Opinion: Here’s what the smartest guys in the room expect from the U.S. stock market

Is the mutual fund going the way of the landline phone?

You certainly can forgive investors for flocking to exchange traded funds, or ETFs. A stunning 88% of active U.S. domestic fund managers lag behind their benchmarks, according to data recently provided to me by fund researcher Morningstar.

To measure outperformance, I applied a simple test. A fund had to beat its Morningstar-designated benchmark over the past three and five years.

Only 269 of 2,292 funds passed the test. That’s terrible. Sadly, it’s even worse than it appears. Fifty of those funds only barely squeak by, with outperformance of only 20 basis points or less. Plus, this doesn’t capture all the funds that simply disappeared because they sucked.

Morningstar mutual fund expert Jeff Ptak thinks one reason so many funds lag is because they have to overcome expense hurdles. Another downfall is managers stray from benchmarks to try to win, but they wind up making mistakes. “Active funds are messy relative to their benchmarks, and that can work against them,” he says.

As for the notion that managers will finally prove their mettle by holding up better in a down market, Ptak says don’t hold your breath. History is not on your side.

We could laugh or cry about this dismal situation. Instead, let’s turn it to our advantage. Who are the rare few fund managers who outperform? What can we learn from how do they do it? What do they like now. And what do they worry about? To find out, I recently spoke with three of these rare outperformers.

The long and short of it

Michael Grant, who manages the Calamos Phineus Long/Short Fund CPLSX, -0.51% thinks many fund managers trail because they were trained to focus too heavily on company analysis, at the expense of understanding the big picture.

This is a problem because since 2000, Regulation Full Disclosure, known as “Reg FD,” makes companies share meaningful information with everyone at the same time. So it’s become a lot harder to get an edge simply by studying businesses. “You might know a bit more about a small group of companies,” says Grant. “But the likelihood that you can have an information edge across 80 names is nonsense.”

Meanwhile, since the 2007-08 financial crisis, big-picture issues like Fed policy, European unity, China’s debt, and trends in the economy, interest rates and currencies have played a huge role in which stocks do well. But making calls on these issues goes against the grain for most managers. They prefer to “diversify around” these decisions. “They haven’t adapted their business model to this shift in the investment world,” he says.

Grant thinks he’s beaten competitors, in part, because he’s more comfortable with mixing big-picture macro analysis and stock analysis. “It’s key to understand the risk regime you are operating in,” he says. “It guides you to the companies you own.” Better understanding the big picture, for example, meant he was OK with buying “riskier” stocks after the financial crisis, whereas most managers remained scared stiff of risk for years.

The numbers bear him out. Over the past three and five years, Grant’s fund beat the Hedge Fund Research Inc. (HFRI) Equity Hedge Index and Morningstar’s Long/Short Equity Category benchmark by over 1 percentage point, annualized. And over the past 10 years, the contrast is much bigger. The outperformance was 5 to 7 percentage points, annualized.

So where does he see opportunity and risk now? Grant doesn’t like to talk about companies, but he’s happy to talk sectors and regions. Recently, he was buying Mexican stocks when most people were worried President Donald Trump’s protectionist agenda would damage its economy. Mexican stocks have rebounded significantly since I suggested them right after the election and in my stock newsletter, Brush Up on Stocks. So far, that’s been a good call.

Grant also thinks the long phase of deleveraging since the financial crisis has come to a close. So now it’s time to invest in growth and “reflation,” especially since Trump has unleashed “animal spirits” in the business world. This may well launch a capital spending cycle. Unlike a lot of investors who are worried about valuations and Trump bumbling tanking markets, Grant thinks this is the wrong time to trim U.S. stock exposure.

“We don’t see recession risk rising meaningfully in the U.S. until late 2018 or 2019.” Markets usually start selling off about six months before a recession.

European stocks look even more attractive, because economies there are behind the U.S. in their recoveries. “It makes sense to add to markets overseas where reflation is much less discounted. The prime opportunity there is Europe.”

Where does he see risk? In bonds, and any stocks that act like bonds because they pay high dividends. In a scary analogy for bond holders, Grant likens the selloff in bonds last summer to the March 2000 selloff in tech stocks, which presaged much bigger declines. He thinks long-bond yields could ultimately move back up into the 5% range. This implies a lot of pain for bond holders since the current yield is around 2.3%.

“I’m not sure people see how potentially overvalued the fixed-income part of the landscape is,” says Grant. So he’s short, or avoiding, bond proxies in the stock market like consumer staples, utilities and telecoms. He thinks they’re overvalued relative to their growth prospects. He’s also negative on health-care stocks because of the political clamor about drug pricing.

Shadowy figures

Hennessy Focus HFCSX, -0.76% fund manager David Rainey thinks a lot of funds lag because they are “shadow” indexers. “Most active managers aren’t really active managers. They can’t help but mimic the market, and because of fees they have a heavy wind in their face,” he says.

Rainey gets around this problem by running a concentrated portfolio — only 21 names at the moment. A lot of mutual funds like to have portfolios of 80 stocks or more.

What gives him the confidence to make such concentrated bets? He looks for five key qualities at a company. Then, to avoid clutter, he buys only the leader in any given space. “We are selective and concentrated,” he says. “We don’t own three or four auto-parts companies; we own O’Reilly Automotive ORLY, -0.41% ”

There’s a lesson in the five qualities for all would-be stock pickers. To start with, Rainey looks for quality businesses and management, predictable revenue, and good growth and reinvestment opportunities.

Then he wants to see relatively cheap valuations. He says his portfolio trades at a discount to the market but with twice as much expected earnings growth. Finally, to help dodge blowups, he wants to see an absence of risk factors like balance-sheet issues, litigation risk, or sales based on a fashion trend or fad.

In practice, this means looking for above-average returns on invested capital or return on equity, stable and increasing profit margins, a management history of running the business carefully and promoting from within, and an independent board. He likes to see companies that are taking market share and offering differentiated products or services.

He also tends to hold names for a long time. According to Morningstar data, 15 of the 21 stocks he owns were first purchased in 2011 or earlier. Rainey’s fund has outperformed its benchmark by about 2.7 percentage points, annualized, over the past three and five years.

One company he singles out at the moment is American Woodmark AMWD, -3.04% the only pure-play in kitchen and bathroom cabinets. There are only three major companies in this space, so American Woodmark has pricing power. It’s also a play on continued growth in the housing market. Rainey thinks annual single-family housing starts will grow 50% to 1.2 million over the next five to seven years.

Next, he points to American Tower AMT, +0.19% one of three large cell-phone-tower companies. This is a play on the continued rollout of 4G and 5G service, and the growing amount of content people watch on smartphones.

As for the big picture, Rainey says he’s more encouraged than he has been for years about the economy, because of the potential for greater business confidence and investment under the new administration.

‘Never get out of a stock’

A lot of mutual fund managers are overly focused on hitting short-term targets to collect annual bonuses. So they’re too quick to lock in profits. That’s a problem because once you sell a stock, it’s difficult to buy it back, says Brian Beitner, manager of the Chautauqua International Growth Fund CCWSX, -0.66% “If you never get out of a stock, you never have to worry about that,” says Beitner. Of course, he does take profits. But he thinks his long-term focus helps him outperform.

Another tactic is a trick he uses to manage diversified portfolios that are not “diluted.” The problem with owning 80 stocks to diversify is that large gains in any single big winner get watered down. So what good did it do you? In chat-board parlance, this is “diworsification.”

To avoid diworsification, he starts by grouping together regions or types of stocks with similar characteristics. South Korea and Germany as industrialized exporters, for example, or Canada and Australia as natural-resources exporters. Or utilities, telecom, consumer staples and health care as defensive names. Then instead of owning stocks in all of the buckets, he chooses a favorite from one or two, and still gets the characteristics of the overall group.

The upshot is he can hold 30 stocks but still be widely diversified. “This lets us get more out of stocks,” he says. Next, he looks for “advantaged” companies that benefit from qualities like a protective moat, lower costs or a bullish trend. Then he waits for attractive valuations to buy.

Three he singles out are Genmab GMXAY, -1.42% a Danish biotech company with a unique drug-discovery platform; Ctrip.com CTRP, -0.62% the dominant online travel group in China; and ASML ASML, -0.49% a Dutch chip-production-equipment maker.

His fund outperforms the MSCI ACWI Index by almost 2 percentage points, annualized, over the past three years and almost 3 percentage points, annualized, since its 2006 inception.

As for the markets, he expects choppy trading this year because valuations are high and central bank monetary policy in the U.S. and elsewhere is making a “seismic pivot” toward neutral. “It is a directional change that cannot be overlooked.”

This brings up another cautionary note from Ptak, at Morningstar. If you buy these or any other funds with good long-term records, you better be patient. Even the best funds have a couple of years in a row where they are down in the dumps. “We see this time and again with the most successful funds,” he says.