No matter where in the world you are putting your money, think quality. By Andrew Tanzer, Senior Associate Editor August 31, 2006 Investors are more bewildered than usual. One day they worry about whether the economy and corporate earnings will roll over. The next, they obsess over higher inflation and robust job numbers. Toss in uncertainty over rising interest rates and the proliferation of global flashpoints, and it's easy to see why everyone is just a bit on edge.In Sugar Land, Tex., Monty Campbell is ratcheting down his portfolio's risk. Small-company stocks and emerging-markets funds scare Campbell, a sales manager for Sun Microsystems. So he's adding retirement money to Fidelity Contrafund, which focuses on large companies with above-average earnings growth. "Large-caps look incredibly cheap," says Campbell, 41. He also likes the prospects for Japan and developed economies in Europe, so he is placing more chips in Fidelity Diversified International (which, like Contrafund, is closed to new investors). RELATED STORIES Preparing for Rocky Times Hedge Funds That Work Fund Watch column It's hard to fault Campbell's instincts. Market fundamentals shifted abruptly in May 2006, and we believe they're headed in his favor. For several years, many investors have chased more-speculative and volatile assets, such as small-company stocks, emerging-markets stocks and bonds, as well as gold and other commodities. But now, central banks around the world are signaling that the party's over. Leading the pack is the U.S. Federal Reserve, which has raised short-term interest rates 17 consecutive times. All of the sectors that performed heroically between 2002 and last May were hammered in the recent market correction. "Investors have gotten paid very well over the last couple of years to own lower-quality and higher-risk assets," says Scott Merritt, a strategist for JPMorgan Asset Management. "That play's over." How should fund investors confront this risk-averse environment? Simple: Focus on quality. It makes sense to shift some money from small-company funds to large-company funds, especially those rich in dividend-payers. Investing globally makes more sense than ever, but we prefer funds that focus on developed markets rather than emerging markets. Advertisement In the fixed-income arena, the gap between Treasury-bond yields and those of emerging-markets and domestic high-yield bonds seems awfully thin. So you're better off with short- and medium-term high-grade bond funds. And with yields on virtually risk-free money-market funds starting to hit 5%, cash is beginning to look mighty attractive. History lesson The economic and stock-market recoveries of the past few years shed light on today's shifting ground. Typically, small-company stocks perform well in the early stages of a rebound because, among other things, it takes less capital to move these stocks. Early in this cycle "a tidal wave of money poured in," says Eileen Rominger, chief investment officer and portfolio manager for the US Value Team of Goldman Sachs Asset Management. "And a rising tide lifts all ships." Rominger argues that investors failed to discriminate between mediocre and superior companies. In fact, Alan Skrainka, chief investment strategist at Edward Jones, notes a perverse investment relationship over the past few years: The higher the quality of a company, the poorer the performance of its stock; the lower the quality, the better the performance. As a result, the price-earnings ratio of small-company stocks relative to large-company issues is the greatest it's been in more than 20 years. "Small-company stocks look very, very expensive," says JPMorgan's Merritt. Large-company stocks are cheaply priced by several measures. Take the stock market's earnings yield (the inverse of the price-earnings ratio) compared with the yield of Treasury bonds. As of mid July, the earnings yield of Standard & Poor's 500-stock index stood at 7% (based on estimated profits over the next 12 months). That compares with the 5.1% yield of ten-year Treasury notes. An earnings yield well above bond yields implies stocks are a better value than bonds. Advertisement Meanwhile, the SP's P/E of 14 is about half the average P/E of the past ten years. So high-quality, large-company stocks are inexpensive. Says Mark Keller, chairman of investment strategy at A.G. Edwards, "That's why we see a great opportunity." What are "quality stocks"? They are shares of companies with solid balance sheets; strong, consistent growth in earnings and cash flow; and the ability to weather and even expand in a flagging economy. Many of these firms steadily raise dividends and do substantial business overseas. A good chunk are found in sectors such as consumer staples and health care, which do well in good and bad times. In a slower economy, investors would likely pay premium prices for these kinds of stocks. Strong positions Robert Millen, co-manager of Jensen Portfolio, says one way to discern quality is to study a company's return on equity. His fund targets firms that produced returns on equity above 15% for at least ten consecutive years, a record that suggests a dominant business. Millen extols such companies as Colgate-Palmolive and Procter & Gamble in household products, and Medtronic and Stryker in medical equipment. "There's more safety in large, quality growth stocks than there's been in ten years," he says. Bill Nygren, manager of Oakmark and Oakmark Select funds, says he has been buying shares of ten big "fallen growth stocks." Among them: Time Warner, Home Depot and Wal-Mart Stores. Nygren figures that their long-term earnings growth will soundly beat the earnings gains of the overall market. "The market is not charging a premium for quality," he says. "Therefore, we think quality is cheap." Advertisement Companies that regularly boost their dividends should perform well in this climate. Skrainka found that since 1972 dividend-paying stocks returned 10% annualized, compared with just 4% for stocks that don't pay dividends. Companies with a pattern of raising dividends returned about 11% a year. Brian McMahon, who runs Thornburg Investment Income Builder and favors rising-dividend stocks, sees opportunities in companies such as Bank of America, Chevron, General Electric and Pfizer. Much is made about the difference between growth stocks (those of companies with above-average earnings gains) and value stocks (those that are cheap in relation to key measures, such as sales and earnings). But today the distinction is blurred. Rominger of Goldman Sachs is a value manager, but one of her favorites is Cisco Systems, a fallen growth stock that she says is cheap. Edward Maraccini, co-manager of JohnsonFamily Large Cap Value, believes that stocks such as Citigroup, Johnson & Johnson and Symantec also represent good growth at value prices. The case for foreign Although foreign stocks took the brunt of the recent correction, you can still make a case for them. For one thing, the long-term trend for the dollar is almost certainly down because of the nation's yawning trade and budget deficits. Dan Fuss, the ace bond manager at Loomis Sayles, says he thinks that over the long term, expanding budget deficits will drive up inflation and cheapen U.S. currency. Buying foreign stocks is one way to take advantage of the falling dollar because money you invest in yen, euros and the like gets translated back into more greenbacks. But depreciating currency is only one reason you need foreign stocks. Many of the best companies in the world, with the best growth prospects, are based abroad. The Wharton School's Jeremy Siegel, author of The Future for Investors (and a Kiplinger's columnist), recommends that U.S. investors place 20% to 40% of their stock holdings in foreign names. Advertisement So what should fund investors do? We don't believe you should try to time the markets. Instead, base your plan primarily on your risk tolerance and time horizon -- and stick to such time-tested principles as diversification and rebalancing (see Preparing for Rocky Times). If you've been lazy and have let your winning funds ride, now is a good time to rebalance to your target allocations. But it also makes sense to tinker with your portfolio on the margins to reflect the current -- and expected -- environment. For instance, you might move some money from small-cap funds to ones that invest mostly in large companies, such as Marsico Growth and T. Rowe Price Equity-Income. Overseas, it would be wise to trim holdings in emerging markets and substitute funds that focus on developed markets, such as Dodge & Cox International Stock and Oakmark International. And consider adding a hedge-fund-like mutual fund to your mix (see Hedge Funds That Work). It may also be a good time to add to your holdings in short- to medium-term bond funds, such as Harbor Bond and Fidelity Floating Rate High Income. In a paradox of fixed-income investing, bond returns deteriorate as yields rise, but bonds become more attractive because they pay more (bond prices move inversely with yields). Bond funds should even out portfolio volatility and help you sleep at night. The risky stuff was fun while it lasted, but now it's back to basics. As Edward Jones's Skrainka puts it: "Quality rarely goes out of style for long." Additional reporting by Thomas M. Anderson and Katy Marquardt.