By Herbert Lash - Analysis
NEW YORK (Reuters) - For American Century money manager Phil Davidson, the tech boom’s peak a decade ago was worse than last year’s bloodbath in equity markets.
In the late 1990s, his expertise of knowing how to value a company based on fundamental stock analysis appeared worthless in an Internet-crazed market that priced companies with little to no revenue at astronomical prices.
Some funds doubled investments in a year while Davidson was down 15 percent during one 12-month period.
”I had a shareholder write to me, and he sent me his list of these companies I had never heard of, all these dot-coms, saying ‘It’s a new world, you’re toast,’ he recalled.
“In certain ways, that was worse than last year,” said Davidson, who is chief investment officer for value investing at Kansas City, Missouri-based American Century Investments.
Equity income funds like American Century focus on dividends and other income that companies pay out as interest, such as convertible debt. Popular years ago, the funds fell from grace during the tech boom when celebrating the joys of a 3 percent dividend paled against technology stocks’ gains of 200 percent -- or more.
OUTPERFORMING THE S&P 500
The U.S. stock market again went topsy-turvy after the housing bubble burst and asset values plunged in 2008, but this time Davidson’s skills paid off in spades. The American Century Equity Income Fund (TWEIX.O) he manages lost 20.5 percent in 2008 -- the best return that year of similar funds tracked by Lipper Inc, a unit of Thomson Reuters.
Its slide, while steep, was almost half the 38.5 percent drop for 2008 in the Standard & Poor's 500 Index .SPX, a widely followed benchmark for investing in large-cap U.S. stocks.
Davidson is one of a trio of equity income managers whose adroit selection of the stocks of solid businesses and eye on building income helped them outperform a number of star money managers who paid dearly for taking big risks during the bear market.
The performance of Davidson, Todd Ahlsten at Parnassus Investments and Wasatch Fund’s Ralph Shive demonstrates that active managers can handily beat indexes and avoid the blow-ups that pulled down the overall market and many other managers.
Davidson is a solid bottoms-up value investor while Ahlsten and Shive are steeped in value, but can lean toward growth companies. All three oversee funds with more than $1 billion in assets. Davidson’s is the largest, with $4.84 billion.
Their record is remarkable, analysts say, because the stocks they own come in large part from the same universe as the S&P 500, whose return they have more than doubled over the past decade.
To be sure, dividend growth has slowed and could damp performance. Yet the investment style could come back in favor -- mutual fund watcher Morningstar Inc (MORN.O) doesn’t even track equity income funds -- as investors seek to preserve capital and find that investing for the long term can pay off.
The allure of giant gains blinds many investors to what the steady building of income can do. Fidelity’s Select Automotive Portfolio (FSAVX.O), for example, jumped 81.4 percent in the second quarter, the best performance of any U.S. stock fund with a long-term record.
The Fidelity fund over the past decade had posted three years of double-digit returns, including a 44 percent jump in 2003, and only one year of big declines -- a 14 percent fall in 1999 -- before last year’s plunge of 61.2 percent.
But the second quarter’s gain wasn’t enough to make up lost ground. The fund is down almost 10 percent after 10 years.
Suddenly investors rediscovered their taste for plain vanilla -- equity income funds whose stocks pay dividends or interest.
“When the bear market struck and people lost a lot of money, there was more interest in preserving capital than there had been,” said Gregg Wolpher, a senior analyst at Morningstar.
“There has been a revival of interest in dividends also, for that reason,” he said.
American Century’s Davidson believes his focus on companies with strong competitive positions, strong balance sheets and strong cash flows will lead to better performance. That focus should also minimize exposure to companies with broken business models.
“We were able to identify those situations that were more risky,” Davidson said about Wall Street brokerages that were highly leveraged, such as Bear Stearns, or were dependent on unsustainable growth rates.
“If you think about it, if you avoid stocks that go down 99 percent in value, that is a source of alpha, isn’t it?” he said, using Wall Street parlance for above-average returns.
Parnassus Investments’ Ahlsten likes companies that sell a good product or service that is gaining in relevance, have stable or widening barriers to entry from potential rivals and are run by good management.
Ahlsten also likes to find undervalued companies that will grow revenues faster than the overall economy. He believes Microsoft Corp (MSFT.O) is now in that position.
“If you can invest in a company that’s got a nice dividend, and has an ability to raise that dividend over time, say above inflation, you probably can do well over the long haul by having a dividend with a growth component,” Ahlsten said.
Davidson and Ahlsten both take big positions -- top 10 holdings often make up 40 percent of their portfolios -- while the Wasatch Fund’s Shive manages more names and takes a top-down approach to develop a theme before picking stocks. He likes companies that will prosper from faster growth in emerging markets.
It will take time for Americans to get back on their feet after this decade’s consumption binge left many people deep in debt, Shive said. For the next few years, the U.S. economy will grow at a slower pace, in his opinion.
“So much of that spending was on these, call it phantom profits or phantom profit growth,” he said. “It will be sluggish and individuals may get some religion and come back to some conservative principles. That, I believe, will be a trend.”
The investor class of the Parnassus Equity Income Fund (PRBLX.O) has returned 5.48 percent annually over the 10 years ended June 30, while Wasatch-1st Source Income Equity Fund (FMIEX.O) returned 5.14 percent and American Century’s Equity Income Fund returned 4.92 percent. That compared with a negative 2.22 percent for the reinvested returns of the S&P 500 index over the same decade.
On an annual basis, that difference in rates of return appears small, yet over time, the difference is enormous.
A $10,000 investment at the end of June 1999 in one of those three funds would have grown to more than $16,000 -- a gain of over 60 percent -- by June 30, 2009.
Yet that same investment in an S&P 500 index fund would have declined more than 20 percent to about $7,987 over that same 10-year period.
It’s the classic story of the tortoise beating the hare.
“Here’s what I think. It goes back to the tortoise and the hare,” Shive said, referring to one of Aesop’s fables. “Most people think that the hare wins. I believe the tortoise wins in the long run. The slow steady (pace) wins, that’s what I believe.”
Editing by Jan Paschal