CryptocurrencyInvestingBanksReal Estate

Stocks: Jeremy DeGroot of Litman Gregory picks the best of the best

November 8, 2011, 3:00 PM UTC

The mutual fund firm’s chief investment officer explains how to choose a mutual fund – and where to invest today.

Jeremy DeGroot of Litman Gregory

FORTUNE — Litman Gregory aims to be the all-star team of the mutual fund world. The firm, which has $6 billion in assets, scours the industry for top managers, then commissions each to run a mini-portfolio for its Masters funds. The roster includes such standouts as Oakmark’s Bill Nygren, FPA’s Steven Romick, and DoubleLine’s Jeffrey Gundlach, to name a few. Litman Gregory’s biggest fund, Masters International (MSILX), has returned 7.7% a year since 2001, beating its benchmark index by 2.2 percentage points annually.

The company’s chief investment officer cum talent scout is Jeremy DeGroot, who explains how he evaluates fund managers and why his star investors are bullish on large-cap stocks and emerging markets. Edited excerpts:

Q. Litman Gregory specializes in finding talented fund managers. What qualities should investors look for?

A. We like to find managers who have a track record of success. We look at how they’ve performed in different market environments and economic cycles. Ideally you have a 10-year track record, though we’ll look at investors with five.

But there’s a real danger in relying on performance — it’s just a starting point. We also look at their willingness to underperform over short or medium time periods if their process is out of favor. We look at whether they’re sticking to what they know and believe in and what has been successful over time.

One example is David Herro, a Masters manager who runs the Oakmark International Fund (OAKIX). He has a very successful long-term record but has had significant periods of underperformance. He’s been a heavy investor in European large-cap companies, and he owns some European financials, which are among the most hated stocks out there. He believes the value of a company isn’t driven by the next quarter’s earnings, but by long-term cash flows. He’s extremely disciplined.

Stocks have been struggling the past few months. Does that mean they’re now cheap?

We believe there’s still a risk of a major deleveraging cycle because of the massive debt buildup. We think the S&P 500 is 15% to 20% higher than its fair value, though as the market has come down, there are more individual stock-picking opportunities.

One theme our managers like is large-cap stocks. High-quality multinational companies are undervalued relative to small-cap companies. A couple of our managers own Dell (DELL). It’s obviously very out of favor, but they feel it’s a high-quality business, and it gets a significant percentage of its sales from outside the U.S.

Some have also shown conviction in certain U.S. financials. One example is Bank of New York Mellon (BK), which is one of the largest asset custody businesses. They’d be a big beneficiary of a rise in interest rates, which have been a depressant on their profits with the T-bill at zero. That’s a stock held by Ken Feinberg and Chris Davis of Davis Advisors. They think it’s extremely undervalued.

Have emerging markets been beaten down too far?

In late September the emerging-markets index dropped 6% in one day after declining for a couple of months. Our analysis suggested that over the next five years emerging-markets stocks could achieve 12% annualized returns. For Litman Gregory’s clients, we invested in Vanguard’s Emerging Markets ETF (VWO).

Among our managers, there is a theme of trying to benefit from the growing emerging-markets middle class and rise in consumer demand. That doesn’t mean buying Petrobras or a commodities producer, but trying to find businesses that sell to local customers. One of our managers owns a company in China called 51job (JOBS) that is essentially like the (MWW) of China — there’s a huge opportunity.

Can bonds continue to outperform?

There’s no way the aggregate bond index can continue to perform over the next three to five years the way it has over the past 10 years. With yields at about 2%, the math is almost impossible. If interest rates don’t change, you’ll return about 2% a year; if interest rates increase, you’ll return less. It’s pretty obviously unattractive.

Our approach has been to allocate some of our investments to high-quality bonds to provide downside protection. But we’ve looked more to flexible bond funds that can generate returns from different sectors and don’t just depend on falling interest rates. Pimco Unconstrained Bond Fund (PFIUX) is one. It’s able to implement Pimco’s secular views more aggressively than the Total Return Fund (PTTRX). It has exposure to corporate bonds, high-yield credits, and mortgage-backed securities.

The market seems to be dominated by macroeconomic forces these days. Can stock picking prevail?

The correlation among stocks has hit an all-time high. So when all stocks are going up or down together, individual stock picking isn’t going to be effective. Macro headlines are driving entire asset classes. But over the long term, the value of businesses will be driven by their fundamentals or their ability to grow their assets and allocate capital, and the market will accurately reflect that.

This article is from the November 7, 2011 issue of Fortune.