Some Blue-Chip Funds Stay the Course, Some Stray Off-Course

As if lovers of large-cap domestic stock funds needed any more validation.

The second quarter proved, yet again, that large-cap U.S. funds remain a consistently profitable vehicle for investors. While the typical U.S. diversified stock fund lost 0.3% for the quarter, the average fund that invests predominantly in big U.S. companies--you know, firms like Coca-Cola, GE and Microsoft--advanced 1.7% for the quarter and 14.6% thus far this year.

If you expect this pattern to continue, the only question now is how should you invest in these large-capitalization, blue-chip American companies.

Should you do it through growth funds, which invest primarily in companies whose earnings are rising faster than the overall market?

Or maybe you’d be better off going the value fund route. These portfolios, which invest in beaten-down or overlooked companies, are a bit less winded. They’re up 10.4% for the year versus 20.6% for the typical large-cap growth fund.

Unfortunately for many investors, the answer really doesn’t matter, because so few funds actually hold the kinds of stocks you’d expect them to.

You see, mutual funds may call themselves value or growth--or anything else, for that matter--but many stray from their original mission. Call it false advertising. Call it mislabeling. Or call it “style drift,” as it is called in the industry.

The end result is that you could easily end up buying one type of fund when you were really interested in the other.

The typical stock in the average large-cap value fund boasts a price-to-earnings ratio of 23.7. That’s 4% higher than the Dow Jones industrial average’s multiple, which is odd because stocks in a value fund ought to be significantly cheaper than the market as a whole.

A similar complaint could be made about large-cap growth funds. With growth funds, you expect a couple of things: 1) The fund will invest in companies whose earnings are growing faster than the market as a whole; 2) and since companies with fast-growing earnings should see their valuations rise in lock-step, the fund will deliver greater total returns than the market as a whole.

Yet less than 10% of large growth funds have accomplished both of these things over the past three-year period, according to Morningstar.

So-called growth-and-income funds are no better. They promise to deliver capital appreciation as well as dividend payouts. Yet today, the typical large-cap growth-and-income fund pays out a miserly yield of 0.87%. Although dividends have fallen overall, that’s still about a third less than the S&P; 500 index’s stingy 1.3%.

So what’s an investor to do?

Search out funds that do exactly what they promise. To help you do that, we screened for solid, top-performing growth, value and growth-and-income funds investing in large companies that stay true to their mission, using Morningstar Inc.’s universe of more than 9,000 funds.

Value Funds

Since value funds ought to invest in undervalued companies and since the Dow’s P/E is 22.8 (the S&P;’s about 27), we screened for funds with average P/Es below 20.

We then screened for funds that boasted a low price-to-book ratio, since that’s another traditional measure of value. The average value fund’s price-to-book ratio is 4.3, so we rejected all funds whose average holding carried a ratio above that.

Of course, we didn’t want funds that didn’t deliver solid returns. So we screened out all the remaining candidates whose annualized returns for the past one, three and five years didn’t beat at least half of their peers. That left us with eight funds.

Here are two that analysts are especially high on:

* Sound Shore, (800) 551-1980. Co-managers Harry Burn and Gibbs Kane Jr. start by defining the universe of the 1,250 largest American companies. Then they toss out the most expensive 80%, based on P/E.

But the managers, who have been running the fund since its 1985 inception, don’t stop there. They will only invest in a company whose current P/E is lower than its historic P/E. This disciplined approach has kept this $2-billion fund’s price-earnings ratio 25% below that of the S&P.;

It has also led Burn and Kane to some beaten-down or overlooked companies. For instance, two years ago, Sound Shore began building a stake in Wal-Mart, at a time when the giant retailer’s shares were trading at just 17 times earnings. They recently sold their stake in Wal-Mart as the chain’s shares approached 30 times earnings.

Today, Burn says one of his favorite stocks is American Greetings, the nation’s second-largest greeting card company, which he bought last year when it was trading at a 65% discount to the market.

* Muhlenkamp, (800) 860-3863. Like most value-oriented managers, Ron Muhlenkamp looks for stocks that are cheap based on their price-earnings ratio. But what distinguishes Muhlenkamp--and what makes him a true value manager--is his reliance on another statistical ratio: return on equity.

ROE measures a company’s earnings relative to its net worth. Muhlenkamp won’t buy a stock if its price-earnings ratio is higher than its ROE. That means if a company’s ROE is 20%, he won’t buy it unless its P/E falls below 20.

Why is this significant? Since World War II, notes Muhlenkamp, the average ROE for the market has hovered around 14%, which makes his P/E threshold rather low. Not surprisingly, this $195-million fund’s P/E is roughly 40% less than that of the S&P.;

This bent toward cheap yet profitable companies continues to drive this fund to the financial sector, where Muhlenkamp likes the life insurer Conseco. Over the past three years, picks like this have helped beat 98% of the fund’s peers, delivering annualized returns of 31.4%.

Growth Funds

To find the best growth funds, we ran a slightly different screen. Since investors buy these funds for capital appreciation, we demanded even greater total returns than we did from our value funds. If a large growth fund couldn’t beat 75% of its peers in each of the past one-, three- and five-year periods, we refused to consider it. Next, since loads tend to wipe out a decent percentage of those gains, we screened out all load funds.

Finally, since it’s not unreasonable to expect growth funds to invest in companies that are growing faster than the market, we eliminated all funds whose average holding didn’t have a three-year growth rate exceeding that of the S&P.; That left us with only three funds. In addition to Janus Twenty, which went through a manager change a year ago, they are:

* Gabelli Growth, (800) 422-3554. This selection may seem odd at first. After all, the Gabelli family is better known for its value funds. And this particular $1.5-billion portfolio doesn’t load up on technology shares. In fact, manager Howard Ward refuses to buy any of the red-hot Internet stocks.

Instead, Ward says he buys only large, growing U.S. companies that dominate their industries, like Home Depot. The nation’s largest home-improvement retailer has grown earnings at an eye-popping annual rate of 39.5% over the past decade.

Overall, the average company in the fund has been growing nearly 22% a year over the past three years. Notes Morningstar analyst Kevin McDevitt: “Gabelli Growth proves that just because you’re not buying high-multiple stocks it doesn’t mean you’re not buying growth.”

* Harbor Capital Appreciation (800) 422-1050. You’d be hard-pressed to find a more consistent--and consistently good--large U.S. growth fund than this $3.6-billion fund. Spiros Segalas’ portfolio has beaten the majority of its peers each year for the past eight, something few of his peers can say. In fact, in five of those eight years, the fund trounced 75% of its peers.

Like Ward, Segalas has delivered these returns by focusing on blue-chip growth companies that dominate their industries and deliver consistent earnings growth.

Unlike Ward, though, Segalas has been more willing to place bets on technology companies, like Microsoft and Dell Computer. That’s made Harbor Capital significantly more volatile than Gabelli Growth. But that extra risk has given Harbor a slight advantage in terms of annualized returns over the past five and 10 years.

Growth-and-Income Funds

To find the best growth-and-income funds, we started with a simple premise: A fund that calls itself “growth and income” ought to deliver as much income as the typical large-cap fund. So we screened for actively managed growth-and-income funds with yields in excess of the S&P;’s 1.3%. Then we screened out those that couldn’t beat at least half of their peers over the past one, three and five years.

Surprisingly, this left us with a just seven funds. All had outstanding records, but here are the two that generated the most income:

* T. Rowe Price Dividend Growth, (800) 638-5660. Investors in this $1-billion fund can be assured that manager Bill Stromberg won’t forget that he’s running a growth-and-income fund. Stromberg favors companies like Philip Morris and AlliedSignalthat have raised their dividends annually for several years.

Why does he do this? Obviously, part of his mission is to deliver yield. But this stock-screening method concentrates his search on extremely healthy companies.

And while its 2% yield isn’t much to write home about, it is more than twice the average offered by its peers.

* Vanguard/Windsor II, (800) 662-7447. “Windsor II is a classic growth-and-income fund,” said Dan Wiener, editor of the Independent Adviser for Vanguard Investors newsletter.

Here’s why: The fund’s lead manager, Jim Barrow, demands that the stocks he buys yield as much as 50% to 60% more than the market average.

That’s led the fund to many financial stocks, like Chase Manhattan, as well as large retailers in the midst of a turnaround, like Sears and Kmart.

In addition to focusing on high-yielding stocks, the fund generally seeks out shares trading at a 20% to 25% discount to the S&P; in terms of P/E and price-to-book ratios.

Honest Performers

Looking for funds that remain true to their descriptions and perform well? Below are six funds -- two in each of the three blue-chip categories -- that met our criteria.*

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Annualized Year-to-date 1-year 3-year return return return P/E Average large value 11.62% 18.95% 23.31% 23.7 Sound Shore 5.87 19.25 27.76 19.9 Muhlenkamp 18.58 31.30 31.43 16.9 S&P; 500 17.50 29.78 30.15 27.3

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Annualized Year-to-date 1-year 3-year 3-year return return return growth Average large growth 21.82% 28.03% 25.23% 21.4% Gabelli Growth 18.09 33.66 30.83 21.5 Harbor Capital Appreciation 22.16 30.66 26.07 21.5 S&P; 500 17.50 29.78 30.15 17.1

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Annualized Year-to-date 1-year 3-year return return return Yield Avg. large growth and income 16.58% 23.76% 26.32% 0.87% T. Rowe Price Dividend Growth 10.45 22.17 27.29 2.02 Vanguard/Windsor II 16.19 26.97 29.91 1.91 S&P; 500 17.50 29.78 30.15 1.25

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Value funds with reasonable price-to-earnings ratios, growth funds that invest in companies growing faster than the S&P;, and growth and income funds that generate more dividends than the S&P; 500. All of these no-load funds have compared favorably with their peers and the S&P; in delivering returns. Fund performance data are through July 2.

Source: Morningstar.