Low-Cost Funds That Picks Winners

After rigorous analysis of ~7,500 mutual funds, I found a low-cost fund that successfully picks businesses with quality earnings and cheap valuations. BrandywineGlobal Dynamic U.S. Large Cap Value Fund (LMBGX) is this week’s Long Idea.

Forward-Looking Research Reveals a Very Attractive Fund

LMBGX earns a very attractive Predictive Fund Rating, after my analysis of its holdings reveals the fund has a higher allocation than its benchmark to highly profitable companies with low expectations for future profit growth baked into their stock prices. The fund’s benchmark is the iShares Core S&P U.S. Value ETF
IUSV
.

I leverage my firm’s Robo-Analyst technology to drive assessment of mutual fund portfolio quality by analyzing each fund’s individual stock holdings. This uniquely rigorous approach enables me to create forward-looking mutual fund ratings based on the strength and valuation of the underlying businesses of the stocks held in a fund. 

Per Figure 1, LMBGX allocates 55% of its assets to Attractive-or-better rated stocks compared to just 34% for IUSV. On the flip side, LMBGX allocates just 13% of its assets to Unattractive-or-worse rated stocks compared to 27% for IUSV.

Figure 1: LMBGX Allocates Capital to Superior Holdings

BrandywineGlobal Dynamic U.S. Large Cap Value’s Strategy Considers Quality and Valuation

It is not by chance that LMBGX allocates to better stocks than the benchmark. LMBGX’s investment strategy utilizes a quantitative approach to identify stocks that “have upside potential with relatively low downside risk to the Russell 1000 Value Index”. The fund ranks stocks by a multifactor score, which incorporates the following criteria:

• earnings quality
• profitability
• investor sentiment
• management’s utilization of capital
• attractive price-to-earnings ratio
• attractive price-to-book ratio

Unfortunately for investors, the fund does not give specifics as to how it measures all of the criteria involved in its score. For example, the fund does not state how it measures management’s utilization of capital. I would suggest the fund evaluate a company’s return on invested capital (ROIC), since accurately assessing a company’s ROIC is an important part of any rigorous investment process, as there is a strong correlation between improving ROIC and increasing shareholder value. Though I don’t know exactly how LMBGX evaluates management’s utilization of capital, the fund’s ROIC is higher than its benchmark.

The fund’s methodology doesn’t just look for good companies, but also considers valuation to identify good stocks. The fund’s managers rely on price-to-earnings (P/E) and price-to-book (P/B) ratios, which can mislead investors. I think the methodology could be improved by incorporating price-to-economic book value (PEBV), free cash flow (FCF) yield, and a reverse discounted cash flow (DCF) model to more accurately understand the expectations embedded within a stock’s current price. Despite using inferior metrics, the fund is successful in identifying stocks with expectations for future growth that are much lower than the benchmark.

Quality Stocks Drive Very Attractive Risk/Reward Rating

Figure 2 contains my detailed rating for LMBGX, which includes each of the criteria I use to rate all mutual funds under coverage. These criteria are the same for my Stock Rating Methodology, because the performance of a mutual fund’s holdings equals the performance of the mutual fund after fees. 

Figure 2: BrandywineGlobal Dynamic U.S. Large Cap Value Fund Breakdown

LMBGX’s holdings are superior to IUSV in four of the five criteria that make up my holdings/Portfolio Management analysis. Specifically:

• LMBGX’s ROIC is 13% and greater than the 11% earned by IUSV holdings
• LMBGX’s free cash flow (FCF) yield of 4% is higher than IUSV’s 3%
• the price-to-economic book value (PEBV) ratio for LMBGX is 1.1, which is much less than the 2.6 for IUSV
• my discounted cash flow analysis reveals an average market implied growth appreciation period (GAP) of just seven years for LMBGX’s holdings compared to 27 years for IUSV

The stocks held by LMBGX generate higher-quality cash flows and have lower valuations than IUSV. Market expectations for stocks held by LMBGX imply profits will only grow by 10% (measured by PEBV ratio) while the expectations embedded in IUSV’s holdings imply profits will grow by 126%.

A Closer Look at LMBGX’s Quality Holdings

Out of the 104 of LMBGX’s holdings under coverage:

• 100% have a positive ROIC
• 80% have a positive free cash flow yield
• 81% have a PEBV ratio of 1.3 or less
• 81% have a GAP of 10 years or less
• only 13% receive a Risk/Reward rating below Neutral

Given its ability to identify quality companies with low valuations, it’s no wonder that 11% of the mutual fund’s assets are allocated to stocks we’ve featured as Long Ideas. Figure 3 shows the 11 LMBGX holdings that are open Long Ideas.

Figure 3: Open Long Ideas That LMBGX Holds

Quality Stock Selection at Below Average Cost

LMBGX’s 0.91% total annual costs (TAC) are well below the 1.59% simple average and 1.22% weighted average of the 948 other All Cap Value mutual funds under coverage. Figure 4 shows my breakdown of LMBGX’s total annual costs.

Figure 4: LMBGX Total Annual Costs Breakdown

The Importance of Sector and Holdings Based Fund Analysis

Simply buying a mutual fund or ETF based on past performance does not necessarily lead to outperformance. Only through holdings-based analysis can one determine if a mutual fund is allocating to stocks with businesses with high earnings quality and low valuations, as LMBGX does.

Build An Even Better Fund For Yourself

As I showed in The Paradigm Shift to Self-Directed Portfolio Construction, new technologies enable investors to create their own fund without any fees while also enabling better, more sophisticated weighting methodologies. If I reallocate the fund’s holdings according to economic earnings, the customized fund allocates:

• 74% of assets to Attractive-or-better rated stocks (compared to 55% for LMBGX)
• <1% of assets to Unattractive-or-worse rated stocks (compared to 13% for LMBGX)

See a detailed view of the quality of stock allocations in the customized fund versus LMBGX’s actual allocation here.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.