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A Stirring in Growth Stocks?

Stocks should go up as much as 5% this year, with small- and mid-cap issues faring better than their larger cousins, says Arthur J. Bonnel, portfolio manager of the U.S. Global Investors Bonnel Growth Fund (ACBGX). He sees investors moving back into growth from value stocks as the economy warms up, and he adds that if the trend continues, "it could be a fun year."

Health care, retailing, and food are the three groups Bonnel likes best now, largely because of the demographic swing toward the swelling ranks of older people. In retailing, he leans to discount and specialty retailers -- big names such as Wal-Mart and Kohl's are overvalued now, he thinks. And in food he likes Whole Foods Market and United Natural Foods.

Among the success stories of his fund, Bonnel points to JDS Uniphase, which the fund bought at $5 in 1998, started selling at $120, and got completely out at $100. But he cautions that he has been wrong in his picks about 40% of the time.

Bonnel's comments were made in a chat presented Mar. 21 by BusinessWeek Online on America Online. He was replying to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Art, the market seems to sag almost as often as it spurts. What's your reading?

A: Our outlook is very positive for the market. We believe this year will be very positive for equities -- with growth in the 3% to 5% range, which should bode well for companies in most industries this year. However, we're still not bullish on technology. Corrections, we feel, should be viewed as an opportunity. So it's two steps forward, and maybe one step back at times.

Q: Smaller stocks have been doing better than larger caps lately. Do you think small- and mid-caps will continue to outperform, and why would they be a good choice now?

A: We do feel that the small- and mid-cap arena will be the place to be this year. They should outperform large caps by the magnitude of 1.5- to 2-to-1. Small- and mid-caps have the flexibility to make instantaneous changes in relationship to their company, which gives them the opportunity to take advantage of a changing market for their products. Therefore, they tend to bounce quite nicely. Historically, they outperform at the beginning of a bull market and as the economy turns.

Q: What themes are you following with the small- and mid-caps? Any favorites to name?

A: There are three areas we like: Health care, retailing, and the food group. The reasoning behind this revolves around demographics. This year, 350,000 people will turn 50 years old each and every month. That bodes well for health care, from hospitals to drug companies to the biotech arena.

In the retailing arena, as people get a little older, they tend to become a little more conservative and tend to do shopping in discount chains like the Wal-Marts (WMT) and Target (TGT), and there, we also see an opportunity. The third category I mentioned is food. As people get older, they tend to want to eat better. Two stocks we like in the food business are Whole Foods Market (WFMI) and United Natural Foods (UNFI).

I would like to mention that we're monitoring these companies carefully, and if we see anything we don't like, we will immediately recommend selling these issues. And the names I mentioned are not necessarily recommendations to buy these stocks.

Q: [In retail,] what's your opinion about Kohl's (KSS), Wal-Mart, and Kmart (KM)?

A: Kohl's is acting very well in today's market. However, the stock is selling at a p-e of almost 50, which makes it very risky -- a retailer selling at 50 times earnings. Can earnings grow that fast? We tend to doubt it. However, investors are looking for consistent earnings growth, and Kohl's seems to have that. So I'd say: Great company, but too pricey for us. The same caveat applies to Wal-Mart, which is trading at a 42 p-e. Technically, both companies look very good -- but be careful because of the valuation.

As far as Kmart goes, a bankruptcy takes five to seven years to work out. It could be a great buy at this low price. But there's a risk that you could lose all your money with a retailer in bankruptcy.

Q: What are your favorites in that sector?

A: We like the specialty and discount retailers. We mean the 99 Cents Only Stores (NDN), Hancock Fabrics (HKF), Dollar Tree Stores (DLTR), Ross Stores (ROST), and issues similar to that. We feel the larger retailers are under a lot of competition from the very aggressive smaller retailers. You have to be careful in retail, but it's worth being in right now. A lot of companies are doing extraordinarily well. We own the aforementioned stocks. And we're hoping to hold them for many more quarters, assuming that they continue to meet our criteria.

Q: Outlook for Citigroup (C) as a growth company?

A: Well, on Citigroup, we see it partially as a growth company, but don't be surprised if it underperforms a little because of its huge size. Hopefully, it will be nimble enough to raise interest rates faster than rates are being raised, which could make it one of the leaders in the money-center banking industry.

Q: I was interested in purchasing shares of Steak n Shake (SNS). Any comments?

A: For those unfamiliar with the company, it owns 330 restaurants in the Midwest and Southeast. It has had a good run this year, from 10 to 14 a share, which shows some potential. Volume seems to be picking up as the stock appreciates. This also is a positive. Earnings have been growing, and this one does look attractive. Also, SNS has a low debt level, which is another positive.

Q: You mentioned the food group -- any comments on Kraft Foods (KFT)? Is it overvalued?

A: Kraft is an excellent company. It could be overvalued right now, with a p-e of 34. Earnings for this year look as though they'll grow dramatically. But in 2003, earnings could slow down into the 10% range. A stock with a p-e of 34 and growth of only 10% makes it vulnerable. It could head higher, but you really have to be careful in this kind of situation.

Q: What do you think of United Technologies (UTX) for an IRA investment?

A: It looks very attractive for the short and long term. It's a wonderful company with good management. The stock is selling at a reasonable level. The p-e is 18. Earnings growth should continue for quite a few years. UT is in the defense business. And with this Administration looking to build up military might, that's a positive for this stock. Keep an eye on earnings: Make sure they don't go down with this company. Assuming they don't, it should be an attractive holding for an IRA.

Q: What's your opinion of Freddie Mac (FRE) as a long-term hold?

A: We feel that Freddie Mac and Fannie Mae (FNM) will be good long-term investments. If you have a superlong horizon, they should really treat you well. I would consider them very safe stocks.

Q: Will Tyco (TYC) bounce back to the $60 range this year, or is it in trouble?

A: On Tyco, we don't see it bouncing back to $60 this year. There's too much overhead supply in the stock, and we think there are better issues elsewhere. What you're trying to catch with Tyco is a falling knife. Sometimes that works, sometimes it doesn't work. As a fund manager, I'm not going to commit any of our capital at this time to Tyco.

Q: Art, in the years you've been running your fund, what have some of your success stories been? What are the latest?

A: Thanks for the question! I like to talk about my winners, because we also have so many losers. Historically, we're right 60% of the time, which means we're wrong 4 out of 10 times. Let me say we bought JDS Uniphase (JDSU) at $5 a share in '98 and started liquidating when it was trading at $120. We got totally out at around $100. But we do get caught periodically with stocks that come out with bad news. There are so many that I'd rather not name them. We've had more winners than losers, but it's hard to rack up prodigious gains in this environment.

Q: Any opinions on IBIS Technology (IBIS)?

A: If you bought it after 9/11, it was at $4 a share, and now it's about $14. So clearly investors are feeling comfortable and confident about the product here. The stock is acting very well, so this could be a big gainer. However, this company is not making money. And we have a methodology that says we only buy stocks that are making money. Once it starts making profits, we'll look at it.

Q: Art, there's growing concern about rising interest rates. What's your forecast?

A: My forecast on rates is that we see the Fed raising once, perhaps twice this year. However, short-term rates are so low that we do feel the Fed will raise them as the economy recovers. As far as long-term rates (the 10- to 20-year rates) go, we don't see them moving a lot higher. And that formula will not have a big impact on stocks or the economy. It also won't put a damper on our economic rebound.

Q: Is Cisco Systems (CSCO) a keeper?

A: We hope so. We think it's a good company, but we don't know how well it will do over the next three to five years. On a technical basis, the stock hit a high of 82 in 2000. And we're now down to 16. There are so many investors out there who want to break even. We aren't aggressive. We don't feel the company will go out of business, but the tech area is extremely competitive, and anything can happen right now.

Q: Art, what's your strategy of choice now? Are growth stocks going to outdistance value stocks again?

A: In a word, yes. Value had its day in the sun. Growth was out of favor for 2 1/2 years. So it's probably time for growth to come back. We've noticed it with the action of our fund. It shows us that investors are moving back into growth. We're keeping our fingers crossed because if that's the case, we could have a fun year.

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