This year’s picks for the Kiplinger 25 include new ways to generate income. By Nellie S. Huang, Senior Associate Editor April 10, 2012 Eight percent a year. That’s the magic number many retirement calculators use for the assumed long-term return of stocks. The awful truth is that over the past decade, it’s been a difficult number to achieve. The broad stock market, as measured by Standard & Poor’s 500-stock index, fell far short, returning just 3.7% annualized over the past ten years. But here’s the not-so-awful truth: Many mutual funds have done better than that. Much better. Some are members of our very own Kiplinger 25 -- the list of our favorite no-load funds. SEE ALSO: Our Guide to the Kiplinger 25 Fidelity Contrafund (symbol FCNTX), for example, has gained an annualized return of 7.9% over the past ten years. Fidelity Low-Priced Stock (FLPSX) has done even better: an average of 9.3% a year. And T. Rowe Price Small-Cap Value (PRSVX)? 9.3% (all returns are through March 9). Those are the kinds of results we aim for when we pick the Kip 25 funds. And after the generally lousy stock market performance of the past decade, the chances are good that the next ten years will be much kinder to stock market investors and stock-owning funds. In compiling the Kip 25, we favor funds run by seasoned managers who take a long view and have proved themselves able to weather many a storm. And we prefer funds with low to below-average fees. This year, the Kip 25 takes on five new members, profiled here. To see descriptions and recent returns of all the funds, see our monthly-updated fund tables. And to find out how you can put the Kip 25 to work, no matter what your investing goal, see Kiplinger 25 Model Portfolios. Advertisement An Asian Dividend Play The search for winners at Matthews Asia Dividend (MAPIX) begins with stocks that yield at least 2% and have a market value of at least $500 million. Lead manager Jesper Madsen and co-manager Yu Zhang, both based in San Francisco, whittle down the list further by identifying companies that they expect to raise dividends over each of the next three years. The fund invests in both emerging and developed markets. At last report, the fund had 26% of assets in Japanese stocks. After getting the list of potential candidates, Madsen and Zhang hit the road. Four times a year, they traipse across the region, visiting up to five companies a day over two weeks. The trips are “taxing” marathons, says Madsen, but they are key to stock picking because they offer the managers a chance to see how companies respond to simple questions: What’s the plan for allocating capital over the next three years? Where will growth come from? What will it cost? What’s the dividend policy? “They’re soft questions,” says Madsen, “but the answers are telling because you find out who management is working for” -- shareholders or themselves. The managers’ ability to uncover good, shareholder-focused companies shows in the fund’s record. Since its inception in October 2006, it has earned 10.4% annualized. Exotic No Longer Fidelity New Markets Income (FNMIX) was the first and only emerging-markets bond fund in the country when it launched in 1993. Now there are 57 such funds with a total of $54 billion in assets. Advertisement It’s a whole new world. Twenty years ago, fewer than eight emerging markets issued bonds denominated in U.S. dollars; today, there are 50. And 15 years ago, most emerging-market government debt was junk-rated (below triple-B) or unrated; today, two-thirds is investment-grade. Bonds from emerging markets are now “safer,” says manager John Carlson, who took over in 1995. But they shouldn’t be considered totally safe -- and that’s good news. The added risk means bigger cash payments. New Markets Income boasts a current yield of 4.8% (the average yield for intermediate-term bond funds is 3.4%). Carlson calls himself a “core investor.” He invests two-thirds of the portfolio in dollar-denominated government debt and divides the rest among corporate bonds, local-currency government bonds and even a little in stocks. To mitigate risk, he follows a few rules: no more than 10% in local-currency bonds, no more than 20% in corporate IOUs and no big bets on the direction of interest rates. Carlson has used this formula for 17 years and sees no need to change it. No need, indeed. His fund’s annualized return of 13.7% over that period outpaces nearly every asset class, including the average emerging-markets bond fund, the S&P 500 and the MSCI EAFE index of foreign stocks. Cheap and Sound Managers George Sertl Jr., Scott Satterwhite and Jim Kieffer together run three funds, each fund focusing on companies of a different size. Artisan Value (ARTLX) invests in large-capitalization stocks, and Small Cap Value and Mid Cap Value (both of which are closed to new customers) invest, not surprisingly, in small- and mid-cap stocks. “It’s like running a single all-cap portfolio,” says Sertl, because all three funds employ the same strategy. Advertisement The process starts with screens. The managers sift for stocks trading at low price-earnings and price-to-cash-flow ratios, among other measures. They use other filters to identify stocks that have experienced big percentage drops, for example, or companies with a lot of selling by corporate insiders. Then the real work -- analysis -- begins. To be chosen for the portfolio, a stock must meet three criteria: It has to trade at a discount to the managers’ estimate of a company’s true value; it must have a pristine balance sheet; and it must have a history of generating free cash flow (cash profits left after the capital expenditures needed to maintain a business) and a solid return on capital. Says Sertl: “We like to stack the deck in our favor with companies that are cheaper and sounder than the ones in the index.” The managers fess up to their errors and try to correct them quickly. “Our worst mistake was to own banks in 2006 and 2007,” says Sertl. Citigroup’s announcement in late 2007 that it needed to raise capital was “a bell-ringing event,” he says. The fund sold its Citi holdings that day for roughly $300 a share. Citi now trades for $34. Lately, the Artisan managers have been buying tech stocks, including Apple and Microsoft. “We never dreamed we’d own these businesses” at such low price-earnings ratios, says Sertl. Advertisement Being in a Cool Place Some fund managers end up owning mid-cap stocks by default. Not Tom Pence, Michael Smith and Chris Warner, who run Wells Fargo Advantage Discovery (STDIX). They invest in companies with market capitalizations of $2.5 billion to $6 billion -- their definition of mid-cap -- because “it’s a cool place to be,” says Pence. He has been investing for 20 years and has been at Discovery since 2001, when the fund was part of the no-longer-extant Strong family. Aided by a squad of 19 analysts, research assistants, traders and others, Pence, Smith and Warner dig deep to find companies with “an edge” -- specifically, those they think will beat Wall Street’s earnings expectations over the next 12 to 18 months. On top of standard analysis, the managers talk with sources who won’t spout the company line. Take Alexion Pharmaceuticals, which the team first bought in 2008. Investigation of this maker of a drug for a rare blood disease included talking with doctors, learning the science behind the drug to get a sense of its effectiveness and tracking other clinical trials to learn what Alexion’s competitors were doing. The stock has quintupled since late 2008. Discovery trailed its peers during the late-1990s bull market because it had half as much in technology stocks as other mid-cap growth funds. We like that the managers stayed true to their strategy and didn’t get caught up in the tech mania. Post-bubble, the fund’s returns have been terrific. Since 2002, Discovery has lagged its category in just two years -- 2005 and 2009. Patient to the Extreme Relatively few have heard of Homestead Small-Company Stock Fund (HSCSX); with assets of $246 million, it’s the smallest fund in the Kip 25. Still, its obscurity is puzzling. The fund’s ten-year annualized return of 9.5% outpaces the average small-blend fund by an average of three percentage points per year. Managers Peter Morris, Stuart Teach and Mark Ashton have weathered all kinds of markets and investigated hundreds of companies -- and they have a lot of patience. Their 50-stock portfolio has a 2% turnover ratio, suggesting an average holding period of 50 years (the typical small-company fund has a 79% turnover rate). “Some stocks don’t do anything for two years, and then they move up 40% in two months,” says Morris. “So we sell slowly and buy slowly.” The trio spend a lot of time on the road in search of out-of-favor companies with a catalyst to turn their fortunes around. They prefer to invest in businesses they can understand. As a result, the fund is light on tech stocks (9% of the portfolio) and heavy on industrials (30%). Homestead has owned shares of aerospace firm Triumph Group since 2002. The managers liked the company’s acquisition strategy and saw growth potential in its industry. Since they bought the stock, its price has nearly quadrupled. 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