How to Fight the Flat

By David S. Waddell

Markets have regained their composure after a sharp, but necessary, sell off in early January. Sentiment has now retreated from the euphoric levels reached toward the end of last year, to more neutral levels.

Earnings season wound down on a positive note overall with better than expected earnings, offsetting lackluster revenue growth and cautious guidance. The poor to mixed economic data has been explained away by the abysmal weather conditions making January and February data largely irrelevant.

Lastly, we passed our first test of the Yellen Fed chairmanship, to date a Ben Bernanke reprisal. So essentially, it’s late February and the market has been reset. The S&P 500 ended 2013 at 1848 and trades today around 1848, otherwise known as unchanged.

In truth, sideways markets provide investment talent scouts more information. When everything correlates one way or another, stocks tend to trade as an asset class rather than on their individual merits. This obscures money manager’s stock picking abilities. Let’s look at this year’s mutual fund winners, according to Morningstar, and see if we notice any similarities:

Category: Large Cap US
Top Performer: Fidelity OTC
Assets in Top 10: 43%
2014 Return: +7.68%

Category: Mid-Cap US
Top Performer: Loomis Sayles Mid-Cap Growth
Assets in Top 10: 27%
2014 Return: +14.80%

Category: Small-Cap US
Top Performer: Artisan Small Cap
Assets in Top 10: 33%
2014 Return: +6.75%

Of the sampling listed above these funds concentrate about 33 percent of their portfolio assets in their top 10 holdings compared with 9 percent for their respective indices.

Clearly, the top-performing funds listed above have concentration in common. For example, I remember speaking with Philip Fine, the manager of the top performing Loomis Sayles Mid Cap Growth fund a few years back. He explained his portfolio strategy of holding a reasonable number of stocks that should hit singles or doubles, and then add a few stocks that could hit absolute home runs. His largest holding at the moment is NXP Semiconductor, a stock up 23 percent so far this year. Also, in the portfolio is Intercept Pharmaceuticals, a previously unknown stock now up 442 percent year to date. In years of single digit returns for the indices, Philip has a pretty high batting average. In 2005, the S&P 500 gained 4.91 percent while the Loomis Sayles Mid Cap Growth portfolio gained 15.16 percent. In 2007, when the S&P gained 5.49 percent, it gained 39.39 percent. Conversely in 2011, the S&P 500 gained 2.11 percent while the LSMCG portfolio lost 7.33 percent. In fairness to Philip, 2011 was an awful comparative performance year for nearly all money managers. Overall, Philip’s stock picking style averaged 15.74 percent versus 4.17 percent for the S&P 500 over this series of sideways index returns.

Bottom Line: Concentrated portfolio strategies often invite more volatility, but remember, no one ever complains about upside volatility. In a year when indexes may continue to oscillate around the flat line, those who seek better returns need to scout out higher conviction, more concentrated portfolios. To outperform in a sideways markets, you need PROVEN stock pickers.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.