(PUB) Investing 2016

The Independent Adviser for Vanguard Investors

•

September 2016

•

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financial crisis of 2007–2009—was

deeper than that experienced by small-

and large-cap stocks, but not by much.

And if we look beyond the finan-

cial crisis to the other three periods,

mid-cap stocks actually experienced

smaller drawdowns than their siblings.

Additionally, mid-cap stocks tended to

recover faster from those declines.

So, for fairly significant extra return,

investors historically haven’t had to

take on much if any extra risk. A sweet

spot, indeed.

That’s why Dan and I are big fans of

mid-caps. Now let’s turn to the funds as

we try to balance the long-term appeal

of investing in mid-cap stocks against

bloated fund sizes and Vanguard’s dedi-

cation to the multimanager system.

ACTIVELY MANAGED FUNDS

Capital Opportunity

Buy.

As I mentioned above, Capital

Opportunity, while still a terrific fund,

outgrew its small- and mid-cap britches

long ago.

The PRIMECAP Management team

runs the fund with an eye toward own-

ing some smaller stocks, but having

bulked up in size, Capital Opportunity

has become much more like its larg-

er-cap brothers,

PRIMECAP

and

PRIMECAP Core

. The median com-

pany here has a market size of about

$38 billion, versus $64 billion and $54

billion for its siblings. That’s seven

times the size of the median stock in

S&P MidCap 400 Growth ETF

, but

half the size of the median company in

500 Index

Despite the creep in size, supe-

rior active management and the tilt

toward mid-sized companies have been

a powerful combination for Capital

Opportunity over the years. Since

MidCap Index

’s May 1998 incep-

tion (which is just a few months

after PRIMECAP took over Capital

Opportunity) through July 2016, the

index fund outpaced its large-cap sibling

500 Index by a wide margin, 428.5%

to 168.6%. Leaning toward mid-sized

companies has provided a nice tailwind

for Capital Opportunity, but it doesn’t

fully explain the active fund’s 789.1%

return over the same stretch. That extra

return above and beyond the index

comes from the PRIMECAP team’s

savvy stock picking.

The unique structure of the

PRIMECAP team also makes the

fund more resistant to the headwind

of a growing asset base. Each portfolio

manager is individually responsible for

investing a sleeve, or portion of Capital

Opportunity’s portfolio. If one or more

of the team focuses on the same stock,

so be it—that company gets a larger

allocation in the portfolio. This has

resulted in the fund’s top-10 holdings

consistently soaking up 30% to 40% of

assets. And though there are typically

140 or so stocks in the portfolio, each

manager may only hold 30 to 40.

Though they make their own buy

and sell decisions, the team is rowing

in the same direction, and looking for

companies with the potential for rapid

earnings growth, but which are selling

at a discount for one or more reasons.

This strategy, known as growth-at-a-

reasonable-price, or GARP, can mean

buying misunderstood companies or

companies in an apparent funk before

their next big hit. The managers are

patient, and confident that if they’ve

done their homework properly (and

they usually do), when a company’s

fortunes turn, the stocks can take off on

multiyear runs.

Still, no strategy or manager is com-

pletely immune to the effects of having

more assets to manage. To highlight

this point, let’s look at

PRIMECAP

Odyssey Aggressive Growth

(POAGX),

which is the fund Capital Opportunity

used to be, and probably never will

be again; it has been our choice over

Capital Opportunity from the day it

launched in November 2004. Since the

inception of the Odyssey fund through

July 2016, Capital Opportunity has

performed admirably, gaining 209.7%,

while 500 Index returned 142.7%.

However, the Odyssey fund ran circles

around both its bigger sibling and the

index, returning 315.5%.

If that doesn’t convince you that

having a smaller asset base can be an

advantage, I don’t know what will.

Caveats aside, Capital Opportunity

remains a top-notch fund and a core

holding in both the

Growth

and

Con-

servative Growth

model portfolios.

But frankly, I wish we had the old

Capital Opportunity back. Unfortu-

nately,

PRIMECAP Odyssey Aggressive

Growth

, which is my (and Dan’s) single

largest personal investment, is closed

to new investors. I hope you took our

advice to buy this fund before the doors

shut, but the best way for new inves-

tors to access the PRIMECAP team is

through

PRIMECAP Odyssey Growth

(POGRX).

Explorer

Hold.

As I alluded to earlier,

Vanguard’s original aggressive small-

stock fund, Explorer, is now the poster

child for the folly of watered-down,

multimanager funds. With seven man-

agement teams, 14 portfolio manag-

ers and over 700 stocks, there are too

many play callers to allow an excep-

tional manager to stand out. As Jack

Bogle, who started the multimanager

trend, has said, “Everyone knows that

if you have multiple managers, you

end up with index-like performance.”

Unfortunately, as the relative perfor-

mance chart comparing Explorer and

the Russell 2500 Growth Index on

page 14 shows, Explorer hasn’t even

provided index-like returns for over

a decade. And the constant manager

changes haven’t helped.

Explorer probably won’t hurt you too

much, but I don’t expect performance

to leap ahead of peers or

SmallCap

Growth Index

. This hasn’t been a table-

pounding aggressive fund for years.

Dan and I have long recommended

Where’s the Extra Risk?

Double-Dip

Recession, 1981-82

Russell

Top 200

Russell

MidCap

Russell

2000

Max Cumulative Loss -21.7% -18.6% -21.8%

Months To Recovery

Black Monday, 1987

Max Cumulative Loss -28.9% -30.2% -35.5%

Months To Recovery

Tech Crash, 2000-02

Max Cumulative Loss -49.1% -30.3% -35.1%

Months To Recovery

Credit Crisis, 2007-09

Max Cumulative Loss -50.1% -54.2% -52.9%

Months To Recovery