All things being equal, the return you earn on any worthwhile mutual fund is a function of two main things. The first is the amount of time you're willing to hold it. For that reason, the approach I take in Champion Funds is a long-term buy-and-hold strategy -- I'm looking to beat the market over the next three to five years (and preferably longer), not the next three to five minutes.
The other main force driving the return you'll earn -- again, all else being equal -- is the price you pay for that investment. The less you have to pony up for each of your shares, the more you stand to gain when those share prices rise -- and, as a bonus, the less you'll have to lose if that fund hits the skids.
Trouble is, you can't value mutual funds in the same way that you do stocks. Yes, a fund's net asset value (NAV) does represent the price you'll pay for a share of that fund. But beyond that, NAV doesn't bear much resemblance to a stock's price. NAV is simply the fee-adjusted total value of all of a fund's assets -- including the cash it holds -- divided by the number of outstanding shares. Moreover, unlike with stocks, there's no supply-demand dynamic behind a fund's price. So long as a fund is accepting new money, investors will be able to buy its shares.
The upshot is that traditional valuation metrics (such as price-to-earnings, price-to-cash flow, and price-to-book value) that investors use to get a bead on whether a stock looks cheap or pricey won't do you much good when you go fund shopping, at least not when you apply them to a fund's NAV.
On the other hand, you can take a look at the average price multiples of a fund's portfolio. Below, I highlight two large-cap growth funds whose portfolios' P/E ratios fall below those of the broader market.
Parnassus (PARNX)
This socially responsible investing (SRI) fund has been managed since its 1984 inception by Jerry Dodson, and during his tenure, patient shareholders have been handsomely rewarded. Through the end of 2004's second quarter, the fund has earned an annualized 10.7% since it first opened for business. Even better, earlier this year Parnassus became a no-load fund.
Those are certainly key points in its favor, but potential investors should make sure that they familiarize themselves with the fund's unusual strategy before writing that first investment check. Dodson is risk averse in the extreme and, as a result, he's willing to make big moves into and out of equities based on his perception of, among other things, the market's overall level of valuation. In September 2003, for example, the fund held nearly 90% of its assets in cash. At the end of June 2004, however, it was back into stocks in a big way. Companies such as Wells Fargo (NYSE:WFC), Pfizer (NYSE:PFE), St. Paul Travelers Companies (NYSE:STA), and Lincare Holdings (NASDAQ:LNCR) held down top portfolio slots. All told, equities at that point accounted for more than 80% of the fund's assets.
As you might imagine, the strategy makes this fund a mighty tough fit for strict asset allocators. For folks comfortable with Dodson's approach, though, I think the fund's long-term success and seasoned manager make it worth a look.
Fidelity Focused Stock
(FTQGX)
I'm much less sanguine, however, about Fidelity Focused Stock. Yes, like Parnassus, the fund's portfolio looks attractively valued just now. Unlike that fund, however, the manager of Focused Stock (Bob Haber) has been in place only since February of this year. True, performance on his watch thus far has been well above average, with picks such as Costco (NASDAQ:COST), Motorola (NYSE:MOT), and Countrywide Financial (NYSE:CFC) chipping in with fat, market-walloping gains on a year-to-date basis. But if Haber appears to be off to a good start here, the manager will certainly need additional time to prove his mettle.
Generally speaking, I have to see a successful track record of at least three to five years before I'll consider investing in a fund or recommending it to Champion Funds subscribers. Even longer is even better, of course, but, by and large, I think that's a sufficient amount of time to discern a manager's stock-picking abilities.
To be sure, managerial tenure alone isn't enough to get the nod. In addition to skippers who've been around the pond a few times, I also require a reasonable price tag, a smart, time-tested strategy, and a strong commitment to shareholders. Best of all is when a manager "eats his own cooking" by plunking down his money right alongside that of the fund's investors. Indeed, that particular trait goes a long way toward demonstrating shareholder-friendliness in my book -- and, not coincidentally, in Champion Funds, too.
Motley Fool Champion Funds analyst Shannon Zimmerman is a dyed-in-the-wool value hound, but he thinks that, as a group, growth stocks -- particularly those of the large-cap persuasion -- look pretty attractively valued right now. He doesn't own any of the securities mentioned. The Motley Fool is investors writing for investors.
