THE MONEYPAPER,
555 Theodore Fremd Ave., Ste. B-103, Rye, NY 10580.
Monthly, 1 year, $99.
Fidelity's Specialty Funds
Michael Burke: "The market exhibited a bit more weakness following the increase in short-term interest rates by the Federal Reserve Board. After a strong January showing that was followed by a correction in the middle of March, stocks more or less have been treading water, with not much change from where they were at the end of 2003. The broad-based S&P 500 is now down just 2.3% for the year to date. The Dow Jones Industrial Average has done slightly worse, and it is down 4.7% for the year. The more speculative Nasdaq Composite has been especially weak for the past few weeks, and is now down 7.7%. "Average" stocks have been performing much better than the "averages," as the breadth has been quite good all year. (Breadth compares the number of stocks rising every day with the number of those that go down.)
Indicators continue to suggest that there is a lot of risk in the market. Price/earnings ratios are still far above normal, and dividend yields are below normal. There also continues to be too much optimism among investment newsletter writers and too much pessimism among company insiders. Investors have been looking at the low interest rates and the strong earnings so far this year, but all we have seen is a flat market, and it usually is not a favorable sign when the news is good but stocks do not rise. For the long term, the outlook is still excellent. Foreign stocks and gold issues are in this category. We added a second gold stock, Freeport McMoran Copper and Gold, to our portfolio this month. We already had Newmont Mining.
One of the most difficult tasks to accomplish in the stock market is to know which stocks you should consider. There are thousands and thousands of stocks out there, and it is not unlike looking for a needle in a haystack to decide which of them will perform best in the immediate future. One thing we like to do after the end of each quarter is to go to Fidelity's Web site to check out its top holdings in its sector funds. This gives us an idea of what experts in 36 industries believe will be the best stocks in the groups that they follow. Here are Fidelity's 36 specialty funds, with their top holdings.
Air Transport: #1 Southwest Airlines (a newcomer to the top 10)
Automotive: #1 *Johnson Controls, #2 Toyota (in our portfolio)
Banking: #1 *Bank of America #2 *Fifth Third Bancorp
Biotechnology: #1 Genentech (it was also #1 three months ago)
Brokerage: #1 *Lehman Brothers (it was also #1 three months ago)
Business Services: #1 Affiliated Comp, #2 First Data
Chemicals: #1 *MMM, #2 *Lyondell
Computers: #1 *Intel, #2 Cisco, #3 Dell, #4 EMC
Construction & Housing: #1 Danaher, #2 Countrywide
Cyclical Industries: #1 *General Electric, #2 Tyco, #3 *MMM
Defense & Aerospace: #1 *Goodrich, #2 *Honeywell, #3 *Boeing
Communications: #1 Erricsson, #2 Alcatel
Electronics: #1 Analog Devices, #2 *Intel
Energy: #1 *BP plc, #2 *ExxonMobil, #3 Schlumberger, #4 *Chevron
Energy Services: #1 Smith International (also was #1 three months ago)
Environmental: #1 *Millipore, #2 Veolia Environment
Financial Services: #1 *Bank of America, #2 American Int'l
Food & Agriculture: #1 *McDonald's, #2 *PepsiCo
Gold: #1 Buenaventura Mining, #8 Newmont (in our portfolio)
Health Care: #1 *Johnson & Johnson (in our portfolio)
Home Finance: #1 Golden West, #2 *Fannie Mae
Industrial Equipment: #1 Tyco, #2 Honeywell
Industrial Materials: #1 Inmet Mining (a new stock for us)
Insurance: #1 American Int'l, #2 ACE Ltd.
Leisure: #1 *Yahoo, #2 News Corp, #3 McDonald's
Medical Delivery: #1 Healthsouth, #2 United Health
Medical Equipment: #1 *Medtronic, #2 *Baxter
Multimedia: #1 *Yahoo, #2 *Viacom, #3 *Disney
Natural Gas: #1 BJ Services, #2 Rowan
Natural Resources: #1 *BP plc, #2 *ExxonMobil, #3 *Chevron
Networking: #1 PMC-Sierra, #2 Avaya
Paper & Forest Products: #1 Smurfit Stone, #2 *Bowater
Pharmaceuticals: #1 *Merck, #2 *Schering, #3 *Pfizer
Retailing: #1 *Home Depot, #2 *CVS, #3 *McDonald's
Software: #1 *Microsoft, #2 Amdocs, #3 BEA Systems
Technology: #1 *Microsoft, #2 *Intel, #3 Cisco, #4 Dell
Telecommunications: #1 Quest, #3 Verizon (in our portfolio)
Transportation: #1 Northfolk Southern, #2 Federal Express
Utilities Growth: #1 Verizon (in our portfolio), #2 *SBC (in our portfolio)
Wireless: #1 *Qualcomm, #2 *Nextel
Scan this list, and you come up with a roster of blue-chip names. One strategy for success in the market is to buy great companies, reinvest the dividends, and dollar-cost average over time. As we noted, several of these stocks are also in our portfolio, and that to us is a plus, since we trust Fidelity's excellent research.
The sector funds are pretty well limited to stocks that are in their specific areas, whereas the managers of Fidelity's general funds can buy just about anything they wish, and so it is interesting to consider their holdings as well. The Magellan Fund is one of the biggest in the country. It had the benefit of spectacular management for a number of years by the famed Peter Lynch. After he left, the fund had various managers, the latest of whom is Bob Spasky. As of June 30, its top 10 holdings were Citigroup, American International, General Electric, Microsoft, Pfizer, Viacom, ExxonMobil, Johnson & Johnson, Home Depot, and Bank of America. All of these, with the exception of Citigroup, at some point were held in one, or more, of the listed funds.
Lynch was Magellan's manager when Citicorp (now Citigroup) was having some problems. The stock had fallen from around $40 to about $15, when the company unexpectedly cut its dividend. The stock plunged to $7 or $8. The Fidelity funds then bought 15% of the company. This contrarian approach paid off, as the stock became a big winner in the next several years after the dividend cut. As we mentioned previously, buying stocks in major companies that decrease their dividends has often proved a very profitable tactic. Fidelity enjoyed the same success when it bought British Petroleum, the old BP plc, when it sliced its dividend some years ago.
In Fidelity's Pacific Basin Fund, the top stock is Toyota, with Honda #7 and Australia and New Zealand Bank #8. And all of these are also in our own portfolio."
Consumer Reports MONEY ADVISER
101 Truman Ave, Yonkers, NY 10703.
Monthly, 1 year, $24.
How to know if a fund is a dud
Q. When do you sell mutual funds that have gone badly south? I have $10,000 in PBHG's Growth and Emerging Growth funds in an individual retirement account that was worth $30,000 in 1999? - S.L., Jersey City, NJ.
A. Dump a fund if it underperforms its category average (for the emerging-growth fund, that would be small-cap growth) or a benchmark index (the Russell 2000) by at least 10 percent for over a year. Both funds trailed their categories and benchmarks for the three years endings June 30, 2004.
Pilgrim Baxter & Associates, investment adviser to PBHG, was charged with fraud last year by the Securities and Exchange Commission for permitting market timing - rapid trading that dilutes the value of the funds for long-term shareholders. A $90 million settlement should be distributed, but trial counsel tells us that no one has yet decided when, how or to whom it will go. So replace the funds with others, and keep most of your aggressive funds in taxable accounts, where you can write off losses and claim winnings as capital gains on your tax return.
The NO-LOAD FUND INVESTOR
P.O. Box 3029, Brentwood, TN 37024.
Monthly, 1 year, $139.
Sheldon Jacobs: "In May 2003, Congress cut the tax on dividends from the ordinary income rate to a maximum of 15%. That put most dividends on a par with the capital-gains tax, which also was cut to a maximum of 15%. We believed that this would give a huge boost to dividend-paying stocks and the funds that owned them. Whether or not it has worked out that way is debatable.
It is indisputable, however, that after cutting dividends from 1999 to 2001, corporations have been increasing their payouts. Through July 28, 170 companies in the S&P 500 have increased their dividends this year, while 10 companies in the index have instituted dividends for the first time. Even Microsoft, which formerly hoarded cash or invested it in other software businesses, has decided to pay large special dividend while tripling its quarterly payout.
One important question is: have the prices of dividend-paying stocks benefited from the decrease in the tax on dividends? We investigated this matter in terms of our mutual fund database. On a total-return basis, funds paying out dividends have done fine over the past 12 months, but we can't say they have gone wild. As you can see in the following table, diversified funds yielding 2% or more haven't posted significantly greater total returns than lower-yielding diversified funds.
Furthermore, we suspect that the differences in performance reflect varying risk levels and market considerations more so than differences among dividend yields.
In the last three years of the 1990s bull market, funds with no dividend payouts had far superior gains than did funds with dividends. However, that was mostly because of the soaring prices of tech stocks, few of which paid dividends. On the other hand, during the subsequent bear-market years, dividend-paying funds excelled because they were more conservative.
Where does this leave fund investors? By and large, dividend-paying funds are less risky than funds that pay no dividends. Diversified funds with dividends of 1% or more have an average beta of .85, while funds that don't pay dividends have an average beta of 1.00. That means dividend-paying funds are likely to fall less than the market when it falls, while funds with no dividends are likely to fall more than the market. It seems to us that if dividend-paying funds are doing as well as non-dividend paying funds this year, investors can decrease their risk by including some dividend-paying funds in their portfolios.
One dividend-paying fund we recommend is Alpine Dynamic Dividend (ADVDX; 888-785-5578), which was started in direct response to the dividend-tax cut. The fund is on track to yield more than 6% this year.
Every stock in the fund pays a dividend of between 1% and 10%, and manager Jill Evans hopes to provide a yield of at least 4% annually going forward. She invests in three types of stocks: mature; growth & income; and turnaround. The mature category includes the stock of companies that return cash to shareholders as opposed to pursuing faster growth. Evans' growth & income stocks tend to be companies that provide moderate levels of dividends as well as growth. Turnarounds are dividend-paying companies whose stocks have fallen but that may benefit from a catalyst.
Industrial-machinery stocks, as well as other areas of the market that tend to include many dividend-paying companies (e.g., financial services and healthcare), have strong exposure in the fund, but Evans buys stocks wherever she can find attractive yields. She recognizes also that most of the funds' shareholders are likely to be low-risk investors, so she's careful to keep the fund diversified by limiting the amount she puts in any one stock and being careful to buy her stocks at reasonable or low prices.
Another diversified stock fund we recommend that pays relatively high dividends is T. Rowe Price Equity Income (PRFDX; 800-638-5660), managed by Brian Rogers since its 1985 inception. Rogers views dividends In two ways: one, as a desirable end in and of themselves, and two, as a means to finding attractively valued companies. The fund's yield in nay one year had been about 1.5 times that of the S&P 500.
Rogers seeks out the stock of companies that appear cheap relative to their own histories and the market. Relative dividend yield, which measures a company's dividend yield in comparison to that of the market, is often Roger's most important valuation tool. For example, if a stock usually yields twice that of the S&P 500 but currently yields triple the index. Rogers might be interested, depending on whether or not the stock also meets this other criteria, including financial strength.
Rogers gravitates toward big companies with staying power, and the fund tends to go where the yield happens to be: areas such as financial services, industrials, energy, healthcare and telecommunications services.
The fund produced gains in 2000 and 2001 (while the market tanked) and a much-less-than-average loss in 2002. It's a conservative fund, run by an experienced manager with a proven investment approach.
More Perspective: There are several reasons corporations haven't increased dividends more dramatically and investors haven't demanded them as much as expected.
1). For corporations, the tax code still favors debt. The tax cut was made at the investor level. It would have been far more effective in raising dividends and limiting corporate debt if it had been made at the corporate level. While interest from debt is a tax-deductible expense for corporations, dividend payouts are not.
2). The cut in the dividend tax does not increase after-tax returns in retirement accounts. All pretax withdrawals from retirement accounts are taxed at your income-tax rate effective at the time of withdrawal, regardless of whether you are withdrawing principal, dividend income, interest or capital gains.
3). Share repurchases are seductive for corporations that wish to return cash to shareholders. Many corporations still here to pay dividends because dividend payouts are difficult to reduce. (So far in 2004, only four companies in the S&P 500 have decreased or suspended their dividends.) Disappointed shareholders are likely to sell on news of a dividend cut and drive the price of the stock down. In contrast, share repurchases reduce the supply of outstanding stock and may increase share prices. Executives holding options love this. Share repurchases are also far more flexible, in that they begin and end on the whim of managements without much pressure from shareholders.
4). Corporate habits die hard, and investors still have faith. From the 1950s through the 1980s, corporations paid out about half their profits in dividends. The remaining half was reinvested in the business. In the 1990s, the percentage payout ratio declined to the low 30s, where it remains.
Also, once investors bought the notion that corporate management could invest their profits better than they themselves could, a lower tax hasn't necessarily changed their minds.
5). The cut in the tax rate on dividends and capital gains may be reversed. Unless extended by the federal government, the taxes will revert to their old levels (and may be reversed before then if Congress and whoever is President changes the law).
Concluding Thoughts. As investors in equity mutual funds, we must put dividends into perspective. In our June issue, only seven diversified equity funds yielded more than 2%. In part, that's because the funds deduct their expenses from the dividend income before distributing it. The pickings are slim among high-yielding diversified stock funds, and certainly you should not restrict your portfolio to dividend-paying funds only.
Second, whenever we are in a bull market, the bulk of profits will come from capital gains. For the year ending June 2004, capital gains accounted for 87% of total return even for diversified equity funds yielding more than 2%. In a bear market, however, dividends will be the sole source of profits for holders of most stock funds. In a more neutral environment for stocks (including the current environment), dividends are likely to provide a substantial portion of total return.
Also note that while the lower tax on dividends hasn't made an earth-shaking difference vis-à-vis non-dividend paying stocks, it makes investing in stocks more attractive generally than investing in taxable bonds. While investors pay no federal tax on interest earned from municipal bonds, they must pay tax at their regular federal income-tax rates on interest earned from Treasury and corporate bonds, for example."
The Financial REPORT CARD
PO Box 7173, Kensington, CT 06037.
Monthly, 1 year, $129.95.
Dr. Robert Valuk: "Do not think that the Federal Reserve is finished with its rate increases. A weakening earning season and other softer economic indicators has led some bond investors to think all is well in bond-land. Guess again! What we will see is best described as rate creep. Over the next year, rates will increase 1 - 1 1/2 points. The prime rate will go to 5%, and possibility as high as 6%. Mortgage rates will rise also, but not always as much as the prime rate. The Fed is taking what is called a measured approach, but rest assured the trend is skyward. Municipals should continue to be a bright bond spot for those seeking returns free of Federal taxes. GNMAs will tread water and should produce a small positive return. The author is personally using Fidelity Floating Rate High Income, Fidelity Ultra Short Term Bond, Fidelity Short Term Bond, and Vanguard High Yield Tax Exempt. Money market returns will be upticking over the next year, and some bank CD offers may become attractive. Vanguard Limited Term Tax Exempt and Fidelity Short/Intermediate Muni offer tax-free (free from Federal taxes) alternatives to money markets, with higher current yields.
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