10 Questions With Morningstar's Scott Cooley

Stock prices are back where they were three years ago, the average stock mutual fund fell almost 30% over the past year, and third-quarter fund statements will almost certainly be waffled with investors' tears.

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10 Questions With Morningstar's Scott Cooley

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For this week's 10 Questions, we mulled over the past year's losses and possible next steps with Scott Cooley, a senior analyst with Chicago fund-tracker Morningstar. A keen observer of the fund world, Cooley's penchant for pragmatic and articulate advice made him a natural to help us weigh our options, without getting too wrapped up in the market's recent drama.

Stocks have trailed bonds and even three-month certificates of deposit over the past three years. The third quarter, when every stock fund category lost ground, put an exclamation point on those losses. What returns should we expect from here? What should you do if you've got a tech-sick portfolio? Where are the smartest fund managers putting shareholder money? Read on.

1. Have you ever seen this kind of a downturn for funds? What do you think investors should make of it?

I don't think we've seen a decline of this magnitude over the past 20 years or so, certainly not a downturn that's lasted this long. I think people who invest in stocks need to keep in mind that what's important is where the market is 15 or 20 years from now when they need their money, not where it is today. In terms of shorter-term action, they need to think about whether their portfolios are balanced and diversified or if they've taken on more risk than they knew or intended.

2. What are some big funds that have struggled and others that have proved their mettle over the past 18 months?

Talking With: Scott Cooley Senior Fund Analyst, Morningstar

I think (FDEGX Quote)Fidelity Aggressive Growth [down 71% over the past 12 months] is the signature example of a fund that people may have considered as a core holding and [has] since imploded. I think people probably expected [aggressive fund shops such as] PBHG and Van Wagoner to get hit hard, but I'm not sure they expected a big Fidelity fund to fall as much as Aggressive Growth has.

On the flip side, I think the (AGTHX Quote)Growth Fund of America has performed very well. There are some big core funds where the managers were kind of catching some criticism in 1999 that have kind of held up well. Another one that comes to my mind is (FGRIX Quote)Fidelity Growth & Income. If you want to look at value fund managers, I'd point to David Dreman ((KDHAX Quote)Kemper Dreman High Return Equity) and the (OAKMX Quote)Oakmark fund [run by Bill Nygren].

Strong Bonds Bond funds are topping stocks over the past 90 days, 12 months and three years
Fund Category	Third Quarter*	1-Year Return	3-Year Return
Taxable Bond	0.8%	6.1%	4.1%
S&P 500	-17.9	-29.9	0
U.S. Stock	-18.2	-27.8	3
Foreign Stock	-20.1	-32.3	-0.3
Source: Morningstar. *Returns through Sept. 24.

3. With such weak stock returns, a lot of money is going into bond funds, money markets and bank savings accounts. What would you say to folks abandoning their stock funds?

If you're investing for the long haul, it's a mistake to be shifting money from stocks to money market funds right now. It doesn't make sense to be buying tech stocks with the Nasdaq at 5000 and selling them now that it's at 1500. The yields on money market funds are as bad as they've been for many years, and they're going to get worse probably in October [if the Federal Reserve lowers interest rates]. When I look at the market, I see many more attractively valued stocks than I've seen in a long time.

4. It's often said that when stocks are battered like they are today, smart fund managers can make their shareholders a lot of money. What are some of the boldest picks you've seen during this downturn?

I think the willingness of some value managers to look at selected technology stocks is really interesting. David Dreman has done it, and Bill Miller ((LMVTX Quote)Legg Mason Value Trust), whatever you may think of his brand of value investing, has picked up tech and tech-related stocks for cheap in the past and he's buying in the tech area right now.

Marty Whitman ((TAVFX Quote)Third Avenue Value) is another investor who's seen some value in the tech sector again this year. I think their willingness to buy into an area other people are shunning right now is probably going to earn some nice rewards for their shareholders.

What are some of the companies they're buying?

It's a mixed basket. With Dreman, it's Nortel(NT Quote). Miller has bought Level 3(LVLT Quote), Corning(GLW Quote) and Tellabs(TLAB Quote). Marty Whitman's typical buys have been more in the cyclical areas like semiconductor stocks. Bill Nygren bought Guidant(GDT Quote) [in the second quarter], which is another example of picking up a real franchise company for a song. He did the same thing four years ago when he bought Amgen(AMGN Quote) when nobody was interested in biotech stocks.

5. Historically, stocks have averaged an annual gain between 10% and 11%. What kind of returns do you think investors should plan on over the next five to 10 years?

Value Is a Haven -- Sort of Value funds have held up better than growth peers, but both were whacked in the third quarter
Fund Category	Third Quarter*	1-Year Return
Large-Cap Value	-15.6%	-12.8%
Large-Cap Growth	-22.7	-46
Mid-Cap Value	-14	-3.3
Mid-Cap Growth	-24.3	-46.9
Small-Cap Value	-12.9	2
Small-Cap Growth	-20.8	-36.9
S&P 500	-17.9	-29.9
Source: Morningstar. *Returns through Sept. 24.

My suggestion to people would be to try to figure this out by thinking about the long-term earnings growth rate for the S&P 500 and its dividend yield. If you add those together, you'd be looking at an average annual return somewhere in the neighborhood of 8%. That would be my suggestion. That would be a more conservative number than some people might expect over a very long period of time, but if you expect 8% and you get 10% or 11%, you probably won't be very disappointed.

6. What stands out to you as a very likely and damaging mistake someone can make today?

There are two big mistakes that some people are making right now. One is that they're reducing their equity exposure at a time that could be a cyclical low. The second thing I see is that a lot of investors are finally throwing in the towel on their growth funds and shifting to value just because value stocks have outperformed growth by an unprecedented margin over the past year. To some extent, people are just rebalancing because they realize they had too much growth exposure, and I think that's fine. But I think there are also a lot of people who are just chasing performance.

That often translates to buying at a top and selling at a low.

Right.

10 Questions Archive

Dividend Devotee John Snyder

Fidelity Expert Jim Lowell

Janus Growth & Income's David Corkins

White Oak Growth Stock's Jim Oelschlager

Firsthand Funds' Kevin Landis

Oakmark's Bill Nygren and Transamerica's Jeff Van Harte

John Hancock Financial Industries' Jim Schmidt

7. Does a brutal time like this prove why you want 40% or 50% of your money in a broad and cheap core stock fund to avoid big sector bets and limit risk?

I still think it makes sense for people to have that big, broadly diversified fund. Some would look at those funds and say they've fallen really hard over the last 18 months, too [given the S&P 500's 30% drop over the past year]. I guess my argument would be people's inclinations were to chase some funds that fell even harder than that. I think these funds did protect some people from the catastrophic losses that others suffered because they had all their money in a handful of very narrowly focused growth funds.

What are a couple of solid core funds people should consider?

A couple of no-brainers are the (VFINX Quote)Vanguard 500 Index and (VTSMX Quote)Vanguard Total Stock Market funds. You don't get more breadth at a lower cost than you get with those funds. Among actively managed funds people will still find several of the Fidelity funds' decent choices, like Growth and Income or (FMAGX Quote)Magellan, if it's in your 401(k) plan.

Among broker-sold funds, you can't go wrong with any of the American Funds like (AWSHX Quote)Washington Mutual, (AIVSX Quote)Investors Company of America and Growth Fund of America. I don't think there's a bad large-cap fund in that organization.

8. Last year Janus set a sales record, but many of the tech-heavy funds are far down now. What would you say to someone who's sitting with a Janus-heavy, tech-sick portfolio?

The Opposite of Hot Every sector lost ground in the third quarter
Sector Fund Category	Third Quarter*	1-Year Return
Real Estate	-1.3%	3.4%
Utilities	-11.7	-20.1
Financial Services	-16.8	-6.3
Health	-17.4	-27
Natural Resources	-20.6	-16.7
Communications	-22.9	-56.4
Technology	-33.3	-69.8
S&P 500	-17.9	-29.9
Source: Morningstar. *Returns through Sept. 24.

I'd be a lot more comfortable with a Janus-heavy portfolio now than I would have been a year ago. Over time it makes sense for that sort of investor to rebalance and shift some money to more value-oriented funds to be more broadly diversified. I think one advantage is that a latecomer to Janus should be able to make some rebalancing moves without incurring much in the way of tax liability. You may be able to realize a loss, and that certainly has a benefit.

Aside from Janus, people with real growth-heavy portfolios need to look at tax issues. When someone sells a fund where they have a gain, we ask them are you going to be able to pick a fund with enough of a high return to compensate for the taxes you have to pay today rather than down the road? Now, the opposite applies. Now that funds that are under water, you could pick a fund that performs worse and still come out ahead because you have the benefit of booking a tax loss to offset any gains. That's a weird way to think of things, but it's a weird time.

9. [Any] advice on how to know when you should sell a sagging fund?

The first thing you need to do is look at the fund's performance relative to style, specific peer group. I think that prevents a lot of errors in measuring performance. For example, if you own a large-cap growth fund, it's going to be way down this year. But if it's down 20%, that's actually a really good showing relative to its peers. As we know, over time investment styles tend to change, and if you stick with a fund that consistently outperforms its peers in down and in up markets, then you have a pretty good fund over time.

One of the problems in 1999 was that, in some ways, the dumber your investment approach, the larger your returns for a short time. If you bought funds off the 1998 and early 1999 leaders list, it worked really well until [the Nasdaq peaked in] March 2000. It became very easy to pooh-pooh all the notions about diversification and research, but I think people now realize that that's very important.

10. Behind every fund is someone calling the shots. When we talk about growth funds and value funds, who are a few managers from each camp that stand out?

Well, there's no question on the value side I'd pick Bill Nygren ((OAKMX Quote)Oakmark/(OAKLX Quote)Oakmark Select), whom I've followed for about five years now. He's just been right about so many things over time that I just have a lot of confidence in his judgments. Like any fund manager, he's made mistakes. There are some stocks like USG (NYSE Quote) and U.S. Industries that he wishes he hadn't bought, but I'd take his batting average anytime.

On the growth side, I'd think of someone like Sig Segalas, who runs the (HACAX Quote)Harbor Capital Appreciation fund. If you look at the last 10 years, he's beaten his average peer in nine of them, and I think it's pretty hard to argue that it's luck. And then there's Bill Miller, whom we consider a value manager, but some people arguably wouldn't. He's done a terrific job.

He's the only fund manager to be on the same fund and beat the S&P in each of the last 10 years, right?

He's either pretty good or he's the luckiest guy that ever lived.