portfolios. It has a modest gain this year, putting it well ahead of the indexes and most U.S. stock funds. It maintains a policy of holding a full portfolio of stocks, then hedging it against the market indexes as its quantitative models indicate. These positions give the fund the potential to gain whether the market indexes rise or fall. That doesn’t mean the fund will profit all the time. But it does give us potential protection if the market indexes sharply decline, while retaining the ability to profit in market rallies. It is a good fund to own in the trading range markets we have had the last few years.

We’ll re-evaluate Hussman’s position in the portfolios once it becomes clear that the Fed is through raising interest rates.  That might be the point to switch to an unhedged fund, depending on how the fund’s models direct it to be invested.

In the core portfolios, Tweedy, Browne Global Value now is closed to new investors. The fund has been a solid performer for us for years. It has handily outperformed the competition and relevant indexes for many years, with far less volatility than other funds and the indexes.

I will continue to list the fund as our primary international stock recommendation. Substitute funds are listed in the One-Stop Portfolios box and on the web site under Carlson’s Choice Funds. The best choices are Fidelity Diversified International and Oakmark International.

Income and Income Growth Funds

Long-term interest rates surprised almost everyone with their sharp decline beginning in late March. That brought us modest capital gains in these portfolios.

The Income Portfolio has been composed entirely of the Vanguard Short-Term Investment Grade fund for some months now. The Income Growth Portfolio is 80% that fund and 20% in Dodge & Cox Balanced. We could have earned larger profits by being invested in a fund with longer-term bonds. Vanguard Long-Term Treasury, for example, returned 2.02% over four weeks compared to VFSTX’s 0.30%. But that would have meant taking more risk than seemed prudent a few months ago.

With the yields on short-term bonds nearing those of longer-term bonds, it is tough to make a case for investing in the longer maturities now. The long bonds will earn higher capital gains if rates continue their decline. But one has to firmly believe in a deflationary or recessionary scenario for the coming months to take the risk. An upward blip in inflation would cause a sharp rise in rates and a steep drop in the value of the bonds.

This also is not a good time to seek higher yields in vehicles such as high yield bonds or emerging market bonds. Until recently there was an historically small gap between yields on those bonds and treasury bonds. The gap is widening to more traditional levels. Investors realized that they were not being paid to take the additional risk inherent in those bonds, and that the risk had the potential to be realized.

I recommend you stay with Vanguard Short-Term Investment Grade Bond fund.

Dodge & Cox Balanced adds the growth element to our Income Growth portfolio. Because it uses Dodge & Cox’s successful value investing process, the fund offers solid potential returns with low risk. Continue to own the fund.