Mutual funds finish 2005 pretty much as the experts predicted.
Perhaps "boring" is too colloquial a way to describe
the collective performance of mutual funds in 2005. But it may be
accurate to say the year was short on surprises.
In fact, the most shocking aspect of the stock market and mutual funds in 2005 was that for once it performed as many expected.
Prognosticators have been saying for several years now that investors need to accept 5% to 7% returns as the norm. In 2005, that's about what they got. "In terms of the market overall and the way the fund market did, the domestic side was pretty much as expected," says Kunal Kapoor, Morningstar's director of fund analysis.
Market watchers have been saying "to start expecting 7% to 10% returns from some of their domestic investments going forward," Kapoor says. "You saw a lot of funds fall into that range in 2005."
Perhaps the most surprising shift in the fund market last year was the margin by which international funds-fueled partly by a booming Japanese market-outperformed domestic funds, notes Kapoor. There were other shifts in momentum, although not entirely unexpected. For the first time in five years, growth funds outperformed value funds in the large- and mid-cap categories. Large growth funds had average gains of 6.46% in 2005, compared with 5.88% for value, according to Morningstar. Among mid-cap funds, growth was up 9.70% and value up 8.41%.
Given the strong finish by growth in 2005 and years of comatose returns, some savants see the year as a possible foreshadowing of big things to come from both the growth and large-cap sectors.
Energy continued to prop up gains across a multitude of funds, in both growth and value investing funds, although a loss of steam toward the end of the year has some investors fearing drops in oil price and demand in 2006. Shareholders of natural resource funds saw an average gain of 38.11% last year.
Real estate provided solid performance yet again-real estate funds, dominated by REITs, were up 11.59%-leaving investors to wonder: Is there really a real estate bubble and, if there is, will it ever pop?
In many ways, 2005 was more of the same, says Jerry Jordan Jr., manager of the Jordan Opportunity Fund, which launched slightly less than a year ago as a successor to a closed limited partnership that was more than ten years old. The fund uses a multi-cap growth strategy that leans toward mid- and large-caps. "Generally speaking, 2005 was very much a year of continuation of themes from 2004," Jordan says, citing the performance of energy and disappointment in technology as two examples. "It was this continuation of fund flows into and out of the same areas."
The fund, however, is banking on some changes this year. Oil prices, for example, are viewed as being on a downward cycle. For Jordan, this has translated into a transition out of the exploration and production segments of the industry, and into the service and drilling areas. The reason: Oil companies need to expand to increase growth. "The only way they can legitimize their stock price is to try to grow capacity and expand reserves," Jordan says. "They are going to spend like crazy globally ... That is going to help the Haliburtons, who can grow their profit through both unit and price."
Based on historical data, energy growth cycles typically don't end until the oil and drilling service industry outperforms the exploration and production industry by anywhere from six months to three years, he adds. "We are a whopping month-and-a-half into that outperformance" as of the end of the year, he says.
Jordan is making plays in technology, as are other
growth managers interviewed, but with a consumer slant. He feels
consumers are going to be fueling growth in the sector by gobbling up
products such as iPods, smart phones and flat-panel television sets. As
an owner of Apple stock, he's also banking on the company's iPod line
to stir up sales in its PC division. Other companies the fund owns
include Motorola and AU Optronics, the third-largest manufacturer of
LCD flat-panel television sets. "Technology for the next five years is
more about the consumer and what the global consumer wants, rather than
what the corporate consumer wants," he says.
Although health care was a poor performer for the fund in 2005, he sees health-care facilities as an investment opportunity going forward. Jordan notes that at a time when baby boomers are starting to retire, he feels the government will be forced to divert funds to hospital reimbursements. "The U.S. government can't afford to allow the hospitals to go out of business," he says. But if left on their own, that just might be what happens. Private hospitals comprise about 85% of the hospitals in the nation, he says, and almost 25% of all private hospitals are unprofitable. He also notes that the number of hospital beds in the United States is down 50% over the last 20 years.
In a stock pickers market, there was no loss of value managers enjoying returns on yesterday's no-name and maverick stocks. The Al Frank Value Fund, for one, was up 11% in 2005 by relying on the same strategy it's used since its inception in 1998. According to manager John Buckingham, that would be a strategy that focuses on casting a large net on a multitude of cheap, relatively anonymous and dividend-paying stocks in a variety of sectors.
"In a sense, I think the market kind of took a breather last year and valuations became very attractive," Buckingham says. "The average stock was actually down, so it re-emphasizes the point of it being a stock pickers market."
Like many funds that found success last year, Al Frank reaped heavy rewards by applying its investing strategies in the energy sector. Among the companies behind Al Frank's positive return last year were refiners Valero Energy, Holly and Giant Industries. Far from viewing last year's energy bonanza as a fluke of oil price cycles, Buckingham feels the sector will continue to shine bright in 2006-particularly from a value perspective. "The interesting thing in energy is, given the tremendous earnings gains, the stocks are not expensive," he says. "In fact, we have several energy companies we're still buying today."
Buckingham, for example, is plucking cheap companies out of the oil tanker industry, where he believes the fear of diminishing oil demand and overbuilding of tanker fleets are unrealistic. "With strong demand out of Asia, particularly China, I just don't see the price of oil collapsing," he says. Plus, he says, companies are phasing out older tankers. Playing on that theme, Buckingham is buying bargain-priced companies such as Tsakos Energy Navigation, which he finds attractive with earnings per share of $5.79 and a dividend yield of 5%.
Energy isn't the only place Buckingham is looking for bargains. He estimates that about 60% of the companies on his buy list are in energy, pharmaceuticals and technology. In all areas, the formula is the same: Look for cheap companies that everyone else is ignoring, but with solid fundamentals, a good dividend yield and a decent chance for growth. That was how Buckingham zeroed in on one of the fund's biggest winners last year, ValueClick, an Internet advertising company.
The fund bought one of the company's acquisitions, BeFree, when it was trading in the $2 to $3 range, at a time when it had no debt and cash reserves that just about matched its share price. "We were paying zero for the business," he says. As a result of the acquisition, the fund saw its share price go from $2 to $19.
For Buckingham, it was the classic value play: Find a company that's cheap and hold on until the greater market wakes up and moves the price up. "I'm thrilled that's how it works," he says. "I hope they continue to listen to Jim Cramer and jump into and out of the next hot stock. If everybody invested the way we did, there wouldn't be any opportunities."
If anyone has any doubts about how important the energy sector was to fund performance in 2005, just ask some of the better managers who didn't make any energy plays. The ABN Amro Growth Fund finished the year up only 1%, which amounted to a loss for investors when expenses and taxes are deducted. Richard Drake, a co-manager of the fund, readily admits that the fund's lack of energy holdings stung in 2005. But he defends the decision, saying the fund was just sticking to its growth investment principals. "We didn't chase that sector, given our belief that long-term these are not growth companies," he says. "We are sticking to that. We still think supply is greater than demand and oil prices will continue to fall."
The energy play had a ripple effect on other parts of the fund's portfolio-namely consumer discretionary, Drake says. ABN Amro was betting on retailers like Dollar General, Kohl's and Home Depot to churn out decent earnings in 2005, but performance was lower than expected, as high energy prices diverted disposable income away from consumer spending, he says.
Dollar General, for example, was added to the fund in February and has been down about 15% since that time, Drake says. "With the rising oil prices and the increasing interest rates, the consumer was struggling a little more than we thought he would," he says. "So these stocks tended to disappoint."
Dollar General, for example, depends on low-income families as the core of its customer base. That demographic group, however, was hit hard by the surge in gas and heating oil prices.
Although the fund continues to stay in the consumer discretionary sector, partly because of attractive valuations, it doesn't expect standout performance. "The consumer is still going through, or looking forward to, a shaky year," Drake says.
Health care was the fund's best-performing sector in 2005-a year in which the fund dumped many of its old growth health-care companies, including Pfizer. The fund bought companies such as pharmacy benefits manager Express Scripts, Amgen and Gilead, which holds the patents on a promising AIDS treatment. "We just felt we couldn't find value and growth in the large-cap pharmaceutical space," Drake says.
Some funds made gains in 2005 without a heavy reliance on oil. The Thornburg Core Growth Fund, a multi cap, finished with a 22% return-following up on a 15% return in 2004-with an eclectic mix of holdings that included Google, Apple, Underarmor, Gilead and Ormat Technologies. "Our process is very flexible, so it allows us to look at a lot of different companies," says manager Alex Motola. The fund also is busy evaluating overseas companies. Overseas research has led the fund to buy companies such as Fuji Catering, a China-based company that provides corporate cafeteria services, and CJ Home Shopping, an online shopping service that transitioned last year to selling life insurance, mutual funds and other financial products. The two companies were among the top ten performers for the fund in 2005.
On the domestic front, Apple and Google were the fund's top performers. Motola says he views Google, whose share price scared away many investors in 2005, as another strong play in 2006.
Many analysts, he says, underestimate the company's earning power and the potential of Internet advertising. Apple has been a popular fund holding mainly due to sales of its popular iPod portable digital media player, but Thornburg bought it largely because of the spillover effect on its PC sales. The company saw 30% growth in its PC sales in the third quarter of 2005, compared with 3% growth a year earlier, Motola notes.