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Portfolio > Mutual Funds > Bond Funds

It's The Large Caps' Turn To Shine

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The mutual funds that get talked about at cocktail parties are usually the small, singular sensations that deliver the sexiest returns. But the bulk of the money still resides in the big-stock funds that have been lagging behind small-company offerings for the past six years.

Finally, though, the millions of investors with billions of dollars in large funds had something to crow about at their holiday get-togethers. Large-cap value funds have gained ground since late spring and are now only one percentage point behind small-cap value funds for the year: 17%, vs. 16% total return (through Dec. 8). Other large-company funds are also catching up with their small-cap counterparts. “This is not a head fake,” says Mark Keller, chief investment officer for Gallatin Asset Management, the fund management arm of A.G. Edwards Inc (AGE).

We’ve heard about large-cap comebacks before. In fact, this time last year, Keller’s line was a common refrain. But now that the economy has slowed markedly, there’s a better chance that larger companies might finally maintain their edge. “Higher-quality, higher-capitalization companies are the safest place to be if the U.S. economy is heading for a soft landing,” says Bob Doll, vice-chairman and chief investment officer for equities at money manager BlackRock Inc. Doll, who is in the soft-landing camp, is further tilting his portfolio to large-cap growth stocks.

With the Dow Jones industrial average and the Standard&Poor’s 500-stock index on high ground, you may not think big stocks are cheap, but they are. That’s because this is the first bull market in 45 years where the price-earnings ratio of the S&P 500 has contracted, says John Carey, portfolio manager at the $7.7 billion Pioneer Fund as well as the $1.1 Pioneer Equity Income Fund. In 2002, the typical S&P 500 stock traded at 17 times the next year’s earnings. Today the forward p-e is 15. That means blue-chip stocks are moderately priced and have room to run.

You can tell large-company stocks have some momentum by looking at the folks who are lining up to buy them. Just peek under the hood of “all-cap” mutual funds, the kind that are free to buy any size stock the manager desires, and you’ll find that the focus is on bigger companies. At Hodges Fund (HDPMX), 66% of the $570 million portfolio is invested in large-cap stocks such as Apple Computer (AAPL), ConocoPhillips (COP), Cisco (CSCO), Wal-Mart (WMT), and Caterpillar (CAT). That’s up from about 45% a year ago.

Co-manager Don Hodges buys a company when it sports a strong balance sheet, good revenue growth, and a stable stock price. In the past nine months some of the blue chips that passed this hurdle are General Electric (GE) and Coca-Cola (KO). “These are stocks I’ve never owned before,” Hodges says. “They haven’t done much for six years, but they quit going down.” He’s also added Halliburton Co. (HAL) to the fund because “as long as oil stays above $40 per barrel, you are going to have a lot of drilling activity.”

Mark Coffelt, manager of the $77 million Texas Capital Value&Growth Fund (TCVGX), also thinks big is better. In the past five months he has shifted half of his go-anywhere fund from small-cap and mid-cap names into big global equities, including the ADRs of Sanofi-Aventis (SNY), Diageo (DEO), and ABN-AMRO (ABN). “These companies have a big global footprint,” Coffelt says.

ABN-AMRO, for example, is gaining market share in India and China, two of the hottest emerging markets. Yet the company’s stock is trading at a mere 12 times 2007 earnings. “That’s cheap for a bank,” Coffelt says. The Manning&Napier Equity fund (EXEYX ), which also has an all-cap mandate, is finding the best opportunities in bigger stocks, too. The fund’s managers aren’t concerned about where a company is domiciled. They point to the fact that 26% of the companies in the S&P 500 derive most of their revenues from outside the U.S. Take Coke: It gets 71% of net operating revenue outside North America, says George H. Stamey, a Manning&Napier managing director. “The distinction between U.S. and non-U.S. is not meaningful,” Stamey says.

Even the big-cap funds are getting more mega in scope. The Chase Growth Fund always focused on larger companies, but the market cap of stocks in its portfolio jumped from $20 billion to $95 billion in the past six months. Lead manager David Scott, who uses quantitative screens to initially identify good prospects, recently upped the fund’s exposure to large pharmaceutical companies such as Johnson&Johnson (JNJ ) because of better earnings prospects.

Overall, fund investors will be pleased when they look over their 2006 yearend account statements. Although U.S. equity funds as a whole failed to outpace the 15% total return of the S&P 500 in 2006, they came close, with 13%. The best performance came from overseas funds, bolstered by strong markets and a weak dollar that made non-dollar holdings more valuable for U.S. investors. Diversified international funds earned 22%, while Latin America funds soared 40%, making Latin American equities the best-performing fund category for the second year. Pacific/Asia funds (excluding Japan) also jumped 34%. The only losses among any category came from Japan funds, which dropped 4%.

Thanks to the potent performance of foreign funds as well as strong inflows, mutual fund assets hit an important milestone in 2006: They passed the $10 trillion mark for the first time, according to the Investment Company Institute, the fund industry’s trade group.

Precious metals (read: gold) funds rose 33%, extending a rally that began back in 2001 when gold traded at just $260 per ounce. After peaking at $730 per ounce in May, gold finished 2006 trading around $628 per ounce. Investors continue to pour money into the iShares Comex Gold Trust ETF, and that’s expected to drive gold prices higher in 2007. “The ETF holds almost 600 tons of gold,” notes John Hathaway, manager of the Tocqueville Gold fund. “That makes it larger than a lot of the central banks.” Most precious metals funds, however, hold gold-mining stocks instead of gold bars.

Charl Malan, co-manager of Van Eck International Investors Gold Fund, says gold also will continue to glitter in 2007 if the U.S. dollar continues to lose ground, as many analysts expect. “There’s an inverse correlation between gold and the U.S. dollar,” Malan says. Another reason gold prices will continue to climb is because the Chinese, Russian, Indian, and German central banks are expected to shift more of their reserves from U.S. dollars into gold, he notes. “In next 12 months gold can do very well,” Malan says. His prediction: Gold will close 2007 at $780 per ounce.

The outlook for bond funds, however, is more boring than bright. Fund managers expect interest rates as well as inflation to remain low, and the flat yield curve isn’t expected to budge very much.

THAT’S WHY THE CO-MANAGER of two Loomis Sayles funds, Kathleen C. Gaffney, has shifted 40% of her Bond and Multisector Bond funds overseas. She gushes about the 8.5% yields for investment-grade Mexican government debt. “If you were going to look for 8.5% yields in the U.S., you’d be looking in the junk-bond market,” Gaffney says. And while there’s a risk that a falling peso could make Mexican debt less sweet, she doesn’t foresee the peso weakening in 2007.

Municipal bond funds provide good opportunity, too. That’s because short and intermediate muni bonds are sporting attractive yields. Munis also have lower default rates than corporate bonds. That said, the supply of new bonds is slim. Most municipalities are in good financial shape thanks to tax revenues, so new issuance was down about 10% in 2006. It’s not expected to rise in 2007, says Tom Spalding, a senior portfolio manager at Nuveen Investments (JNC ). But some states, such as Texas and Nevada, are still coming to market to finance lots of high-quality infrastructure projects, Spalding notes.

Corporate bond investors may face a rocky year. Although recession is always a risk, few corporate bond managers think one is imminent. The real wrench in the corporate market, they say, is the private equity boom. To orchestrate leveraged buyouts, private equity companies force their takeover targets to issue debt. That can result in a credit downgrade, which drives down the market value of the bonds. “What is an opportunity on the equity side is a risk on the fixed-income side,” says Mark S. Jordahl, chief investment officer at First American Funds.

Even worse, the new debt that’s issued often puts existing corporate bondholders in a subordinate position, which means they’re more likely to lose out if the company goes bankrupt. What’s a corporate bond manager to do? “It’s best to hide out in a larger company,” says Carl W. Pappo, lead manager of Columbia Income fund. So far, no megacap companies have been leveraged up. Corporate bond funds, and the people who invest in them, might want to take a page from the equity market and think big.


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