Note: Although this Newsletter does not deal directly with the current downdraft in stocks, you will find my perspectives on future stock market performance included under both of the two main headings below.

Value Funds Have Disappointed: Hold or Fold?

By Tom Madell

Value funds, that is, funds that focus on stocks that are thought to be undervalued, have been the worst performing major fund category over recent years. On the other hand, Growth funds, funds that are expected to show a high degree of capital appreciation, have been the best performing category.

Digging deeper, we see that Large Cap (LC) Growth funds have outperformed Large Cap Value funds over the last 10 years with the gap particularly stark over the last 5 years. Thus, according to Morningstar.com, the difference between the average annualized return for the two fund categories has been about 2.5% per year over 10 years and nearly 4% over 5 years (data as of 3-21). To further rub salt in the eyes of LC Value investors, the difference has soared to over 14% over the last 12 months.

So what is behind this continuing underperformance of LC Value funds and does this mean if you own one of more of them, you should reconsider their place in your portfolio?

One way to understand the performance of a given fund is to examine in which of the 11 stock sectors it typically invests and in what proportions. Often, LC Value funds tend to have their largest holdings financial, healthcare, and technology shares in that order. LC Growth funds also hold technology shares but almost always as their largest holding, in far greater proportion than any other sector and most LC Value funds. Their second largest holding is usually in consumer discretionary shares. They tend to have about the same proportion of healthcare shares as Value funds, but much less in financial stocks. Another relatively big difference is that LC Value funds tend to hold some energy stocks while LC Growth funds hardly do.

When we look at which sectors have done best over the last 10 years, we see that technology and consumer discretionary stocks do indeed top the charts, helping to explain the LC Growth outperformance. Energy shares have by far the worst, even negative, performance. We see similar results over the last 5 years, with the outperformance by technology stocks particularly large. On the other hand, financial stocks, relatively subpar performers over 10 years, have done quite well over the last 5 years. And finally, one year performances have also featured similar results with even greater technology outperformance, while funds with allocations to energy shares have paid a performance price.

All told then, the composition of LC Growth funds has favored them over LC Value funds, with the exception that financial stocks have comparatively given more of a boost to Value funds than Growth funds, but not nearly enough to counteract the above sector composition advantages manifested by Growth funds.

Funds with biggest allocations to technology stocks have therefore left most funds with smaller allocations to such stocks in the dust. Given the extremely long economic expansion we've been in, it's not surprising that consumers and corporations have had the wherewithal to spend on technology and also on products and services that, while not essential, add to the feeling of well-being of purchasers, that is, consumer discretionary stocks. Such are quite different than products that are considered necessities or staples for everyone, such as food and soap.

It is interesting to note that some LC Value funds have been able to capitalize on owning the best performing sectors to a larger extent than most Value competitors. For example, the Dodge and Cox Stock Fund (DODGX), currenty owns approaching double the proportion of technology shares as the average Value fund. It also has an outsized representation in healthcare and financials. This is why Morningstar.com shows both the investment category and the "investment style" for stock funds, the latter which represents how the fund is actually positioned currently vs. its long-standing category orientation; when the two differ, this is sometimes referred to as "style drift." Thus, in the case of DODGX, the fund may actually be closer right now and several years back to a Large Blend fund than a Large Value fund according to Morningstar analysis.

Looking forward, it would appear that if LC Growth funds are to continue to be the place to be rather than LC Value, the economic expansion will likely have to continue further and technology shares will need to continue to excel. But the current expansion is already one of the longest on record. And technology shares, already overvalued, will need to defy those extreme valuations, helping to keep Growth funds aloft. But historical data shows that if we are in the late stages of this extremely long expansion, both technology and consumer technology shares may finally start to fall off their perch.

Readers may find it helpful to examine the chart here which shows graphically which sectors have performed the best in the past and which the worst depending on where in the expansion-contraction cycle we now find ourselves. Most economists might agree that we are in the late stages of the cycle where interest rates and inflation are starting to pick up.

For Value funds to gain a comparative advantage, it would seem that financial stocks would need to be more of the place to be than technology shares. However, financial stocks aren't consistently at their strongest in the late stages of an expansion, historically speaking. On the other hand, energy shares could start to turn around, given historical patterns, and because they are the most undervalued of all the stock sectors suggesting a turnaround may happen sooner rather than later.

From an historical perspective, then, it would appear the typical LC Value fund, composed as described above, has a good chance of having the mix of stock sectors that can outperform the typical LC Growth fund. Of course, no one can guarantee that will happen. In fact, Value funds have seemed ripe to outperform for several years now without that happening. But, in my opinion, as soon as the mass of stock investors start to become disenchanted with technology and consumer discretionary stocks, and if and when the next, as of now, unexpected recession hits, Value stocks should again start to enhance your portfolio rather than detract from it. Since no one can predict exactly if and when that will happen, and since stock prices often move in anticipation of actual events, investors may want to still maintain a healthy allocation to these current severe underperformers.

2nd Quarter 2018 Model Portfolios

Overall Allocations to Stocks, Bonds, and Cash

Stocks have become more volatile lately, and therefore, more risky. However, I do not expect the stock market's current problems to make the asset class's long-term returns likely to drop below the long-term returns for bonds. Investors, however, may not see double digit annualized yearly returns in stocks that they may have come to expect over the next several years. In other words, although no one can predict the future, the "golden era" for investors over the last 5 to 10 years will likely not be repeated in upcoming years. And a still relatively high allocation to stocks for long-term investors does not preclude the possibility of an intervening bear market; bear markets are a normal part of investing.

With interest rates on an upward track, cash has become slightly more attractive than previously.

Model Stock Portfolio

There are some significant changes from last quarter's Stock Portfolio as shown and explained below.

Notes:

1. A stock or bond fund shown with (C), (M), or (A) indicates it has characteristics that may make it most suited for Conservative, Moderate, or Aggressive investors, respectively.
2. Vanguard ETFs (exchange traded funds) are often practically identical to similarly named Vanguard "Investor" index funds with even lower expense ratios and without the higher minimums required for the "Admiral" funds. Therefore, these ETFs can be substituted for any Vanguard stock or bond index fund shown in tables. E.g. Vanguard FTSE Pacific ETF (VPL) can be substituted for VPACX; Admiral funds can also be substituted when available, e.g. VPADX.
3. While my International exposure appears to have dropped, inclusion of Vanguard Global ex-US Real Est Idx (VGXRX) under sector funds, instead of here, means a 48% allocation to the international category.

Rationale for Changes

Vanguard Small Cap Value Index Fund (VISVX) has been underperforming, partly due to its underrepresentation in financial services and overrepresentation in real estate as compared to other funds in its category. Its replacement, Vanguard Extended Market Idx (VEXMX), allows you to participate more in the Mid-cap area which has been a better performer than Small Value.

I have eliminated Tweedy Browne Global Val (TBGVX) from the Portfolio. It appears positioned for the bottom to drop out of stocks, something that seems quite unlikely for international stocks right now. In fact, I expect international stocks to continue to excel as they have for the last year. And with TBGVX's low portfolio turnover, it appears unlikely they will move to a less defensive portfolio any time soon.

I am replacing Vang. US Value (VUVLX) with Vanguard Value ETF (VTV): The former strays from large cap stocks, blending in small and mid-cap stocks; the latter sticks mainly to large caps.

Vanguard Global ex-US Real Est Idx (VGXRX) (unlike US real estate stocks), is a definite BUY due to global economic expansion and low interest rates around the world.

Model Bond Portfolio

Although no new bond funds have been added nor any eliminated, there are slight changes to the allocations to each fund.

Notes:

1. When possible, select PTTRX, although the minimum initial investment is quite high; HABDX is nearly identical if you want a lower minimum.
2. The two funds are the same but have different minimums; select DBLTX if possible because of lower expense ratio.
3. Muni bonds are only suitable for taxable accounts. Invest in a fund with bonds specific to your own state, if available, for the greatest tax savings.
4. When possible, select PRRIX, although the minimum initial investment is quite high; HARRX is nearly identical if you want a lower minimum.

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