It's a good time to be a stock picker. Some 57 percent of US funds run by active managers are beating their benchmark indexes this year, according to fund-tracker Morningstar. That is the best overall performance for the industry since 2009 and well above the 37 percent of funds that typically top the indexes.
Stock pickers are doing well in part because after more than four years of marching higher en masse, stocks have started to separate themselves into leaders and laggards. The lines of demarcation became more pronounced during the past few weeks as US companies reported their recent quarterly results.
Nearly 69 percent of companies are beating analyst estimates in the third-quarter - that's typical, but this season the misses are not concentrated in any particular sectors. Each sector has had its share of high-profile shortfalls. Look no further than technology: Thomson Reuters data shows that 84 percent of the 55 tech companies reporting so far surpassed earnings forecasts. Yet investors sent IBM to a 2-year low on weak sales figures, and several chipmakers took a hit after issuing disappointing forecasts.
Implied correlations - a measure of how closely the performance of individual stocks mirrors that of the index itself - have fallen to their lowest since October 2007 after peaking in 2011, according to a research note from Cantor Fitzgerald. That means that instead of the returns of most stocks clumping close to the index returns, there is a much broader spread on how individual shares are performing.
That's a sign that investors are picking winners and losers. It also suggests the bull market - which has carried the S&P nearly 170 percent higher since March 2009 - is starting to show its age. The S&P 500 has set 33 new highs this year after failing to reach record levels since 2007. Now there are fewer beaten-down stocks that offer the chance for a quick pop higher.
Instead of searching for screaming bargains, fund managers are turning their focus to well-run companies that have sustainable advantages and may hold their value during a downturn, however unlikely that may seem at the moment. "Ultimately as any recovery ages you start to see a selection process where better executing companies are afforded more attention. The general 'trade the group' strategy does not quite hold as well and you have to be more careful," said Michael Sansoterra, the manager of the $289 million Ridgeworth Large Cap Growth fund.
THE EARNINGS SEASON REVEAL There are several reasons for the growing disparity in corporate performance. For the past four years, companies benefited from the rising tide, and some were able to use stock buybacks and dividend hikes to fuel share prices even when operating performances was not up to snuff. The Federal Reserve's economic stimulus program, which has put a lid on interest rates and allowed companies to refinance their debt cheaply, also helped lower-quality companies shine.
Now, as third-quarter earnings reports reveal which companies have stronger or weaker sales prospects and profit margins, choosy investment managers are rewarding stronger companies and walking away from those that display weakness. Shares of United Continental Holdings, for instance, fell as much as 4 percent on October 24 after the airline operator missed analyst estimates because of high costs and unused seats. Analysts from J.P. Morgan, Raymond James and Evercore Partners cut their outlooks for the company, citing its poor results, while revenues are growing at other airlines.
Shares of Delta Air Lines and Southwest Airlines have continued to rally as a result of a pickup in business travel and thinner competition. For the year, Delta is up 123 percent, compared with United's 45 percent rise. Among clothing companies, VF Corp rose 5 percent on October 21 to an all-time high after it beat estimates on strong demand for its Timberland, Vans and the North Face brands.
VF Corp is up 42 percent for the year, while competitors like Gap Inc, Ralph Lauren and Abercrombie & Fitch Co have lagged the broad market after missing sales targets and relying on heavier discounts during the back-to-school shopping period. Gap, for instance, is up 19 percent for the year, while Abercrombie is down 22 percent.
'HARDER' MARKET Managers complain that finding hidden gems is increasingly challenging as the most promising companies are already pricey and there are no obvious bargains.
"It gets harder now that the market has gone up and you have to avoid overpaying for growth," said Craig Watson, a portfolio specialist who works on the $19.8 billion T. Rowe Price BlueChip Growth fund and the firm's other large-cap funds. The fund is up 32.5 percent for the year, or about 7 percentage points more than the S&P 500. His BlueChip Growth fund added to its position in Amazon.com despite its 43 percent gain for the year because of its strong management and earnings potential, Watson said.
"If you are taking a longer-term view like we are, then something that may look expensive today won't look like it is in two or three years because the company is so well-managed," Watson said. John Fox co-manages the $902 million FAM Value Fund , whose 28 percent gain for the year puts him 2 percentage points ahead of the S&P 500. He said the rush to equities by investors looking for yield has stretched valuations. The fund, which has 42 stocks, has added only four new positions this year, compared with the 12 Fox bought "in only a few weeks" during the fall of 2011, he said.
Fox's most recent purchase: Forest City Enterprises Inc, a commercial real estate developer that is up 25 percent for the year. Fox likes its plan to sell some of its assets and focus on the higher-end New York and Washington, D.C., markets, and estimates that the stock could jump 15 percent from its current price of about $20.26. Bill Smead, who has steered his $530 million Smead Value Fund to a 30 percent gain for the year, is optimistic that the gains in the US housing market will keep pushing stocks higher. He has been adding to his position in Walt Disney Co, for instance, because he expects that more families will opt for vacations at its amusement parks as their home values rise. Shares of Disney are up 37.8 percent for the year.
Still, he longs for the volatility - and subsequent correlations - of the market of the past few years. "You don't like to see people going on TV talking about how great stocks are," he said. "That stuff bothers you when you're picking stocks. You want to be in an environment where no one agrees with you."
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