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Don't Give Up On Domestic Stocks


Mutual funds that invest in domestic stocks have been an object of scorn. During the five weeks ending April, investors pulled out $20.1 billion from such funds, for instance. And, since 2007, $500 billion.

But that doesn't mean fund managers are giving up on equities. Some hunt for undervalued companies. Some hunt for fast growers. Others look for moats.

Such is the habit of Morningstar's chief equity strategist Paul Larsen. He and his staff of credit and equity strategists regularly scour 1,800 companies in the search for those with distinct competitive advantages, such as great brands, strong patents or cost efficiencies. These are called moats, after the largely impassable castle defense.

"A company that has an economic moat is worth more than one that does not," says Larsen.

In the domestic equity wars, portfolio managers-perhaps more than ever-are struggling to act like wily Homeric hero Odysseus, who hatched tricks and stratagems to beat the Trojans and get through their city's walls. Only this time, managers need a better Trojan horse, because the wall they need to crack down is investor distrust.

"What we have seen, money has been moving out of equity funds, and into other products like ETFs," says Todd Rosenbluth, senior director at S&P Capital I.Q.'s Equity Research Department, "There have been some winners and some losers in fund flows, but collectively, equity mutual funds have been losing ground."

Ironically, domestic equity funds, performance-wise, have had a good year.

According to data from Tom Roseen, Lipper's head of research services, equity fund categories saw year-to-date gains as of April . Large cap core funds gained 9.9%, while S&P 500 Index objective funds have gained 9.97%. Large cap growth funds enjoyed a 14.25% surge, while equity leverage funds jumped 17.39%.

Roseen believes that investors "are really in search of yield and cautiously stepping back into equity funds, despite the stellar first quarter returns."

Either they have decided that the volatility in the equity market is just too high, coming on the heels of the credit crisis of 2008, or they are now allocating toward their fixed income portions of their portfolios because of a prior heavy allocation to stocks.

"In any case, we see a trend toward investors padding the coffers of their fixed investment investments and only selectively investing in equity funds: world equity funds, mixed asset funds, equity income funds," he says.

Another emerging rival in this space is exchange-traded products, according to S&P's Rosenbluth.

"Some people are realizing that it is a challenge to find the funds that beat the market and they are saying to themselves, 'Let's just pay less and stick with the market,'" he says.

The problem is that investors are at a loss when it comes to gauging the viability of equity funds and fund managers are unable to bridge that gap due to a natural reluctance to reveal their unique strategies. More than a dozen firms declined comment for this story.

But some firms were willing to give insights into how they are building or re-building business in equity funds.

For example, Invesco touts its equity investment teams, which it staffed with industry and sector specialists across geography and asset class.

"We believe the best investment insights come from specialized investment teams with discrete investment perspectives, operating under a disciplined philosophy and process framework with a keen emphasis on strong risk oversight," says senior director Ivy McLemore.

Invesco sees equity opportunities in two areas: large-cap dividend-paying stocks and low-volatility stocks, according to McLemore, who offers that her company believes large-cap stocks are undervalued relative to small-cap stocks and that large-cap dividend-growing stocks are undervalued when compared to high dividend-yielding stocks. "The valuation for dividend growers is undervalued at a % discount to the overall historical market average'' in equities, she says.

Meanwhile, T. Rowe Price boasts its on-site research. In 2011, T. Rowe analysts had more than 5,000 meetings with companies' management, which included on-site visits and first-hand overviews of operations in order to produce an independent assessment of each company's leadership and future, according to a spokesperson.

Morningstar's Larsen says that a key problem with the equity fund market is that it is increasingly focused on the short-term. The bonuses of many managers are dependent on how they did each quarter or each year, cutting down on the incentives for developing a long-term vision.

"We are much more concerned with where a company might be five or ten years down the road," he says.

Morningstar works to make sure that its analysts are on the same page in their research, according to Larsen. More than equity analysts use the exact same framework when they research roughly 2,000 securities. This framework is used when Morningstar constructs its Wide Moat Focus Index, which looks at U.S. companies deemed to have powerful advantages in their markets.

In comparison, Larsen says many other firms conduct their research in silos, with each team having a different approach.

"Our consistency in coverage is a competitive advantage," he offers.

The question of methodology right now may not seem so important given that many funds have done well this quarter, but S&P's Rosenbluth warns that more than a few equity funds have succeeded so far largely by taking big, risky bets on easy wins like Apple.

"Apple has had a very good year so far," he said. "However, having a disproportionately large amount of money tied to Apple leaves these funds vulnerable to huge amounts of downside risk in the future."

Last Tuesday, however, Apple stock - already trading at $560 a share - soared $50 to $610. Its net income in its most recent quarter, was $11.6 billion, up from $6 billion in the same quarter a year ago. The company sold 35.1 million iPhones, 11.8 million iPads and 4 million Macintosh computers in the quarter.