Posts Tagged ‘equity’

Over the last month or so, the Mutual Fund Site has had a lot to say about the financial services industry, whether we were bragging about our top small cap fund pick for 2010 (for those who have not read the post, the fund in question is the Ivy Small Cap Value fund), talking about the importance of dividend funds in building a profitable portfolio, or tooting our own horn about how we did a great job applauding Dryden’s approach with financials.

To tie these areas together, let’s consider that our 34% of our small cap fund pick for 2010 consists of regional financial services companies, many of which contribute heavily to the fund’s average dividend yield of 2.8%; many dividend funds will rely heavily on financial services companies whose stocks have become devalued to the point that the dividend yield alone makes them attractive assets to own; and Dryden’s Financial Services fund owns a substantial amount of high-dividend paying Canadian bank stocks.

The point above may not be obvious.

What we have here is something of a reverse-engineering problem. Consider that Canadian banks have been touted as the most solid in the world and they pay healthy dividends. Consider that dividend paying stocks are instrumental in ensuring healthy returns, whether inside or outside of a mutual fund investment. And consider, lastly, that Canadian banks are heavily involved in the retail banking segment of their  country, just like the regional banks held in the Ivy Small Cap Value fund are. In fact, those financial services firms in the Ivy fund are doing exactly what Canadian banks are doing – lending responsibly to Joe Public so he can go and buy himself a home, car, boat, whatever and get the economy turned around.

The point above might make a little more sense when you consider that regional banks are an important party in the economic recovery efforts that are being promoted by US officials like Barack Obama, Timothy Geithner, and a host of others who have taken a hard-nose approach with the “big” banks who are often blamed for bringing an end of the last economic boom and practically killing the global economy. In fact, a lot of these officials are trying to convince these big banks into behaving the way these smaller banks are behaving.

So what might that mean for the regional banks?

Well, it could be acquisition for one thing. Canadian banks, who conduct business in a similar manner as these regional banks, have been acquiring some of these regional banks for some time (and now with the US dollar as low as it has been, the Canadian Banks’ purchase power has increased) such as TD Bank purchasing Commerce Bancorp, an award-winning regional bank based out of Cherry Hill, NJ, in 2007.

More likely, however, is that these smaller banks, which pay bigger dividends (based on dividend yield) than their big bank counterparts like Citi and Wells Fargo, will have the support and encouragement of government. They are already operating the way the government would like to see them operate; they already understand responsible lending practices, they are already profitable and fiscally strong (one in particular has increased its equity value by more than 50% over the past two years alone!). The government should love these players.

And, most importantly, when the economy turns around and people start waiting in line for mortgage approvals, credit card approvals and other types of credit or credit-related services, these regional banks will see their income increase exponentially. Why? Well, they are already profitable and the economy is just slowly finding its feet.

It’s a perfect situation for mutual funds like the Ivy Small Cap Value fund (we went so far as to call buying this small cap fund a no-brainer). And for the strong-willed investor with the right risk tolerance, time horizon and investment objectives, it becomes and easy lesson in investment strategy, one that requires very little advanced research. It’s almost the best-kept secret in the mutual fund space (except we exposed it, and we are always proud to help out). And if you are not sure how to get your hands on these stocks, just head on over to Ivy and let them do the number crunching and trading for you.

Despite all of the press out there that suggests that high yield investments are not where investors want to invest, there is a small group of professionals (including those of us at the Mutual Fund Site) that believe that these mutual funds are indeed still favorably priced. But not everyone is well suited for high yield investments. Those people will typically chasing growth rather than income. For those investors, dividend funds might be where to invest.

The interesting thing with dividend funds is that they provide income, much like a bond fund or high yield investment would pay income (the difference is dividend income versus interest income). With dividend mutual funds, investors can expect yields around the 5% range, some higher and some lower depending on the fund you are considering.

But the kicker with dividend funds is that investors should be more focused on the growth prospects of the securities held within that mutual fund. The Vanguard High Dividend Yield Investment as an example pays roughly 5% but is also invested in large-cap value stocks. While that yield is certainly nice, the underlying holdings have an average P/E ratio of 15.7. This suggests that the future gains will come more from the growth of those underlying securities than the dividends themselves.

While we have not completed our full analysis of the Vanguard High Dividend Yield investment, this fund illustrates the difference between high yield funds and dividend funds. That key difference? Where the future returns are most likely to come from.

As for risk, the investor will need to determine the proper level of risk he or she is willing to assume. This will ultimately determine the type of fund (growth versus value, large cap versus mid- or small-cap, etc.) and can help create something of a short-list for the investor. In essence, however, dividend funds are similar to high yield bond funds. But the bottom line is that bonds will pay income and dividend funds pay dividends as a bonus; the key is in the long-term growth prospects.

So when it comes down to it, dividend funds are not the new high yield investments. They are merely different beasts co-existing for different investors with different needs.

One of the most e-mailed op-ed columns in the NY Times was published on February 1, 2010… a few days after the Mutual Fund Site released its write-up on the Dryden Financial Services Fund, a mutual fund that has a strong reputation for its investment management prowess and stunned investors with staggering returns in 2009.

Why is this important and why should you care?

Let’s take a look at the column in question. In it, Nobe Prize winner, Paul Krugman describes how the Canadian banking system, which was coincidentally modeled after the first American secretary of Treasury, Alexander Hamilton, is remarkably the soundest system in the world (versus the US system at 40th). More specifically, Krugman points out that the banking reform currently pushing its way through the system will substantially Canadian-ize the domestic banking system.

In addition to the obvious statements by Paul Volcker (who advocated in early 2009 that his vision for the banking system “looks more like the Canadian system…”) and those by President Obama (let’s not get started), it seems that the US banking system may some day soon resemble Canadian system.

This is key, and also brings us to the importance of the publication dates for these two pieces. Less than a week prior to Krugman’s op-ed column, the Mutual Fund Site gave “top marks” to the Dryden Financial Services fund. And guess what makes up their core holdings. That’s right, Canadian banking stocks.

More than 11% of their meager $162 million under management is invested in Canadian banks. In fact, three of their top 25 holdings are Canadian banks, all of which have among the lowest P/E ratios in the fund’s top 25. What makes this interesting is that the Dryden Financial Services mutual fund has outperformed, by a long-shot, the S&P 500 as well as its peers in the last year, proving that their investment management strategy and, most importantly, their attention to detail has really paid off. Some of this might have to do with the Canadian banks’ ability to maintain dividends and, in many cases, increase those dividends. If bought at the right time, some of those yields would have exceeded 8%. Still, even with an 8% dividend yield, another 60% in return had to come from somewhere…

Does Krugman’s popular piece provide support for investing in a mutual fund like Dryden’s? Not necessarily, although it certainly provides some credibility to why we, at the Mutual Fund Site, gave Top Marks to the Dryden mutual fund. More importantly, given the amount of attention the New York Times piece has attracted, it seems that, if governments start modeling their financial services firms after the Canadian system, and it seems they will, Dryden could see some good, long-term growth provided their investment management team and strategy remains intact.

It seems that any time positive news comes out about the state of the economy, growth funds and small-cap funds in particular get a nifty little boost in value. It stands to reason, of course, that as the markets react to such positive news, so too should mutual funds. But what mutual funds stand to benefit most? This is a question that a lot of investors, like those who want to know where to invest $20,000 or so, have.

Homebuilders
One area that gets a nice boost (or gets tanked) every month relates to the housing market. Since this sector was blamed for many of the problems relating to the latest recession (if it was not the bank’s imprudent lending practices, then it was housing for its hyper-inflated values and the subsequent flooding of inventory), it makes sense that housing stocks will be particularly, positively influenced by positive news for the sector.

For example, on February 2nd, positive news about housing  had the impact of bumping one particular housing company’s stock price by as much as 10% in the session. Other related shares got a nice boost of no less than 5%. A nice little return, wouldn’t you agree?

Risks
The risks with such big moves is twofold. First, this has the effect of increasing volatility for these types of shares, making them more difficult to trade individually. An investor needs to exercise displine to realize the gains he or she wants and not stay in too long; otherwise, they will record an immediate loss.

What Mutual Funds Own Such Stocks?
The best way to find the funds that invest in these types of sensitive shares is to visit Yahoo! Finance and search under the security’s Major Holder’s section. This gives a fairly accurate snapshot of what companies are owned by what mutual funds.

In the case of housing stocks, Vanguard has taken a fairly large interest in several of the housing stocks in its Small-Cap and Mid-Cap funds. It makes sense. Housing continues to be out of favor and these types of out-of-favor stocks are often what turn regular investors into astute investors.

As well, housing is one of those areas that will need to improve before the rest of the economy improves. That means that it is quite likely that the sector could receive a boost through some type of government incentive that sees people buying more and more houses and in the interest of keeping people employed (or hiring more people back), some of these incentives are likely to incent or at least benefit the homebuilders. Vanguard has taken an interesting approach (among others).

Does this suggest that mid- and small-cap mutual funds is where to invest $20,000 (getting back to that question)? Probably not for the whole $20,000. But 20-25% of an aggressive portfolio that can benefit from a mid- to long-term investment period, sure… no, absolutely. In fact, they can be expected to easily outperform growth funds held for that same period.

Choosing the right growth funds for 2010 is not an easy task. Normally, this might not pose such a problem because growth funds tend to perform over the long-term, unlike some other mutual funds which perform better at certain times in the year or economic cycle. But after a fairly remarkable 2009 to follow up the turbulent credit-crisis-inspired 2008 and 2007 years, 2010 has provided something of a wake-up call to most investors.

2010 has provided something of a wake-up call.

In fact, most growth funds opened the year with an average return of -2.55% (that’s right, a negative!). And most of the best-ranked funds have returned even less.

What this tells a lot of investors is that growth funds not only have to be held for roughly 5 years in order to realize the type of returns one has come to expect of such funds. But that’s not all. In fact, the stuttering start to the year has led even the highest paid and most respected portfolio managers to wonder whether there is more bad news to come. In an interview with Morningstar, Rudoph-Riad Younes of Artio International Equity claims that by bailing out the banks and not letting them fail, government have simply delayed the inevitable. In that same piece, Oliver Kratz of DWS Global Thematic commented that his fund has taken a less aggressive position globally, investing as little as 10% in one of the hottest economies of the world, China.

One of the only growth funds we could find that outperformed the average, the Monetta Young Investors Fund (MYIFX) which has been managed by Robert S Bacarella since the fund’s inception in 2006, holds a five-star rating from Morningstar. In digging deeper into its portfolio, it seems that Mr. Bacarella has taken to domestic securities as well. Where has he invested? Consumer Goods and Consumer Services with Apple Inc. Wal-Mart, Proctor & Gamble and McDonald’s ranking among their Top 25 holdings (they actually only hold 25 securities). Many of these are the same securities that Younes and Kratz cite in the Morningstar article, hold in their respective funds or they belong to sectors where these two managers invest heavily.

What does this tell investors looking at growth funds this year?

It could be that funds investing in domestic, large-cap securities are part of a growing crowd of institutional investors who believe that there are plenty of risks that are expected to materialize outside of the domestic, North American markets. Does that put global growth funds in the penalty box? It certainly seems that is the message for 2010.

So where should investors put their money? What growth funds are expected to perform in 2010?

Unfortunately, that will be a topic for another day, but the underlying message here is this: even growth funds have a tough time deciding where to invest. So if you have the courage to pull the trigger on investing, remember a couple of things:

• Invest regularly if you can — ten monthly contributions of $1,000 each will average out your $10,000 investment.
• Stay the course — stay invested for a period of 3-5 years (preferably 5 years as the performance on nearly all of these growth funds really starts to shine after 5 years).
• Choose funds that you believe in. Right now, you might believe in a high concentration of domestic securities (the big mutual fund managers seem to as well) but don’t pick a fund that must, by virtue of its Investment Objective/Statement stay invested this way.

This is certainly one area that needs further exploration and we will get into what we believe will be characteristics of the top growth funds in 2010 within the next 30 days.

As far as growth mutual funds are concerned, Dryden offers one of the top performing mutual funds out there in its financial services specialty fund; the Dryden Finances Services Fund. With nearly $13 billion under management, the expectations for this fund are quite high. And with a new manager handling the investments since January 2009 (Mark T. Lynch, who has been with the fund in different capacities since the fund’s inception in 2001) there is no reason to believe Dryden will not continue to deliver.

In reviewing this fund’s top holdings, it seems evident that Dryden’s investment management focus is on only the largest-cap banks, both domestically and, more interestingly, overseas. Well, we should make a quick clarification… overseas should really read “foreign” since nearly 12% of its top holdings are in fact Canadian banks. Those 3 banks stand quite high in Dryden’s Top Holdings – numbers 3, 8 and 9.

While Canadian banking is a lot less lucrative than domestic financial institutions, there has been a lot of attention on Canadian banks as they have been leaders in global risk management and in banking system reform. As well, Canadian banks (at least those held by Dryden) have been fortunate to enjoy continued profitability, allowing them to maintain their dividends, something that many others have been unable to uphold.

The rest of the portfolio is actually a lessing in investment management. With just 40 holdings, this fund is tightly managed as far as growth mutual funds go. Dryden has carefully chosen their holdings so as to provide a broad geographical exposure so as to not over-expose their fund to any single banking environment. Its top 3 holdings are represented almost equally by Chinese, US and Canadian banking systems.

The benefits to the Chinese system is that government is heavily involved and with the inflow of money into China, its banks will rank among the largest in the world, providing ample opportunity for investors. On the Canadian front, their banking system is among the most stable in the world. Also highly regulated, their system will stand to benefit from the country’s heavy dependence on resources. While Canadian financial services may no benefit directly from the growing demand for the country’s resources, it will benefit from the flow-off through its large retail presence.

And of course, the damaged domestic banking system has a lot to look forward to. With closer government scrutiny, the domestic system is believed to become one of the safest and largest in the world, but with greater government interest there are also risks to this model. This explains why Dryden has heavily invested in banks that stand to really benefit from different markets, including some of the riskier markets like the domestic and some EU systems.

Areas of concern with the fund would the current manager’s short tenure. While Mark T Lynch clearly has the experience needed to fill the shoes of previous managers of this fund, how he will realistically ensure future performance remains unknown.

As well, the fund has shifted its asset allocation over the past three years, with it taking a Large-Cap blended approach in 2007, then shifting to a Mid-cap blended approach in 2008 and ending 2009 as a Large-cap value fund. While of this can be attributed to recovering stock prices, one must still question whether this has been a management strategy and what other types of investment management changes remain on the horizon.

However, one thing remains clear: the Dryden Financial Services Fund is arguably one of the strongest performing and managed mutual funds in the industry. Their investment management skill speakds for itself and where growth mutual funds are concerned, this is one fund that stands to benefit at least during the first part of this period of economic recovery.

Why invest 10,000 dollars? Why not spend it? Why not update the house, take the family on a nice vacation, pay off some debt? These are all great investment management question, even though few of them deal with investments, much less mutual funds or bond funds in particular. In reality, the best way to invest 10,000 dollars will depend largely on your risk appetite.

Low Rates?

Then you are looking at high yield investments, bond funds. High yield bond funds, specifically. Why? Because over the next decade, your investment will perform fairly well. Right now, spreads between corporate bonds and government bonds is rather wide. That means that corporations are paying a lot more to borrow on the market compared to governments. Now, it will always be this way (or it should), but the disparity between the two became unnaturally wide during the credit crisis. This makes sense because lenders wanted to be compensated extremely well for the perceived risks involved with lending to companies.

Of course, those perceived risks slowly began to disappear as the investment world realized that, lo and behold, not all companies were going to fall off the face of the earth. Additionally, inflation is beginning to creep into the system. What this means for bond funds is that the money corporations pay will start to come down (the risks just aren’t there like they used to be) and governments will start to pay more (inflation pressures push for higher yields and this should coincide with an improving economy). Therefore the spreads will narrow.

As corporate bond rates drop, those bond prices will rise. The holders of those bonds will happily take those gains while simultaneously enjoying the income generated from those previously negotiated higher rates.

High Risk?

Higher risk appetites demand higher risk investments. This does not mean getting crazy with highly speculative investments. For the hands-off, sophisticated investors this probably means large- or giant-cap equity funds. Preferably dividend-paying stock will be held within these portfolios, further reducing some of the risks associated with equity funds. Why equities?

Simple. A strong fund with a history of performance, a history of high risk-adjusted rates of return.

Can this be achieved? Yes, and it is probably easier achieved with equity funds than it is with high yield bond funds. After all, even companies that are virtually guaranteed to be around tomorrow and for years to follow are still considered under-valued thanks to the fears of those investing in the markets. Why? Because there are so many mid and small-cap investments that remain poised for failure.

But consider the big oil companies. Industrial materials companies that are directly benefiting from the government stimulus? Financial services companies who have all but promised to repay government loans as of well, yesterday? Are these the types of companies that will further cripple the economy? For the time being, no. (We will have to wait a good five to seven years to know for sure).

So, Where Can I invest 10,000 And Walk Away With 20,000?

We think that if you have three to five years, either high yield bond funds or large-/giant-cap equity funds are the place to be (preferably value-based equity funds) with minimal risk. Will you double your investment in this short period of time? Well, it has been proven by many of these funds that it is not only possible and not only likely, but a matter of history. Just make sure that a 100% is sufficient for your needs. See investment management is not only about knowing when to get in, but when to get out. Whether you want 100% returns or 50%, stick to your objective and get out, regardless of what the markets promise in the months to come. This is particularly important for that first investment, when you are looking at how to invest 10,000 dollars the smartest, most efficient way possible.

Growth funds are something of a sub-asset class when it comes to your overall asset allocation model. In most cases, growth funds are part of the equity holdings, but depending on your income class profile there could be a growth component to the income class as well. In the case of the income glass, growth will normally come from investing in higher-risk bonds or discounted bonds. These bonds will experience growth in periods of declining interest rates or at maturity when the bonds mature at face value.

In most instances, growth will come from capital appreciation in the value of an equity security, most often a stock. And this is typically how equity class growth funds operate – they will hunt for equities that have demonstrated long-term growth trends or potential. In many cases, growth funds will target stocks in high growth fields such as technology, bio-technology and developing technologies. However, since such industries are often speculative, so too can the investments be speculative.

As such, growth funds can be further categorized into sub-categories such as Large Cap Growth Funds which will invest primarily in securities that have a large market capitalization. These types of growth funds will have a slightly different approach and often a less aggressive investment objective. In most cases, the securities owned by the fund will be larger companies (such as Apple in the case of technology or General Electric in the case of emerging technologies) with strong balance sheets and heavy investments into longer-term, emerging technologies.

In some cases, growth funds will be “laser-focused” on an industry or sector. In the example above, this could mean the technology industry or, in less generalized terms, say the water-purification technology industry. This means that the fund might invest in a blend of large or small cap equities.

And in some cases still, some fund managers will target growth regions of the world. In the latest market bubble, many funds jumped on the “BRIC” nations which showed tremendous growth potential. These nations were Brazil, Russia, India and China. Even after the economic slowdown, many funds remain invested in these regions because of their perceived growth potential.

In other cases, growth funds will take a more general approach and simply invest in equities that show growth potential. In such cases, the fund can diversify across all market capitalization areas as well as across the different industries and sectors and geography. Normally, such broadly focused growth funds are larger mutual funds that merely aim to exceed the index performance.

Generally, growth funds make up a special area of the equity class of investments. Their primary focus is capital appreciation through growth rates that are expected to be greater than growth in other industries/sectors, similarly sized market-capitalized equities, or different geographical areas. Determining what makes a smart growth investment is often a subjective task that relies rather heavily on the skill and astute observations of a keen portfolio manager or analyst.