(PUB) Morningstar FundInvestor

September 2 014

Morningstar FundInvestor

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Did You Notice These New Sector Bets? Red Flags | Dan Culloton

stocks in the past three years. Although the stocks have recovered from controversies over enroll- ment growth, job placement rates, and aggressive marketing tactics, they remain contentious. FPA Capital managers say concerns, investigations, and determined short-selling by hedge funds gave them the opportunity to buy leaders in a key component of the U.S. education system at attractive discounts. DeVry Education Group DV is best-of-breed in an oft-troubled industry, with strong and effective franchises in test prep and information technology, accounting, and medical-services training. Mean- while, Apollo Education Group APOL has abun- dant opportunities to improve its cost structure and margins by focusing on student retention and licensing its technology to other schools seeking to offer classes online. The positions have paid off for the fund so far, but they can be volatile and controversial. have consumed the bulk of their investments. Managers Dennis Delafield and Vince Sellecchia, however, also seek companies that look cheap because of failed acquisitions, management upheaval, or aborted strategies. In recent years, they’ve found a lot of those in the energy sector. The fund’s commit- ment there has increased from nothing to 10% of stocks in the past three years as it has snapped up coal firm Consol Energy CNX , oil- and gas-services and equipment companies Weatherford Inter- national WFT , McDermott International MDR , Boardwalk Pipeline Partners BWP , and others. œ Contact Dan Culloton at dan.culloton@morningstar.com Delafield Fund DEFIX is usually more comfortable in industrial and technology sectors, which typically

Change can creep up on fund investors. Occasionally managers will make big sector shifts that you wouldn’t want to miss. The moves can alter the risk profile of the fund and your portfolio, so it pays to pay attention. Below are a few funds that have upped their stakes in certain sectors in the past three years. Bottom- up stock-pickers run each of these examples; none of them would say they’re making conscious bets on particular sectors. Because these fairly concentrated, benchmark-agnostic managers are comfortable letting their stock picks gather where their research leads them, the funds often end up making de facto sector wagers anyway. It’s worth keeping an eye on. Jensen Quality Growth JENSX is known for its strin- gent profitability criterion. So, it was surprising to see that the fund had increased its basic-materials stake from 1 . 3% in 2011 to more than 11% of stocks as of June 2014 . Basic-materials companies, miners and those dealing in commodities in particular, aren’t exactly known as bastions of quality; many struggle to earn their cost of capital. Jensen’s stake consists of a big chemical company benefiting from positive secular change and two industrial-service companies with strong positions in their markets. The fracking revolution has lowered the cost of one of the key inputs of DuPont ’s DD chemical-manufac- turing process—natural gas. And industrial gas company Praxair PX and environmental-services company Ecolab ECL have business models that generate a lot of recurring revenue. Arguably these are higher-quality basic-materials companies, but Jensen’s increased exposure here still bears watching. For-profit education companies make up virtually all of FPA Capital ’s FPPTX increased consumer defen- sive stake, which went from next to nothing to 11% of

What is Red Flags? Red Flags is designed to alert you to funds’ hidden risks. Such risks can take many forms, including asset bloat, the depar- ture of a solid manager, or a focus on an overhyped asset class. Not every fund featured in Red Flags is a sell, and in fact, some are good long-term hold- ings. But investors should be prepared for a potentially bum- pier ride in the near future.