Many investors may think now is the right time to buy the drop in tech stocks. Proceed with caution. Many tech stocks, despite significant declines, still have a lot to fall. We identified a technology-focused All Cap Growth Mutual Fund with an investment methodology that looks good on paper but failed in execution. Our in-depth analysis of the fund’s holdings reveals a portfolio that underperforms its benchmark and the S&P 500. Franklin Custodian Funds Dynatech Fund (MUTF:FKDNX) is in the danger zone.

Prospective research makes a difference (very unattractive)

Our fund research differs from traditional fund research in that it is forward-looking and based on bottom-up fundamental research on each individual fund portfolio. Most legacy fund research is retrospective as it is based on past price performance.

Figure 1 shows how different our forward-looking fund ratings are from Morningstar (MORN). We rate FKDNX as very unattractive (equivalent to 1 star from Morningstar), while Morningstar gives FKDNX, along with three of its other classes (FDTRX, FDYZX, FDNRX), its 4-star rating. FDYNX gets a 3 star rating.

Figure 1: Franklin Dynatech fund ratings

Sources: New Constructs, LLC, Company, Mutual Fund Filings and Morningstar

Solid methodology on paper, poor execution on the ground

Similar to ARK Innovation Fund (ARKK), Franklin Dynatech Fund has an attractive investment methodology on paper. The fund’s annual report notes that fund managers use “bottom-up fundamental research to seek out companies that meet our criteria for growth potential, quality and valuation.” Managers believe that the key attributes of “quality” are:

• experienced and talented management teams
• financial strength reflected in:
  • gross and operating margins
  • free cash flow generation
  • returns on capital employed

We would generally applaud the use of fundamental data, free cash flow generation and return on capital employed, especially since improved return on capital employed (similar to return on capital employed) is directly correlated to the improvement in shareholder value.

However, stating a methodology and successfully executing such a methodology are not the same, and our rigorous analysis of holdings reveals that the methodology stated by FKDNX does not translate to its actual portfolio.

The fund invests in companies with a lower ROIC, negative cash flows and higher valuations than its benchmark and the S&P 500. More details below.

Stock research reveals poor ‘quality’ portfolio

Our rigorous analysis of holdings, powered by our Robo-Analyst technology, reveals that FKDNX holds stocks of much lower quality than its benchmark, iShares Core S&P US Growth ETF (IUSG) and the market, represented by State Street SPDR S&P 500 ETF (SPY).

According to Figure 2, FKDNX allocates 32% of its portfolio to unattractive or lower-rated stocks, compared to just 7% for IUSG. On the other hand, FKDNX’s exposure to attractive or better rated stocks is much lower at 15% versus IUSG at 30%.

Figure 2: The Franklin Dynatech fund is allocated to stocks far worse than IUSG

Sources: New Constructs, LLC, company, and ETF and mutual fund filings

Our holdings analysis also reveals that FKDNX’s portfolio is much lower quality than the S&P 500. According to Figure 3, FKDNX allocates 32% of its portfolio to unattractive or lower-rated stocks, compared to only 13% for SPY . On the other hand, FKDNX’s exposure to attractive or better-rated stocks is much lower, at 15%, versus SPY at 36%.

Figure 3: Franklin Dynatech fund is allocated to stocks far worse than SPY

Sources: New Constructs, LLC, company, and ETF and mutual fund filings

Given the unfavorable allocation of attractive or higher-rated stocks versus unattractive or lower-rated stocks relative to the benchmark, FKDNX appears ill-positioned to generate the outperformance needed to justify higher fees.

Expensive stocks result in a very unattractive risk/reward rating

Figure 4 contains our detailed rating for FKDNX, which includes each of the criteria we use to rate all covered ETFs and mutual funds. These criteria are the same for our equity rating methodology because the return on a mutual fund’s holdings is equal to the return of a mutual fund after fees have been deducted. FKDNX’s very unattractive rating is primarily driven by holding stocks with high valuations.

Figure 4: Franklin Dynatech Fund Rating Details

Sources: New Constructs, LLC and Company, ETFs and Mutual Fund Filings

As shown in Figure 4, FKDNX underperforms the iShares US Large Cap Growth ETF and SPY in four of the five criteria that make up our holdings/portfolio management analysis. Specifically:

• FKDNX ROI is 30%, below IUSG’s 52% gain and SPY’s 33% gain
• FKDNX’s free cash flow yield of -1% lags IUSG and SPY’s at 2%
• the price to economic book value ratio for FKDNX is 5.6, which is higher than the 3.6 for IUSG and 2.9 for SPY
• our discounted cash flow analysis reveals an average period of implied market growth appreciation of 57 years for FKDNX holdings, compared to 33 years for IUSG and 27 years for SPY

Market expectations for FKDNX holdings are for earnings growth (measured by PEBV ratio) that is more than 5x current earnings and significantly above earnings growth expectations embedded in IUSG and SPY holdings, which are already more profitable.

Too expensive: high fees for mediocre holdings

At 3.03%, FKDNX’s total annual costs exceed 86% of the 459 All Cap Growth mutual funds covered. For comparison, the simple average APR of all All Cap Growth mutual funds covered is 1.64%, the asset-weighted average is 1.30%. IUSG only charges 0.04% and SPY has total annual costs of only 0.10%. Why pay higher fees for less stock selection?

Our TAC metric represents more than just the spend ratio. We take into account the impact of sales charges, exit charges, redemption charges and transaction costs. For example, FKDNX’s annual turnover rate of 19% adds 0.04% to its total annual costs, which is not taken into account by the expense rate. Figure 5 shows our breakdown of FKDNX’s total annual costs.

Figure 5: Distribution of total annual costs of the Franklin Dynatech Fund

Sources: New Constructs, LLC and Company, ETFs and Mutual Fund Filings

To justify its higher fees, FKDNX must outperform its benchmark by 2.98% per year over three years, the average holding period for all funds.

However, FKDNX’s 3-year quarter-end annual yield outperformed IUSG by just 21 basis points. Its quarter-end one-year return underperformed IUSG by 24.9%.

Given that 32% of assets are allocated to stocks with unattractive or worse ratings, and 77% are allocated to stocks with neutral or worse ratings, FKDNX looks likely to continue to underperform, including fees.

Gain an edge with asset-based fund analysis based on superior stock research

Smart investing in a mutual fund (or ETF) involves analyzing each of a fund’s holdings. Failure to do so is a failure to exercise proper due diligence. Simply buying an ETF or mutual fund based on past performance does not necessarily lead to outperformance. Only thorough research based on holdings can help determine whether an ETF’s methodology leads managers to choose high or low quality stocks.

Easily upgrade any fund, even FKDNX

As we showed in The Paradigm Shift to Self-Directed Portfolio Construction, new technologies allow investors to create their own funds at no cost while providing access to more sophisticated weighting methodologies. If, for example, investors wanted exposure to FKDNX’s holdings, but weighted by core income, the risk/reward ratio of this customized version of the fund improves significantly:

• 32% of assets in attractive or better rated stocks (compared to 15% for FKDNX)
• 4% of assets in unattractive or lower-rated stocks (vs. 32% for FKDNX).

Compare the quality of inventory allocation in our custom version of FKDNX versus FKDNX as is in Figure 6.

Figure 6: Franklin Dynatech fund allocation could be improved

Sources: New Constructs, LLC, corporate and mutual fund filings

Top Rated All Cap Growth Funds

Below, we profile five ETFs or all-cap growth mutual funds that score attractive or better, have more than $100 million in assets under management, and have below-average APRs.

1. Innovator IBD 50 ETF (FFTY) – 0.89% APR and very attractive rating
2. Vanguard US Momentum Factor (VFMO) – 0.14% APR and Attractive Rating
3. TrimTabs FCF US Quality ETF (TTAC) – 0.65% TAC and attractive rating
4. Delaware Growth Equity Fund (FICIX) – 0.91% APR and attractive rating
5. Delaware Growth Equity Fund (FICHX) – 1.00% APR and attractive rating

This article originally published on March 21, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, industry, style, or topic.