Fund managers stress quality as Fed stimulus fades
April 22, 2014
A roundup of the latest Vanguard mutual fund reports
Note: To view the reports mentioned in this article, you'll need to have Adobe Reader installed on your computer.
Vanguard's advisors traditionally focus on the stocks of high-quality companies in their efforts to build viable investment portfolios. With the bull market now stretching into its sixth calendar year and corporate profits becoming harder to sustain, the emphasis on quality is as persuasive as ever.
In the most recently published Vanguard fund reports, which cover the 12 months ended February 28, 2014, several advisors noted the importance of quality in portfolio construction.
Delaware Investments Fund Advisers, co-manager of Vanguard U.S. Growth Fund, wrote: "Although [economic] fundamentals in some regions may be trending upward (from a very low base during the 2008–2009 financial crisis), we don't believe we are entering a typical postrecessionary boom cycle. Rather, the lingering effects of the credit crisis could lead to moderate growth at best. In such a tenuous environment, the quality of a company's business model, competitive position, and management may prove to be of utmost importance."
The Federal Reserve is slowly weaning the U.S. economy from its monthly stimulus, and a rise in short-term interest rates is widely expected next year. Standout companies will likely rely on their own resources and competitive advantages and won't be as dependent on accommodative programs and policies, according to advisors.
William Blair & Company, L.L.C., also an advisor to the U.S. Growth Fund, wrote: "The market is likely to continue to be data dependent, seeking signs that the economic recovery is sustainable. The pace of the Federal Reserve's tapering and its management of expectations will be critical to limiting volatility. As corporate profit margins remain high, further earnings growth will largely be a function of revenue growth. Although a boost from accelerating GDP growth would be helpful, we look for companies with company-specific revenue and margin drivers. Our bottom-up perspective allows us to focus on identifying and constructing portfolios of high-quality businesses that we believe can sustain outsized earnings growth over the long run."
Mixed international outlook
While international stocks have lagged their U.S. counterparts, they've still managed solid returns despite facing a variety of issues. The developed markets of Europe and the Pacific region have been more productive than emerging markets. Worries about stagnant economic growth in China plagued stocks and currencies in different emerging-market countries.
Advisors for Vanguard International Growth Fund addressed the issues they've faced in the international equity market and how those issues have shaped their outlook.
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"Five years into a recovery from the lows of early 2009, international equity markets have finally rediscovered some genuine optimism," wrote Baillie Gifford Overseas Ltd. "The second half of 2013 marked a notable shift in preference from defensive stocks toward those with more substantial but less predictable growth prospects. We view this sea change in sentiment as a delayed response to the considerable progress made since the global financial crisis at both the macroeconomic and corporate levels. The broadening of the U.S. recovery, resumption of growth in Southern Europe, and ambitious reform proposals emerging from China and Japan are all encouraging signs for sustainable global growth."
Schroder Investment Management North America Inc. pointed out that that the global financial and Eurozone crises have led investors to overvalue "defensive," or stable, earnings and undervalue cyclical earnings.
"This can be seen, for example, in the high valuations being paid for consumer staple companies," Schroder wrote. "These generally good-quality growth businesses have high underlying exposure to the emerging markets that are now experiencing weak earnings growth.
"As we look ahead, we see some potential for upside surprise arising from the continued healing in the European economy, and some downside risk from the serious challenge facing Chinese authorities in the aftermath of China's recent vast credit growth."
Defend risk with diversification
Both U.S. and international markets experience cycles, with stocks of different sizes, styles, and segments alternating as leaders and laggards.
In the conclusion to several letters, Vanguard Chairman and CEO Bill McNabb stressed the importance of diversification and cautioned that sector-specific mutual funds best serve investors by filling gaps in a portfolio rather than functioning as an all-in-one portfolio.
"But keep in mind that by choosing just a slice of the market-capitalization pie, you're also choosing to take on additional risk," Mr. McNabb wrote. "Investors who depart from a market-proportional approach by overweighting a certain segment of the market are exposing themselves to more volatility by reducing their portfolio's level of diversification.
"As we say in Vanguard's Principles for Investing Success: 'Leadership among market segments changes constantly and rapidly, so investors must diversify both to mitigate losses and to participate in gains.'
"You can achieve a balanced market-cap representation through a total stock fund, or you can assemble segment-specific funds in a way that mirrors the overall market. Either way, appropriate diversification should remain paramount."
Another recently published report:
- All investing is subject to risk, including the possible loss of the money you invest. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.
- Diversification doesn't ensure a profit or protect against a loss.
- Past performance is no guarantee of future results.