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"Small Caps Are Currently Very Cheap"

The stock market may continue to face headwinds as companies report poor earnings -- but it's a good time to be aggressive with small-cap stocks. Such is the opinion of Jeff Bernstein, senior vice-president and portfolio manager for ING/Pilgrim Funds. Bernstein co-manages the Pilgrim LargeCap Growth, Growth Opportunities, and MidCap Growth Funds and also works on the SmallCap Growth Fund.

Bernstein thinks the Federal Reserve's round of interest-rate cuts will finally succeed in turning the economy around. As an aggressive growth investor, he favors technology, biotech, and medical technology stocks, and he sees small-caps as particularly cheap today.

In addition, he points out that small-cap stocks historically do better than large-caps in economic recoveries. Among his favorites are BEI Technologies and Brooks Automation, and in biotech, Cephalon and IDEC Pharmaceuticals. Mid-caps he is not so high on these days. Those stocks were the best-performing last year, but he now says they look expensive.

These were among the points Bernstein made in a chat presented June 28 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Amey Stone of BW Online. Following are edited excerpts from the chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Jeff, stocks had a burst of energy today after the Fed acted yesterday and the Microsoft ruling. But can this energy be sustained?

A: Our best guess is that stocks will continue to run into a little headwind from the negative news flow in the earnings reporting season that will take place in July and early August...However, we do believe this is going to present one of the better buying opportunities that investors have seen in a long time...

There are a couple of reasons why we really believe [that] now is the time for people to get more aggressive in the market. While we are going through the last round of hand-wringing with regard to whether the Fed is pushing on a string, whether slowing international economies will drag us down, and whether the unsinkable U.S. consumer is finally full up on all potential products and services they might desire, we do believe that the Fed's accommodating monetary policy will make a big difference.

In the last century, aggressive easing by a central bank has only failed to turn around an economy twice. Once was in the Great Depression, and the most recent experience was Japan in the '90s. In both cases, there were major structural problems that prevented monetary stimulation from being effective. While there certainly is a unique set of circumstances taking place today, none should act as a complete deterrent to the eventual success of this monetary policy.

Q: The Microsoft decision today was big news. Were you surprised by it? And are there any stocks you own [or plan to buy] that you think will benefit from it?

A: We were not particularly surprised by the Microsoft decision, and the Street has widely anticipated that a Republican White House was unlikely to preside over a breakup of Microsoft. In addition to the matters of law that were at work here, suggesting that a breakup might not be beneficial to consumers and might be overreaching, Microsoft (MSFT) is one of the top holdings in our Large-Cap Growth Fund, and we are certainly pleased with the outcome of the trial.

Interestingly, I don't really view this as a major negative for any particular company, which speaks volumes to the question of the necessity of breaking up Microsoft at this particular point in the tech cycle.

Q: What stocks would you suggest an aggressive investor jump into as a buying opportunity now?

A: We are particularly bullish on small caps, as they have tended to outperform in economic recoveries. Small-cap tech stocks are looking particularly cheap now -- we favor a couple. I'll start at the beginning of the alphabet. We really like BEI Technologies (BEIQ), which makes yaw-rate sensors used in high-end automobile antiskid systems...

We also like Brooks Automation (BRKS), which is a semiconductor equipment manufacturer making robots that are the heart of the next generation of products from industry leaders like Applied Materials (AMAT) and KLA-Tencor (KLAC)...

Q: What's your outlook for second-quarter earnings? You hinted earlier that you thought we could be in for some more bad news.

A: Second-quarter earnings will be bad! I can speculate that the number will be down 15% overall for the S&P. Needless to say, it's going to be down enough to worry people. The outlook will not be particularly positive, due to a lack of any new traction in the U.S. economy and slowing economies in Europe and Asia, coupled with adverse currency fluctuations.

This is as bad as it gets. And the downturn is being exacerbated in many instances by the strength of the prior upcycle and tough comparisons that result....What investors need to keep in mind is that this decline in earnings is from historically high levels of profitability...while the comparisons look ugly, this economy is still operating at a very high level.

Q: You've talked about tech quite a bit -- are there other sectors where you see potential now?

A: We are quite enthusiastic about several other sectors, but as aggressive growth investors, we tend to gravitate toward medical technology, biotech, and technology companies due to their excellent long-term growth prospects The '90s was the decade of technology. We think that this is the decade of biotechnology. Some of our favorite stocks in biotech today...include Cephalon (CEPH), whose Provigil was approved for the treatment of narcolepsy but is finding a great deal of off-label uses, including fighting drowsiness in shift workers, military personnel, and sufferers of a syndrome called sleep apnea. The company is seeking approval for the product in fighting depression, which would expand its market very significantly.

We also like IDEC Pharmaceuticals (IDPH), whose Rituxan is being used for the treatment of low-grade non-Hodgkins lymphoma and is being used 50% of the time off-label for medium and severe lymphoma. It's looking like this is potentially a multibillion-dollar drug.

Q: Jeff, you may well have a bias in this regard, but what's your outlook for small- and mid-caps vs. the large-cap stocks?

A: As I was saying earlier, small caps have tended to outperform large caps during economic recoveries, and we're very bullish on small caps for several other reasons. They tend to do well in a strong dollar environment, and...when investors' taste for risk is increasing. As risk tolerance is nearly zero, we think it has only one way to go. The new supply of small caps has dried up with the IPO market, and a very large number of small caps are being eliminated from the market as the dot-bomb fallout continues.

Small caps are currently very cheap -- by our calculation selling at a p-e-to-growth ratio of 50 on 2002 earnings, which may in fact have been cut back too much. Historically, this level of valuation has led to significant upside over the next 12 to 18 months.

As we are uncertain as to the vigor and trajectory of the expansion that is to come, we favor small caps for their ability to grow during times when there is no set of explosive growth trends that are big enough to drive large-cap growth stocks Lastly, small-cap companies are demonstrating in this downturn that the survivors are better managed than ever. In many cases, their balance sheets are coming through this better and their profits are hanging in better than the biggest and most respected companies...

Mid-cap stocks distinguished themselves last year as a safe haven for investors who hoped to park money in companies that were big enough to withstand the economic slowdown, yet small enough to grow through it. As a result, this sector, which was the best-performing last year, looks fairly expensive vs. small caps and even large caps, and we are less enthusiastic on mid-caps generally.

Q: How have the funds you manage been doing?

A: I co-manage the Pilgrim LargeCap Growth, Growth Opportunities, and MidCap Growth Funds. I also work on our SmallCap Growth Fund...Our performance year-to-date has been abysmal as a generality -- being aggressive growth-fund managers and having stuck to our discipline of buying only the highest-potential growth companies....[but] since the bottom in the stock market, our funds have rebounded smartly. On days like today, where the market has rallied, we are significantly outperforming. And our small-cap fund is on track for top-quartile performance...

Q: Can you give us a quick rundown of the funds' top holdings in the small- and mid-cap areas? We have time only for a few highlights.

A:: In mid-cap, some large holdings include UTStarcom (UTSI), a provider of wireless local loop technology to mainland China; Laboratory Corp. of America (LH); IDEC Pharmaceuticals; and Cooper Cameron (CAM), a maker of oil field blowout preventers. In our small-cap funds, we like Microsemi Corp. (MSCC), Williams-Sonoma (WSM), The Wet Seal (WTSLA), and Spinnaker Exploration (SKE).

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