Low-cost index funds are the smart choice for most of your portfolio, given how few active managers consistently beat the market. For the 10% or so of your holdings, though, where you can afford to take more risk in hopes of greater rewards, you need to venture out of index territory to find stocks or funds with the potential for outsize gains—even in today’s hot market.
To find these opportunities, Money sought out fund managers who have beaten the benchmarks over the past five years in different corners of the U.S. market: large and small companies, along with growth and value stocks. Those managers’ picks follow, along with a look at the strategies behind their choices.
Adapted from "Top Picks From Top Pros" in the January/February 2015 issue of Money magazine. Stock prices and P/E ratios (which are based on projected earnings) are as of December 12, 2014. Fund perfornance is through November 2014.
The pros: Win Murray and Bill Nygren
The record: Murray and Nygrene manage the Oakmark Select fund, which has returned an average of 17.8% a year over five year and 8.6% a year over 10.
The strategy: The duo hunts for values among the market’s largest stocks -- and see a payoff from investors’ focus on small and medium-size companies in recent years. World-class businesses such as Oracle, Google, and MasterCard, they say, are underpriced. “We have spent a lot of our careers outside these companies,” says Murray, promoted in 2013 with Tony Coniaris to run the fund alongside famous investor Nygren. “Now the market is giving them back to us.”
Nygren’s willingness to take outsize stakes in sectors has set him apart from other large-cap value managers. The best example of that now: Select’s 36% allocation to financial services companies—J.P. Morgan Chase, AIG, and Bank of America are among its top holdings—compared with the 16% average for large-cap value funds.
Although bank stocks have recovered since the 2008 downturn, their 17.7% average annual return over the past three years trails the overall market’s gains of 21% a year. Banks’ steady income stream from fees and loans is underappreciated, Nygren says. By the end of the decade, he adds, people will say, “I can’t believe how cheap those stocks were.”
Next: Murray and Nygren's three stock picks
Bank of America
P/E ratio: 12.1
Why Murray and Nygren like it: BofA’s stock has more than tripled over the past three years, but it’s still 14% below the average price-earnings ratio of U.S. financial firms. Blame investor worries about the ongoing fallout from the financial crisis, such as
BofA’s agreement last year to pay a $16.7 billion fraud penalty. A more important number, says Murray, is the $21 billion the company generates a year in free cash flow (cash from operations, minus capital expenditures); that’s 23% of revenue, five points more than the industry average.
P/E ratio: 13
Why Murray and Nygren like it: More than 90% of this database software giant’s customers renew their annual subscription fees. That income stream gives Oracle time to catch up to competitors Microsoft and Salesforce in cloud offerings—software and services delivered over the Internet.
Early results are promising: Last fall, Oracle said it had 2,000 sign-ups. The stock trades at a discount to the industry’s average P/E of 16.4 and, Murray estimates, is worth over $60 a share.
P/E ratio: 17.8
Why Murray and Nygren like it: With oil hitting five-year lows lately, this driller has suffered, falling 28% in 2014. But Murray sees management’s recent stock buybacks as a sign the shares are undervalued. Apache is also selling its slow-growing international assets, currently 42% of oil production.
Once investors view it as a North American energy company, says Murray, "it should be valued at more than $100 per share.”
The pro: Sudhir Nanda
The record: Nanda runs the T. Rowe Price Diversified Small-Cap Growth fund, which returned an average of 20.8% a year over five years and 10.6% a year over 10.
The strategy: One of Nanda’s favorite types of investments among small stocks is companies that have been spun off from larger corporations. The offspring is usually cut loose so that it can focus on one business, and it often gets an injection of financing from the parent company that helps foster growth. The spun-off stock often does quite well, says Nanda, a former finance professor.
Mindful of how expensive small-cap stocks have become—they’re up about 40% over the past two years—Nanda takes an almost value-minded approach to picking growth stocks. He looks for companies with a history of returning cash to shareholders through dividends or stock buybacks. He also seeks out stocks he can hold for years, trading only 14% of his holdings annually, vs. turnover rates of more than 100% for many small-cap funds. “High turnover can be expensive,” says Nanda.
The payoff: The fund’s performance has landed it in the top 5% of its category for the past five- and 10-year periods.
Next: Nanda's three stock picks
Marriott Vacations Worldwide
P/E ratio: 23.6
Why Nanda likes it: This timeshare operator, part of Marriott International until 2011, is one spinoff that Nanda favors. Its revenues come from financing and renting 189,000 units, plus running the 1,550 resorts in which they sit.
As the job market improves, so does vacation spending. Analysts expect Marriott Vacations’ earnings per share to grow 18.5% annually over the next two years, compared with 13.3% for its competitors.
P/E ratio: 17.7
Why Nanda likes it: In addition to spinoffs, Nanda is a fan of Brinker, operator of the Chili’s casual restaurant chain. The company is expanding overseas, with plans to open 35 to 39 locations this year in countries such as India and the Philippines. Brinker will keep costs low, says Nanda, by franchising nearly all of those restaurants; the company’s cash flow, after adjusting for capital expenditures, is 6.8% of sales, vs. 5.2% for the similar Cheesecake Factory.
While Brinker’s projected 14% revenue growth is on par with the industry, its lower costs help give it room to raise its dividend, as it did in 2014, says Nanda.
P/E ratio: 17.8
Why Nanda likes it: The manufacturer of lawn-care products has benefited from rising home sales over the past two years, and Nanda sees Toro increasing earnings per share by 13% next year. Another positive development: Last October, Toro agreed to buy snowplow manufacturer Boss, which accounts for 25% of U.S. snowplow sales. The purchase should help offset a slowdown in lawn mower sales over the winter.
Nanda acknowledges Toro isn’t growing particularly fast, but he’s in it for the long haul. Befitting his low turnover strategy, he’s owned the stock since 2007.
The pros: David Carlsen & Elizabeth Jones
The record: Carlsen and Jones manage the Buffalo Discovery fund , which has a 5-year annualized return of 18.3% and a 10-year return of 11.1%
The strategy: Using long-term trends to find growth stocks. This growth fund’s managers start with the long view. They’ve developed a list of 26 trends they believe will shape our economy’s future—an aging population, a push to contain health care costs, and the proliferation of connected devices, for example. Then, says co-manager Elizabeth Jones, they look for companies responding to those shifts. The forecasts Jones has made with co-managers David Carlsen and Clay Brethour have led to big stakes in technology and health care for their midsize-company fund. To ensure their bets are good ones, they estimate the potential returns on a stock if their theories are correct, along with their losses if they’re wrong. If the upside-to-downside ratio isn’t more than 2 to 1, they pass. “We like a safety net,” says Carlsen. The strategy has led to an 18.3% annualized return over five years, vs. 16.9% for the Russell 3000.
Next: Carlsen & Jones' three stock picks
P/E ratio: 28.9
Why Carlsen and Jones like it: One of the trends Buffalo tracks is the use of generic drugs to counter rising health care costs, and Hospira is one of the managers’ favorite providers of generics. The manufacturer gets nearly 70% of its sales from injectables, which require expensive development efforts, thus limiting competition.
Once three drugs now in Hospira’s pipeline are approved for sale, Jones believes that operating margins will grow from 16% to the 20% to 30% range that other companies in the field enjoy. Says Jones: “In three years, Hospira will be a $100 stock.”
P/E ratio: 23.2
Why Carlsen and Jones like it: If you’ve downloaded video content on your phone, then it’s likely you’ve used technology developed by Akamai. It works on the back end of servers and data centers, finding the fastest paths to distribute high-definition videos or apps to mobile devices.
While telecom service providers such as AT&T can do this, Akamai’s expertise and established technology encourage the telecoms to outsource the process, says Carlsen. “The company is in the best position to take advantage” of the increasing amount of content streamed to mobile devices, he believes.
P/E ratio: 77.5
Why Carlsen and Jones like it: This newly public company has developed a portable oxygen machine, as light as five pounds, that can produce the same airflow as a home machine that weighs 10 times as much. Since the number of Americans over 65 is expected to nearly double by 2030, Jones believes Inogen’s machines will become an important technology. Inogen, she says, can grow 20% to 30% annually for the next five years.
The pro: Bill Hench
The record: Hench runs the Royce Opportunity fund , which has a 5-year annualized return of 16.8% and a 10-year return of 8.2%.
The strategy: Finding value in ultra-small packages. One might think there are no bargains left in smaller stocks after their recent run-up. Not Bill Hench, who runs this value fund with lead manager Buzz Zaino. Hench looks for companies that have had hits to earnings because of bad management decisions or poor luck, tending to focus on ultra-small companies. The average stock market value of companies Opportunity holds is $739 million, less than half that of the average small-cap stock. Many of these smaller stocks “are still on sale,” says Hench, because investors tend to avoid these riskier companies.
With these small firms come big swings in stock price. The fund fell 13% in 2011, for example, while rising 44% in 2013. Over the past three years it has returned 20.1% annually, vs. 17.8% for the Russell 2000 Value index.
Hench and Zaino often invest in secondary stock offerings or underperforming IPOs. If a company fails to meet initial expectations, the price can fall dramatically. “We take advantage of that,” says Hench.
Next: Hench's three stock picks
P/E Ratio: 28.5
Why Hench likes it: This chain of boating supplies and accessories has had operational problems, including poor pricing, says Hench. New management is better targeting customers with noncore products such as footwear and apparel, which are now 16.5% of sales, up from 13.9% in 2011. Lower gas prices also help the bottom line. Hench thinks earnings will double by 2017, lifting the stock to $22.
P/E Ratio: N.A.
Why Hench likes it: A marketer of workplace ID systems, Identiv completed a $15-a-share secondary stock offering in September. A month later, the stock fell 42%, hit by concerns about high-priced small stocks. Hench invested then, lured by Identiv’s technology and by the rep of the CEO, hired in 2013, as a turnaround specialist.
RTI International Metals
P/E Ratio: 14.5
Why Hench likes it: Revenues at this maker of titanium parts for the aerospace industry sputtered in 2014, thanks to product oversupply at Boeing, one of its largest customers. That backlog has now started to clear, says Hench, which should help the stock bounce back to the mid-40s.