Fund Spotlight

Healthcare was one of the few bright spots in an otherwise down year for the stock market. Although the sector lost ground, strength in pharmaceutical stocks kept losses in the low single digits for most diversified sector funds. The actively managed Vanguard Health Care (VGHCX) came out ahead of the pack with a decline of 1.05 percent, about 1 percentage point ahead of the overall sector. By comparison, the S&P 500 Index was weighed down by its hefty technology exposure. Vanguard 500 (VOO) slid 18.17 percent on the year.

The stable results by healthcare stocks in 2022 were consistent with their performance history. Major healthcare companies are typically large firms with diversified or stable income streams. Johnson & Johnson (JNJ) best exemplifies the diversified company. It sells all manner of goods ranging from medicine to household products. Shares gained nearly 6 percent in 2022. UnitedHealth Group (UNH) represents the other side of stable. It has a narrower business model, but consumers need healthcare year in and year out whether there is a recession or not.

Medical devices, pharmaceuticals and biotechnology make up the bulk of the remaining firms. These companies are often highly volatile in their early life because they have no income and trade entirely on the hope of hitting a discovery. If they make one, they graduate into being more stable earners.

Pharmaceuticals giants were the driving force behind healthcare gains last year with several enjoying double-digit gains such as Merck (MRK), Bristol-Myers (BMY) and Novo Nordisk (NVO). Pharma strength has waned early in 2023, although mid- and small-cap pharma companies are among the best-performing healthcare stocks this year. Medical devices and biotechnology, the two weakest subsectors in 2022, have led this year thanks to the bounce in technology and growth stocks.

The mix of growth and defensive subsectors makes healthcare a desirable sector for many investors. Other sectors experience boom-bust cycles where they lead for long periods and then underperform. Healthcare is a steadier performer often found in the middle of the pack because it has a healthy mix of growth and value exposure.

Vanguard has two main options for accessing this sector. Vanguard Health Care (VHT) is the passive ETF with an expense ratio of 0.10 percent and a yield of 1.31 percent. The other was the better performer in 2022: Vanguard Health Care (VGHCX). It has an expense ratio of 0.30 percent and 30-day SEC yield of 0.75 percent.

Management

Jean Hynes was named a co-manager of VGHCX in 2008 and took over as lead manager in 2013. She has been an analyst at Wellington Management Company since 1991, covering the healthcare sector. Two years ago, she was named CEO of Wellington. Despite the increased workload, she has stayed on as manager thanks in part to her large and capable team of analysts. She also stepped down from managing a separate healthcare fund, Hartford Healthcare (HGHAX).

VGHCX’s mandate calls for long-term capital appreciation. Management is tasked with investing in health services, medical products, specialty pharmaceuticals, major pharmaceuticals and international markets. The fund hunts for strong companies selling at a discount and will take contrarian positions in companies hit with negative events. The fund overweights the top holdings to the tune of about 30 percent of assets. Turnover is low at 15 percent, which translates to a nearly 7-year average holding period.

VGHCX has a 4-star and Silver rating from Morningstar.

Portfolio

VGHCX has an average market capitalization of $68 billion, more than the healthcare category average of $52 billion but below the index average of $102 billion. VGHCX is very similar to the index in that giant- and large-cap stocks make up 78 percent of assets versus 80 percent for the index. It differs from the category because it has less mid- and small-cap exposure.

VGHCX also differentiates itself geographically. It has nearly 9 percent of assets in Japan, 7 percent in the United Kingdom and 5 percent in Switzerland. The category has more than 90 percent invested in the U.S., and the index has nearly 100 percent.

Subsector exposure is led by 38 percent in pharmaceuticals, 22 percent in biotechnology, 14 percent in managed healthcare, 12 percent in healthcare equipment and 9 percent in life sciences tools and services.

The top 10 holdings as of December 31 were UnitedHealth Group (UNH) 6.21 percent, Eli Lilly (LLY) 5.54 percent, AstraZeneca (AZN) 5.37 percent, Pfizer (PFE) 4.50 percent, Merck (MRK) 4.14 percent, Novartis (NVS) 4.10 percent, Biogen (BIIB) 2.99 percent, Daiichi Sankyo (4568.JP) 2.90 percent, Stryker (SYK) 2.76 percent and Elevance (ELV) 2.70 percent.

VGHCX has a beta of 0.60 versus the 0.74 of the category and 0.67 of the index. The standard deviation is 15.54 versus 20.73 and 16.86 for the category and index, respectively. VGHCX is less volatile than the category and index and is also less volatile than VHT, which has a 0.68 beta and 16.92 standard deviation.

Performance

VGHCX has decreased 1.37 percent in 2022. That was 14 percentage points better than the category and 4 percentage points better than the index.

VGHCX has 3-, 5- and 10-year annualized returns of 6.83 percent, 9.74 percent and 12.64 percent.

It has outperformed the category over all of these periods, by 0.7 percentage points over 10 years and more than 2 percentage points annualized in the 3-year and 5-year periods.

VGHCX underperformed the index in the 3-, 5- and 10-year periods by an annualized 2, 1.4 and 0.8 percentage points, respectively.

 

Distributions

Over the past 5 years, the fund has paid dividends and capital gains equivalent to a minimum of 5.5 percent. Three years were above 8 percent and the highest was more than 12 percent in 2019. Investors should consider holding the fund in a tax-advantaged account.

Outlook

The strongest catalyst for healthcare is demographics. Most countries in North and South America, Europe, and Asia are rapidly aging. Healthcare demand rises as people age. Most countries are seeing their healthcare spending climb as a percentage of their economy. This will provide steady growth for the sector in both good and bad years for the overall economy.

Healthcare delivers a good defensive profile within a moderately weak stock market. Last year, investors rotated money from technology and growth into energy and value. This caused steep losses in technology and growth stocks, and indexes such as the S&P 500 Index were down close to 20 percent. Sectors without that exposure (including healthcare) saw small losses. Healthcare won’t offer much protection in a full-blown bear market where investors indiscriminately sell stocks, but even then, its losses might be meaningfully smaller than the broader markets. In the context of the current economy, technology and growth stocks are most at risk should inflation remain high, while energy and cyclicals stocks are most at risk should the Fed overdo it with rate hikes.

History tells us healthcare typically underperforms when investors are becoming aggressive and holds up better when they turn cautious. Slow and steady wins the race though. After last year’s pullback in growth stocks, healthcare is outperforming consumer discretionary and communication services over the past decade. Only technology has done better.

We recommend investors overweight healthcare stocks in most market conditions. VGHCX is a good option. Its higher international exposure offers some geographic diversification. Portfolios with heavy value exposure should check sector exposure to make sure healthcare isn’t too high a percentage of assets, but since the sector itself has lower volatility and steadier performance, a slightly high overweighting isn’t as worrisome as it would be in the energy sector, as one example.

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Long-term U.S. Treasury bonds suffered one of their worst years ever in 2022. The decline in the price of a 10-year Treasury bond was the worst since 1788, according to one bank’s research. Back then, the newly formed United States was saddled with high inflation stemming from funding the Revolutionary War. This time, the losses were mainly a consequence of an unsustainably high bond price caused by the Federal Reserve’s zero-percent interest rate policy.

Duration

Interest rate risk is a function of time and cash flow. The less cash flow, the higher the interest rate risk. The longer the time until maturity (return of principal), the higher the interest rate risk. Long-term, zero-coupon bonds have the highest interest rate risk, while high-yield, short-term bonds have the lowest. Bond funds are measured by their duration, calculated by factoring in both the cash flow and time until maturity. The longer the duration of a fund, the higher the interest rate risk.

Bond prices move up when yields fall, and they move down when yields rise. When the Federal Reserve pinned short-term rates at zero (again) in 2020, many bonds rallied strongly. Eventually, inflation was out of control and the central bank raised rates. Previously, the Fed hiked rates slowly because there was little consumer price inflation from 2011 to 2020. This time, the Federal Reserve waited far too long before hiking and had to rapidly raise rates back to “normal” levels. Bond prices tumbled in response.

Credit Risk

U.S. government bonds have only interest rate risk. Corporate bonds and riskier foreign countries have interest rate risk and credit risk. Last year saw a rise in credit risk, which peaked in June. Since then, it has been in a general downtrend. As long as the economy is growing, credit risk will remain low.

Peak Inflation

Entering 2023, long-term interest rates are on the decline. Consumer prices remain elevated and will continue rising, but the pace has slowed considerably. How much it slows will determine Federal Reserve policy. From July to December, the Consumer Price Index rose about 1 percent. If it continued at that pace for another six months, the Fed could declare victory. The Cleveland Fed thinks inflation will be in the range of about 4 percent, annualized, in the first quarter. If this scenario plays out, the Federal Reserve will hold interest rates higher for longer and may hike them even more.

If the Federal Reserve keeps rates high and economic growth is strong, investors in floating-rate and high-yield corporate securities will see better performance than long-term government bond holders will. Fidelity Strategic Income (FADMX) is a great option, with its experienced multimanager team covering all manner of fixed-income segments and keeping an eye on higher-yielding securities.

Fidelity Strategic Income has 11 managers. The lead managers are Ford O’Neil and Adam Kramer, who have 10 and six years with this fund, respectively. O’Neil has more than 30 years of experience with Fidelity and has managed Total Bond (FBNDX) for nearly 20 years. Kramer has been with Fidelity for 22 years. The other managers all specialize in various credit sectors, including foreign bonds. Lead managers set the fund’s allocation in each credit class, and the other managers focus on security selection.

FADMX yields 5.74 percent. It has an expense ratio of 0.66 percent. There is no investment minimum. The fund has earned a four-star and a Silver rating from Morningstar.

The fund’s default allocation is as follows: junk bonds 40 percent, investment grade 30 percent, emerging markets 15 percent, developed markets 10 percent and floating rate 5 percent. Roughly speaking, the fund’s base allocation has 60 percent of assets in what would normally be higher-risk, higher-yielding debt and the remaining 40 percent in investment-grade bonds or sovereign debt.

Portfolio

FADMX currently has 41 percent of assets in junk bonds; of those, 34 percent are corporate bonds. There is nearly 3 percent in equity, rights and warrants; 2 percent in cash; and 2 percent in bank loans.

Floating-rate debt is currently underweight, at approximately 8 percent of assets. U.S. government debt is nearly 30 percent; of that, 27 percent is government bonds and 3 percent securitized debt.

Developed market debt is 5 percent, split almost evenly between sovereign and corporate debt. Emerging market debt is nearly 16 percent of assets, with 11 percent in sovereign debt, 4 percent in corporate bonds and the rest in floating rate and cash.

Geographic exposure is heavily weighted in the U.S., with 81 percent of assets. Canada, Germany, Mexico, the United Kingdom and Israel each have more than 1 percent of assets and combine for about 7 percent.

As for credit quality, U.S. government bonds are 29 percent, AAA through A is 6 percent, BBB is 18 percent, BB is 18 percent and B is 23 percent. Nearly 4 percent is CCC and below, while 12 percent has no rating. Almost 100 percent of the fund—to be precise, 99.87 percent—is in U.S. dollar-denominated debt as of December 31.

The weighted average maturity of bonds is 15.60 years, but the duration is only 4.45 years, thanks to the high yield on many of the bonds. For every percentage point decline or increase in interest rates, we’d expect FADMX to rise or fall about 4.45 percent, respectively.

FADMX has a beta of 0.98 and a standard deviation of 8.59, making it more highly correlated with the Bloomberg Aggregate Bond Index but slightly less volatile, despite having much more credit risk than the average multisector bond fund.

Performance

FADMX fell 11.13 percent last year. The five-year U.S. Treasury bond rose from 1.2 percent to 4.0 percent on the year. Given the fund’s duration of 4.45, we’d expect the fund would lose about 12.46 percent; thus, it performed about as expected with respect to the decline in price.

FADMX has a 3-year annualized return of 0.66 percent. This compares with negative 0.35 percent for the category and negative 1.97 percent for the index. It has been a volatile period for bonds, but FADMX has bested the competition.

Income

Dividends are paid monthly. They have fluctuated between 3.6 cents per month and 2.1 cents over the past three years. Dividends trended up with yields in 2022, but investors can’t be sure that rates will stay high. Retired investors looking for spendable income should budget on the low side of that range. On the bright side, that low included the 2020-2021 period, when the Fed slashed the fed funds rate to zero. Capital gains were 20 cents in 2021 and 15 cents in 2020.

Outlook

FADMX offers investors a diversified portfolio backed by Fidelity’s deep manager and analyst pool. Including all the subsector managers who also manage other funds at Fidelity, there are 11 managers providing guidance for this portfolio. While many areas of the market have become dominated by passive investing, credit analysis provides a critical edge for bond investors. Buying the bonds with the largest market share, for example, might mean buying bonds of companies with the largest debt. Most of the time, it doesn’t matter, because the bond markets function smoothly. In March 2020 though, FADMX outperformed iShares iBoxx High Yield Corporate Bond (HYG) by 7 percentage points. In short, high-yield bonds are one of the asset classes where active management provides the greatest value.

As for interest rates and credit risk, the current environment favors higher-than-expected interest rates, falling-but-still-elevated inflation and better-than-expected economic growth (assuming most of the market was buying into all the recession chatter the past two months). This is a good environment for high-yield bonds because long-term bond yields should fall with disinflation, but the fund’s higher-yielding short-term debt will benefit from the Fed keeping short-term rates elevated. Even if longer-term rates go higher this year, there’s no evidence to suggest rates will rise nearly as much as they did last year. This will limit the downside from interest rate risk. Stable economic growth will keep a lid on credit risk.

Finally, after a brutal 2022, some investors have cut back on bond allocations. However, in the wake of such a negative year, the outlook for a diversified portfolio of bonds has improved. Short-term bonds, for example, went from a near 0 percent yield to 4 percent now. Many investors aim for a long-term total portfolio return in the range of 6 to 8 percent. The rise in interest rates has greatly aided investors in reaching their targets with less risk and lower volatility than equities come with.

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Dividend-focused ETFs were outperformers in 2022 thanks to their value tilt and underweighting of technology stocks. Non-dividend-paying stocks were among the worst performers last year, while sectors that outperformed such as healthcare and consumer staples are littered with dividend-paying companies. One of the better-performing funds last year was WisdomTree U.S. Quality Dividend Growth (DGRW).

DGRW’s performance was impressive because the fund has substantial technology exposure. Almost 27 percent of the fund is in technology. A huge chunk of that exposure is also in two stocks— Microsoft (MSFT) and Apple (AAPL)—that saw substantial losses in 2022. They still combine for more than 11 percent of the portfolio and are the fund’s top two holdings. Altogether, the fund has four tech holdings in its top 10. Three of them are down about 20 percent in the past year, while one is flat. Compared with growth and tech indexes, these are impressive results, but they were still an anchor on performance.

Away from technology, top holdings such as Merck (MRK), Philip Morris International (PM) and Johnson & Johnson (JNJ) delivered gains over the past year. Merck was well ahead of the pack with an increase of nearly 50 percent last year.

The strength of dividend funds last year, including ones more focused on growth and capital appreciation such as DGRW, reinforces the case for dividend stocks in a portfolio. While these funds often underperform during a bull market, in the long run, they deliver more consistent returns with lower volatility.

Although DGRW is not specifically an income fund, it has delivered solid dividend growth in its history. Aside from about a year of falling dividends in 2020, dividends historically have risen on an annualized basis. The monthly paying fund delivered $1.30 per share in dividends through December 2022, up 10.8 percent from a year earlier. The yield isn’t high at 1.87 percent, but investors with a time horizon longer than 5 years or, better, 10 years will see substantial income growth over the longer term.

Index Strategy

DGRW tracks the WisdomTree U.S. Quality Dividend Growth Index. It has an expense ratio of 0.28 percent. DGRW earned a 5-Star Gold rating from Morningstar.

DGRW is not a dividend fund in the sense of being designed for higher income. Instead, it uses dividends as a tool for finding companies with better growth prospects and lower valuations. DGRW focuses on profitability criteria such as return on assets and return on equity. More profitable companies will see better stock performance, for a greater total return. It also considers dividend growth.

DGRW weights companies based on their cash dividends; thus, Apple and Microsoft are top holdings because they pay tens of billions of dollars in dividends each year.

The portfolio has changed substantially over time because companies with faster-growing dividends will move up in DGRW faster than their market capitalization growth might otherwise warrant. At times, the fund has been heavily invested in biotechnology and consumer discretionary. As with other indexes that use complex financial criteria, investors cannot bank on the fund’s sector exposure remaining constant year to year. Instead, they are betting that the fund’s selection process will deliver higher returns over time.

Portfolio

DGRW has an average market capitalization of $148 billion. This is below the Large Blend category average of $239 billion. Technology, consumer staples, industrials, healthcare, financials and consumer discretionary have 95 percent of the fund’s assets, with the largest being tech at 27 percent of assets and the smallest consumer discretionary at 11 percent. The fund has small exposure in materials and real estate and less than 1 percent in energy, utilities and communication services.

The top 10 largest holdings are Microsoft (MSFT) 6.64 percent, Apple (AAPL) 4.57 percent, Johnson & Johnson (JNJ) 3.93 percent, Procter & Gamble (PG) 2.98 percent, The Home Depot (HD) 2.75 percent, Merck (MRK) 2.59 percent, Coca-Cola (KO) 2.52 percent, Broadcom (AVGO) 2.50 percent, Philip Morris International (PM) 2.42 percent and Cisco (CSCO) 2.12 percent.

DGRW has a beta of 0.86 and a standard deviation of 18.97, both lower than the category’s 0.98 and 21.18, respectively, making it a lower-volatility option.

Performance

DGRW declined 6.34 percent in 2022. Over the past 3- and 5-year periods, it gained an annualized 10.75 percent and 9.98 percent, respectively.

Since inception, DGRW has performed similarly to the S&P 500 Index except during the 2020-2021 bubble in growth stocks. Then DGRW underperformed, as did most value stocks. Since then, DGRW has roared back. Since inception, DGRW is now beating the S&P 500 Index by almost 20 percentage points. DGRW has been widening its lead on the S&P 500 in recent months. It has outperformed the S&P 500 Index by 4 percentage points since October.

Outlook

DGRW is a growth fund, but its focus is on dividend growth. This separates it from the typical growth fund that has hefty exposure in non-dividend-paying stocks, though it does usually mean DGRW behaves more like a growth fund relative to other dividend funds. This is a bonus for investors who make heavy use of a dividend strategy and end up with a heavy value tilt in their portfolio.

DGRW has historically performed better than the average dividend fund during bull markets but worse during bear markets and corrections, when investors typically prefer holding consumer staples, utilities and healthcare stocks. For longer-term investors, this makes DGRW an attractive buy during market downturns and corrections because they can accumulate shares during a period of weakness.

Another benefit of DGRW is that it has a wider universe of potential stocks than many dividend funds. Apple was added to the fund shortly after it started paying a dividend, but other funds require as much as 10 years of rising dividend payments for inclusion. This criterion makes a quality portfolio but it does eliminate some good companies. Thanks to its different selection criteria, DGRW can help a dividend-focused portfolio achieve a more balanced portfolio with a better growth profile.

DGRW can be used as a core holding within a diversified portfolio by both dividend investors and aggressive investors who may not be using a dividend strategy in their portfolio design.

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Vanguard Value (NYSEARCA:VTV) outperformed all the major indexes in 2022, declining only 2.07 percent. It was one of many value-oriented indexes and funds that beat the major indexes, thanks to avoiding the worst-performing sectors. Technology and technology-related companies such as Amazon, Meta, Netflix, Google and Tesla were anchors of growth sectors. Conversely, energy enjoyed a substantial double-digit gain. Utilities, consumer staples and healthcare, typically overweight in value funds, saw small gains or losses.

Aside from the aforementioned value sectors, Vanguard Value also has hefty positions in financial companies. Financial firms trade positively, with interest rates relative to the broader stock market because rising rates lift the earnings of financial assets. Valuations of stocks and bonds are negatively affected, but the income stream from bank loans rises. Insurance companies’ earnings rise as the interest paid on their large bond holdings increases.

Last year showed that random events can determine which sector leads the market. Russia’s invasion of Ukraine sent oil prices soaring in the first half of the year. Energy was far and away the best-performing sector as a result. If this year continues the trend of the last months of 2022, energy will struggle with a repeat performance. Many energy consumers adjusted to higher prices and Russia sanctions, the result being depressed energy prices. Crude oil and natural gas are flat over the past year, having given back all their 2022 gains.

Lower energy prices are great news for energy consumers, meaning virtually all of us. Lower inflation will lift pressure on financial asset valuations, particularly if interest rates stabilize. Lower energy costs will help energy-intensive industrial companies. Shipping costs are already tumbling internationally, but domestic supply-chain woes have kept diesel prices artificially inflated. If those can drop, consumer price inflation will slide even more than anticipated.

If we condense the past three years of market history into a paragraph, it was a story of a blow-off relative top in growth stocks followed by growth giving it all back. Tech stocks led during the pandemic, since they benefited from lockdown policies, including fiscal stimulus amid low inflation. As inflation picked up, the tailwind for growth started turning into a headwind. Value stocks started outperforming as growth stalled. Last year, growth gave back most or all of its gains, depending on the index. For example, since March 1, 2020, VTV has risen 46.78 percent. Vanguard Growth (VUG) has gained 26.57 percent over the same period. At the start of 2022, VTV was up about 50 percent from March 1, 2020, and VUG was up 85 percent. A similar shift happened with the Dow Jones Industrial Average and Nasdaq. The latter had a big lead in 2020 and 2021, but now the two indexes have sported similar returns since the onset of the pandemic.

The big question moving ahead is whether the bull market in growth resumes or whether the past year was the start of a major shift to value stocks. Given that inflation and interest rates are still elevated, along with strength in areas such as emerging markets that comport with value leadership, it looks like a shift in market leadership is underway.

Vanguard Value (VTV)
Vanguard Value tracks the CRSP US Large Cap Value Index. It has an expense ratio of only 0.04 percent and a 30-day SEC yield of 2.48 percent.

VTV has an average market capitalization of $108 billion, not far off the Large Value category average of $115 billion or the index average of $104 billion. It has substantially less in giant caps than the category though, at 37 percent versus 46 percent, while being in line with the index’s 38 percent. VTV’s large- and mid-cap exposure is also similar to that of the index.

Sector exposure is similar to the Large Value category, but VTV deviates in favor of value. Technology, communication services and consumer discretionary all are underweight. Healthcare, industrials, and consumer staples are overweight. Healthcare is the largest sector, with 22 percent of assets, followed by financials at 20 percent, industrials at 12 percent, consumer staples at 11 percent and energy at 8 percent.

The top 10 holdings in VTV as of November 30 were Berkshire Hathaway (BRK.B) at 3.10 percent of assets, UnitedHealth Group (UNH) 2.87 percent, Johnson & Johnson (JNJ) 2.62 percent, Exxon Mobil (XOM) 2.60 percent, JPMorgan (JPM) 2.27 percent, Procter & Gamble (PG) 2.00 percent, Chevron (CVX) 1.81 percent, Eli Lilly (LLY) 1.78 percent, AbbVie (ABBV) 1.60 percent and Pfizer (PFE) 1.58 percent.

VTV has a beta of 0.90 and a standard deviation of 20.50, compared with 0.94 and 21.75 for the category, making it slightly less volatile than the competition.

Performance
VTV has 1-, 3-, 5- and 10-year annualized returns of negative 2.23 percent and positive 8.66 percent, 8.37 percent, and 11.77 percent.

It has outperformed the category and index in every period.

Vanguard Mega Cap Value (MGV)
Vanguard Mega Cap Value has almost the exact same performance as VTV, with 1-, 3-, 5- and 10-year annualized performance of negative 1.82 percent and positive 8.71 percent, 8.69 percent and 11.87 percent.

MGV is slightly more expensive, with a 0.07 percent expense ratio, and this impacts the 30-day SEC yield, which is slightly lower, at 2.44 percent.

The top 10 holdings in MGV are identical to VTV, but with different weights. MGV’s top holding was UnitedHealth Group at 3.52 percent of assets, and the tenth holding, Pfizer, had 1.93 percent as of November 30. MGV is the more concentrated fund, with more assets in the largest companies. As a result, it has an average market capitalization of $158 billion.

MGV also has more assets in healthcare, at 25 percent of assets, almost 3 percentage points more than VTV, but the other sectors are similar. Performance shows this difference in healthcare hasn’t had a large impact on returns going back as far as 10 years. On the plus side, MGV has slightly lower volatility, thanks to its larger market capitalization. Investors aiming for low volatility may prefer MGV for this characteristic; otherwise, VTV has a slight edge on expenses.

Outlook
Value won 2022 because losses were concentrated in growth stocks. Value investors didn’t see large gains unless they placed hefty bets on the highly volatile energy sector. Otherwise, their outperformance was driven by what they didn’t own.

The factors that drove growth losses last year, such as inflation, higher interest rates and deglobalization, are positive for value stocks. Unless those factors reverse, value stocks will have an edge no matter whether the broader stock market rises or falls. If inflation and rates go higher than expected, losses will again be concentrated in technology, while a shift into a stronger economy will benefit earnings at industrial companies. One major industrial stock and DJIA component, Caterpillar (CAT), has already made a new all-time high in 2023. Conversely, Apple opened the year with a new 52-week low.

Broad value funds such as VTV can serve as core holdings within a diversified portfolio. Investors using value funds are most at risk of being overweight healthcare or financials if they hold separate sector funds in these areas. Unless an investor has all their portfolio in value funds, they probably aren’t very overweight energy or materials. Aggressive investors who want a little more risk probably have room for a small additional position in sector funds such as Vanguard Energy (VDE), but with a bearish outlook at the start of 2023, it may pay to wait some months before buying.

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Fidelity Equity Dividend Income (FEQTX) was one of many value-oriented funds that were outperformers in 2022. Diversified funds that had low technology exposure finished the year with small losses and even gains in many cases. Lack of exposure to mega-cap technology stocks along with avoiding speculative companies with little to no profits was half the battle. The other was having some positive exposure in the few sectors and subsectors that outperformed, such as energy and large-cap pharmaceuticals.

FEQTX’s current crop of top-10 holdings benefited most from the more than 80 percent rally in shares of Exxon Mobil (XOM). Higher oil prices and high inflation, plus low share prices coming out of the 2020 pandemic, helped power energy stocks last year. Consumer staples and healthcare were strong as well. Merck (MRK) was up 50 percent and Bristol-Myers (BMY) 20 percent. Johnson & Johnson (JNJ) had a small gain on the year, while Unilever (UL) saw only a small loss. These wins offset losses in holdings such as Cisco (CSCO) and Comcast (CMCSA).

Heading into 2023, the big debate is over economic growth. Inflation will fall because the first half of the year in 2022 contributed almost 5 percentage points of inflation. As long as inflation doesn’t suddenly reverse higher via geopolitical risk such as escalation in Ukraine, inflation should be far lower next year. Over the past six months (estimating December’s rate), the CPI increased 1.2 percent. If the trend carries into June, the CPI would fall to around 2.5 to 3.0 percent by then. This could dent holdings such as Exxon that rely on higher commodity prices, but the bulk of FEQTX’s portfolio is in dividend-paying blue-chip stocks. As inflation comes down, interest rates will stabilize or even decline.

The economy’s direction is more hotly debated. There are signs growth is slowing in areas such as manufacturing and housing, but overall economic growth remains solid. Surveys show employers report wage pressures and lack of skilled labor. Federal Reserve officials have singled out the surprisingly strong labor market as one reason why interest rates will remain higher for longer. Consumer spending has been robust. The yield curve is inverted, but it usually doesn’t steepen until the Federal Reserve starts cutting short-term interest rates. Finally, if we look at the stock market as a forward indicator, stocks such as Caterpillar (CAT) traded at new all-time highs in December. The market clearly thinks there will be rising demand for industrial products next year.

Funds such as FEQTX will do well in either of the most likely scenarios. A continuation of high inflation, higher interest rates and a strong economy will favor value stocks over growth. If all these trends reverse, investors will still favor dividend-paying stocks with strong financials over speculative growth stocks.

FEQTX is well positioned for variable outcomes because it has broad sector exposure. Financials is the largest sector at nearly 19 percent of assets but underweight relative to the benchmark Russell 3000 Value Index. Healthcare is next with 15 percent of assets. Blue-chip drug makers are a major subcomponent within the healthcare exposure. Along with Johnson & Johnson (JNJ), these stocks have earnings that are about as close to “recession proof” as companies get.

Technology is overweight at 13 percent of assets compared to the benchmark but still about half the exposure of the broader market. FEQTX also owns a different mix of technology stocks as represented by top holding Cisco. Energy is underweight at 6 percent of assets versus nearly 9 percent in the benchmark.

Overall, FEQTX leans toward the “growth” side of value with holdings such as pharma and tech stocks with high dividend yields. This makes it a good companion to more pure value funds that may overload the energy and materials sectors.

Management

John Sheehy has managed FEQTX since April 2017. He also manages Fidelity Stock Selector Large Cap Value (FSLVX).

FEQTX has an expense ratio of 0.58 percent. It has a turnover rate of 47 percent, down from 71 percent in the wake of the March 2020 market panic.

FEQTX paid a capital gain worth 5 percent of net asset value last year, 9 percent in 2021, 6 percent in 2019 and more than 11 percent in 2018. This fund should be held in a tax-advantaged account if minimizing taxes is part of your financial plan.

FEQTX earned a 3-star rating from Morningstar.

Portfolio

FEQTX has an average market capitalization of $54 billion, about half that of the Large Value category. It has fewer holdings in giant-caps and more in mid-caps. Compared to the average Large Value fund, FEQTX has about 14 percentage points less in giant-caps and 4 percentage points more in large-caps. Although only 5 percent of assets, the fund is also overweight small-caps relative to the category and index. Compared to the index, FEQTX has 20 percentage points lower exposure in giant- and large-cap holdings at 60 percent versus 80 percent for the index.

The top-10 holdings as of October 31, 2022 were Wells Fargo (WFC) 3.0 percent, Johnson & Johnson (JNJ) 2.9 percent, Unilever (UL) 2.9 percent, Exxon Mobil (XOM) 2.8 percent, Verizon (VZ) 2.4 percent, Sanofi (SNY) 2.2 percent, Bristol Myers Squibb (BMY) 2.2 percent, Cisco (CSCO) 2.1 percent, Merck (MRK) 2.1 percent and Comcast (CMCSA) 2.0 percent.

FEQTX is highly diversified, with its top-10 holdings accounting for only 24.6 percent of assets.

FEQTX has a beta and standard deviation slightly below that of the Large Value category.

Performance

As of December 27, FEQTX was down 0.91 percent in 2022. Over the past 1-, 3-, 5- and 10-year periods, it decreased an annualized 0.36 percent, then rose an annualized 6.95 percent, 6.99 percent and 10.30 percent, respectively.

FEQTX beat the Large Value category in all periods except the past 10 years, when it trailed by an annualized 0.10 percentage points. However, only about half of this period was managed by the current manager. Sheehy’s performance since taking over in 2017 has been excellent.

Outlook

Value funds outperformed greatly in 2022, and the conditions supporting their outperformance should continue. Fidelity Equity Dividend Income holds many “defensive” stocks that typically hold up better in bear markets. After a year in which some top holdings climbed more than 50 to 80 percent, another year of such strong performance is unlikely.

Economic and financial market conditions favor value stocks unless and until interest rates and inflation head back toward zero, something that won’t happen without further underperformance by growth stocks first. The best-case scenario for value stocks this year would be higher than expected inflation coupled with higher than forecast economic growth. Higher interest rates would trim growth stock valuations, while higher inflation and growth boost corporate earnings in the energy, materials and financial sectors.

Investors who want similar performance with a cheaper, more liquid fund can opt for Fidelity Stocks for Inflation (FCPI). The fund has a 0.29 percent expense ratio and 1.57 percent yield. FCPI outperformed FEQTX the past year as inflation took off because its portfolio is more fine- tuned for inflation. Since we expect inflation will drop at least in the first half of 2023, FCPI should have a smaller lead or even trail FEQTX in the first half of 2023. However, long-term investors who expect higher inflation in the coming decade may prefer building a position in FCPI for its inflation-oriented holdings.

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