Blue-Chip Funds May Gain This Quarter

NEW YORK (TheStreet) -- The stock and bond markets were kind to mutual-fund investors during the first quarter.

With the S&P 500 returning 5.4%, nearly every category tracked by Morningstar delivered solid results. Small value funds rose 9.3%, while financial funds climbed 8.3%. Most bond funds also shined. Intermediate-term funds gained 2.4%, outdoing the Barclays Aggregate bond index, which returned 1.8%.

The outlook remains promising. Stocks have been rising since early March of last year, and the typical bull market lasts at least three years, says Allen Sinai, chief global economist of Decision Economics. So there is good reason to expect a continuing rise. The picture seems particularly bright because corporate earnings have been climbing this year.

Which funds seem most attractive? To profit from an improving economy, consider large-growth funds. Those have lagged the markets lately, returning only 4.4% in the first quarter. Now many blue chips sell for discounts to the market.

For a relatively steady large-growth fund, try Janus Fund ( JDGAX), which has lost 1.8% annually for the past three years, outpacing the S&P 500 by 2 percentage points. Janus aims to find moderately priced stocks that can grow consistently for years. "Our top holdings tend to be among the most predictable growth companies that you can find," says Dan Riff, a co-manager of the fund.

A big Janus holding is International Business Machines ( IBM). The shares sell for a price-to-earnings ratio of 12.9, compared with 14.8 for the S&P 500. The company should grow steadily as sales increase in India and other emerging markets, Riff says. Another Janus holding is Emerson Electric ( EMR), a maker of motors and factory automation. The company has sharply cut costs and is expanding around the world.

A zippier large-growth fund is Counterpoint Select ( CPFSX), which has lost 0.4% annually during the past three years, exceeding the S&P 500 by 4 percentage points. Manager Karl Mills looks for unloved growth companies with solid balance sheets. When Mills finds tempting stocks, he takes big positions. Lately Counterpoint has been overweighting technology companies. "As the economy improves, companies will begin spending again, and the first place they will put money is into technology," Mills says.

Mills likes Qualcomm ( QCOM), which supplies chips for wireless telecommunications. The company will benefit from the explosive growth in demand for data. Mills also owns Microsoft ( MSFT). Helped by a rock-solid balance sheet, the company suffered little damage during the downturn. "Microsoft has so much cash that it could write a check and bail out Greece," Mills says.

While large-growth funds look tempting, some fund categories appear overpriced. After gaining 9.3% in the first quarter and more than doubling in the past 12 months, real estate funds now have an average P/E multiple of 26.1.

Real estate funds typically invest in real estate investment trusts, or REITs, companies that own portfolios of properties. As their shares have skyrocketed, REIT dividend yields have fallen, a sign that the sector may be overvalued. REITs recently yielded 4.99%, down from 6.76% in June 2009, according to the National Association of Real Estate Investment Trusts. REITs now yield only about 1 percentage point more than 10-year Treasuries, well below the historical average. The skimpy yields should serve as a warning flag at a time when property markets remain deeply troubled.

Among the losers during the first quarter were precious metals funds, which dropped 1.1%. Despite the decline, the funds -- which focus on mining stocks -- continue to be expensive, posting a P/E multiple of 29.8.

Bond funds could also prove to be overvalued. Many economists expect the Federal Reserve to raise rates this year. When rates climb, bond funds sink. To limit the danger, focus on funds that hold at least some corporate bonds. During periods when the economy is improving, corporate issues can appreciate as worries about defaults recede.

Beware of long government funds. Those fall hard when rates rise. With Treasury yields rising slightly in recent weeks, long government funds lagged for the first quarter, returning only 0.9%. In contrast, high-yield corporate funds returned 4.2%.

To handle the rough currents of the bond markets, consider T. Rowe Price New Income ( PRCIX), an intermediate-term fund. The fund is broadly diversified and typically has an average credit quality of AA. Manager Dan Shackelford places limited bets, overweighting sectors that appear attractive.

Shackelford figures that rates on 30-year Treasuries will rise from the current figure of 4.73% to 5% by the end of the year. To avoid trouble, he is underweighting Treasuries and overweighting corporate bonds. The fund has about a third of its assets in corporate bonds, compared to a figure of 17% for the Barclays Aggregate index.

Shackelford likes high-quality corporate issuers, including Johnson & Johnson ( JNJ) and Goldman Sachs ( GS). "Corporate balance sheets are relatively healthy, and they should stay that way this year," he says.

-- Reported by Stan Luxenberg in New York.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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