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Big Rewards from Smaller Stocks

By Richard Diennor The Reynolds Fund (REYFX) provided a home for shares of large companies when it began four years ago. Lately, though, portfolio manager Frederick Reynolds has been adopting small and midcap stocks -- a strategy that has been paying off for the fund that bears his name.

Reynolds' recent investments include many biotechnology and Internet outfits, which he envisions growing over the next 5 to 10 years and whose valuations after three down years look good to him. Earlier this spring, Reynolds bought stakes in Human Genome Sciences (HGSI) and Applera Corp-Celera Genomics (CRA), which use genetic research in developing drugs. Both are attractively priced, Reynolds says.

DOMINANT PLAYERS. Among Internet stocks, Reynolds bought giant Web portal Yahoo! (YHOO) and search engine Ask Jeeves (ASKJ). Their leading positions in the industry make them standouts, he believes.

Similarly, what appealed to Reynolds about wireless cell-phone maker Nokia (NOK) and home-improvement retailer Home Depot (HD), which hold the No. 1 and No. 2 positions in his portfolio, respectively, is their control of large chunks of their markets. "It's just really tough to compete against them," says Reynolds about Home Depot. The retailer generates more revenues than its rivals do, which gives it greater leverage with suppliers, he notes. However, Reynolds says he sold some of Home Depot stock this year because he needed to raise cash for other investments.

Although Reynolds is willing to buy any kind of stock, he prefers businesses whose top and bottom lines are fattening to those whose stocks are undervalued. "It's a fund for all seasons," he says of his portfolio, which typically numbers 70 stocks.

CHEAP AND FAST-GROWING. Annual earnings growth of 12% "is fine with me, if it's dependable," Reynolds says. The manager is also prefers sales growth over margin improvement because the latter can't expand indefinitely, he reasons. In addition, Reynolds keeps an eye out for outfits with little debt, and he tries to buy cheap shares. He hunts for stocks with a price-earnings ratio that's 1.5 times the company's earnings-growth rate.

Reynolds started the fund in September, 1999, and it generated annual losses of 40.7%, 33.4%, and 42% in its first three full years of operation. On an annualized basis, the fund shed 25%, compared to a 17% loss for the average large-cap growth fund for the three-year period ended in May. Reynolds says the fund fell victim to the same problems that undermined most stock funds during that period, including the bursting of the technology bubble, the recession, corporate scandals, and geopolitical jitters. "There was nothing out of the ordinary that drove this fund down...other than these basic things that hurt everybody else," he maintains.

Things have changed in 2003, however. The Reynolds fund was the best performer among large-cap growth funds this year through last month, returning 54.6%, compared to an 11.3% gain by its peers. The portfolio, ranked 3 Stars by Standard & Poor's, is also now twice as volatile as the average large-cap growth fund.

BOOST FROM TECH. Reynolds attributes the turnaround to his move into small and midsize companies and to the performance of his tech and telecom stocks, which together account for about 50% of the fund's assets.

These include Citrix Systems (CTXS), a software maker that holds fifth place in the portfolio and whose shares have returned about 150% since he first bought them last winter, Reynolds says. The fund has also gotten major contributions from semiconductor manufacturers Altera (ALTR) and Broadcom (BRCM), he adds.

Furthermore, he has stakes in chipmakers Intel (INTC) and Texas Instruments (TXN). Reynolds says he expects those types of businesses to prosper if the economy picks up steam in the second half.

He's equally optimistic about the stock market, which he believes will post a gain this year with help from the economic recovery. Stocks should also get a lift if corporations increase their capital spending, he argues: "It's not going to be straight up from here, by no means, but I think the market will be higher." Diennor is a reporter for Standard & Poor's Fund Advisor

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