EDITOR'S NOTE: This article is from Kiplinger's Mutual Funds 2008 special issue. Order your copy today.
This is not a market for the faint of heart. Swings of several hundred points in the Dow Jones industrials aren't uncommon these days. Throw in a barrage of negative headlines -- the subprime-mortgage mess, falling housing prices, a credit crunch, the dropping dollar and growing fears of a recession -- and it's no wonder that many investors are focusing less on making a killing and more on avoiding a slaughter.
The conservative move for those unnerved by the current conditions is to sell some stock funds and move the proceeds to cash or bond funds. But then you'll be leaving the superior gains of the stock market on the table. Don't forget that the stock market's long-term trend is up.
A better tack is to seek shelter in funds that are best suited to weather a market storm -- whether it's a mere thundershower or a cataclysmic hurricane. Here are four stock funds that are built to avoid catastrophic losses but that are capable of rewarding shareholders over the long term. These funds are substantially less volatile than their peers, and all but one made money during the 2000-02 bear market (the exception was Jensen fund, which lost 14%, compared with the S&P 500's 47% dive). Three of the four fund picks are concentrated, meaning that their managers invest in a small number of businesses in which they have a high degree of confidence.
Always in the black. Because the stock market goes down every so often, it's unusual for stock funds to go up every year. That's what sets T. Rowe Price Capital Appreciation apart. The fund (symbol PRWCX) has produced black ink in each of the past 16 calendar years while delivering a generous annualized return of 12% (those gains, incidentally, beat the stock-only S&P 500 by an average of two percentage points per year). The fund gained 5% in 2007 to December 1.
Capital Appreciation is not a pure stock fund. It typically invests about two-thirds of its assets in bargain-priced stocks that pay dividends at an above-average rate. The rest is currently in a mix of cash, bonds and convertible securities. David Giroux, who has been running the fund since July 2006, says he pays a great deal of attention to risk when he picks stocks. "We want to find a stock that's so washed out that there's not a lot of downside," he says. "We see a lot of value in the GEs and the US Bancorps of the world -- companies that are not exciting and not sexy to a large portion of the investing crowd."
Although Giroux's tenure at Capital Appreciation is brief, we see no reason to worry. Price is a collaborative firm with a reputation for grooming solid managers, and Giroux has been an analyst there for nine years.
Brand-name buyer. Quality rules at Jensen Portfolio. The fund requires the companies in which it invests to produce a return on equity (a measure of profitability) of at least 15% in each of the past ten years. If a current holding fails the 15% test, it's booted from the portfolio and banned for at least ten years. "We see it as an indication that the company's competitive advantage has eroded," says Bob Millen, one of four managers of the $2.2-billion fund (JENSX). This return-on-equity requirement narrows the fund's investment universe to 170 companies, only 25 to 30 of which make the final cut.
Jensen's disciplined strategy steers it toward big, brand-name companies, such as Colgate-Palmolive and Procter & Gamble, and big manufacturing companies, such as General Electric and 3M. The managers also favor companies that churn out plenty of cash and generate a large portion of revenues overseas.
When the market favors more economically sensitive energy and technology companies, this portfolio of stable growers tends to lag other funds that focus on large-company growth stocks. But Jensen rewards patient investors. The fund returned 8% annualized over the past decade, beating the S&P 500 by two percentage points a year, and it did so with about one-fifth less volatility. It lost 14% during the 2000-02 bear market, a period when many large-company growth funds plunged 60% to 70% or more.
Discount hunters. The three men who run Longleaf Partners International are bargain hunters through and through. Mason Hawkins, Staley Cates and Andrew McDermott, who have all been with the fund since its 1998 inception, buy a stock only when it is selling for at least 40% below their estimate of the underlying company's true value.
Aside from buying cheaply, the trio also reduces risk by hedging most of the fund's foreign-currency exposure. That means performance will depend on their stock-picking abilities rather than on currency fluctuations. (This policy hurts results relative to other overseas funds in years, such as 2007, when the dollar weakens.) The managers also tend to keep the fund's emerging-markets exposure light and allow cash to build when they can't find stocks that meet their value criteria.
Unlike most foreign-stock funds, Longleaf International is willing to invest in U.S. companies with significant business overseas. At last report, for example, its top holding was Dell, which accounted for 9% of the portfolio. Since its launch, Longleaf Partners International (LLINX) has returned 15% annualized, an average of six percentage points per year better than the MSCI EAFE index.
Cashing in with cash. When the market is behaving badly, cash is king. Just ask Don Yacktman, head honcho at the Yacktman fund (YACKX). During the 2000-02 bear market, when the S&P 500 lost 47%, the fund gained 39% by holding cash-rich companies and keeping one-fourth of its assets in greenbacks. At last report, the fund had 16% of its assets in cash.
Yacktman looks for highly profitable businesses selling at bargain prices. Hem homes in on companies plagued by temporary problems that others believe will last forever. "These companies are like escalators, not moving sidewalks," says Yacktman, who has been managing one mutual fund or another since 1968. "They compound your money, and they tend to be relatively defensive." The fund's 31-stock portfolio is filled with large, consumer-oriented firms (together, Coca-Cola and PepsiCo make up 20% of its assets).
Lately, Yacktman has been putting more cash to work and bargain-hunting among beaten-down financial stocks. Like Jensen, Yacktman is a fund best suited for long-term investors because its stock picks can take years to play out. The fund's 8% annualized return over the past decade beat the S&P 500 by an average of two percentage points a year. The fund is also about 15% less volatile than the S&P.