Playing It Safe Didn't Pay Off Last Quarter

Just a week before the end of the third quarter, the little-known Mutual of Omaha Growth Fund seemed headed for glory. The fund looked as if it would be one of the third quarter's top 10 performers, having climbed a fat 20% during the summer, nearly four times as much as the average growth-stock fund. Like several of the third quarter's best mutual funds, Mutual of Omaha Growth's strong performance was driven by a heavy dose of health care stocks. One in particular, SciMed Life Systems, accounted for 15~ of every dollar invested in the fund.

But on Sept. 26, SciMed shocked Wall Street by announcing that, because of patent challenges, it might discontinue a popular line of angioplasty catheters used to treat cardiovascular disease. The stock plunged 30 points, or 34.5%, to 57, and fell a further 6 1/2 the next day. Over the same two days, the net asset value of the Mutual of Omaha Growth Fund dropped 7.6%. Although blindsided by the company's announcement, portfolio manager Eugenia Simpson stood resolute and didn't dump a single share. "The selling was overdone," she says. "What the company disclosed was a worst-case scenario. Long term, I'm not at all concerned about SciMed."

Even with SciMed's plunge, Simpson has no reason to apologize to the fund's shareholders. She missed the top 10, ending the quarter as No. 150. But she more than earned her keep. Her 11.7% return compared favorably with the 7.54% for the average diversified mutual fund and 5.31% for the Standard & Poor's 500-stock index. But the experience is a sober reminder to fund managers and investors that the higher you go, the further you can fall.

This hoary maxim is relevant to many of the quarter's high-ranked funds. Their gains come from stocks that have been on the move for some time, not from some long-depressed sector of the market that recently sprang to life. In addition to health care, they include funds that specialize in technology companies, that focus on small companies, and that pursue aggressive investment strategies to achieve so-called maximum growth. Responding to the dramatic fall in interest rates, financial-service funds also thrived during the quarter--as they have for most of the year. While these winning funds are not generally expected to make dramatic moves in a southerly direction, they are not invincible, either. There will likely be more nasty surprises along the way--if only because expectations are high.

HEALTH KICK. "We're up over 90% for the year," observes Kenneth J. Oberman, who runs the $103 million Oppenheimer Global Bio-Tech Fund. And nearly half of that gain came in the third quarter. "We're certainly not going to see another 90% in the next nine months. The risk-reward ratio is higher now."

Many of the hot companies that propelled the health care and technology-sector funds also gave the better-performing diversified funds their zip. For instance, four health care stocks in the Hartwell Emerging Growth Fund--Continental Medical Systems, Datascope, Invacare, and NovaCare--all appreciated between 50% and 55% during the quarter, helping portfolio manager John M. Hartwell build a fat 27% return.

In like manner, veteran Denver money manager William M. B. Berger is savoring the big hit the $75 million Berger 100 Fund made on Immune Response. Since he bought into the biotech company on July 23, the stock has zoomed more than 200%. The Berger 100 Fund racked up a 22.58% return for the quarter. The tiny $4 million Berger 101 Fund, a growth-and-income vehicle, did nearly as well.

While small funds investing in small stocks dominate the top-performers list, there were some notable exceptions. The CGM Capital Development Fund, up 24.56%, looks for companies with market values of $400 million to $2 billion, but portfolio manager G. Kenneth Heebner seeks good opportunities in bigger stocks. His largest holding--and one of his best--is Philip Morris. "My investment is up tenfold," he says. "And I've never sold a share." Including the dividend, Philip Morris was up nearly 18% during the quarter.

SMALL WONDERS. For all the successes of the aggressive equity funds this year, most of the new money is flowing into more conservative funds. Growth-and-income funds, for instance, raised $22.1 billion in the first eight months of the year, vs. just $9.6 billion for aggressive funds. Observers offer conflicting explanations. Some argue that investors, who habitually chase the hot fund of the day, now seem to be realizing it's best to take a longer-term view. Others argue that investors are still chasing hot funds--not this year's winners but those that racked up the biggest gains over the past decade: funds loaded with blue-chip companies. Since 1983, large-capitalization stocks have left emerging growth and small-company stocks in the dust.

Although small funds and small stocks continued to grab the spotlight, big funds didn't do badly over the summer, either. Of the 10 largest mutual funds (as measured by asset size on June 30), six beat the S&P 500 during the quarter. Fidelity Magellan Fund, twice the size of the next-largest fund, outdistanced the other monster funds, with a 9.06% return.

Still, continued strength in secondary stocks--the Russell 2000-stock index delivered an 8.16% return in the third quarter--suggests that funds specializing in small companies are the place to be. In recent years, for reasons nobody has explained, small-cap stocks have tended to surge in the first half, then collapse in the second. But this year, the small caps are still on a roll.

Some analysts argue that in a slow-growth economy, small companies with well-defined market niches will do better than larger companies, which are more at the mercy of broader economic trends. "You want to have stocks with earnings visibility when you're unsure about the shape of an economic recovery," says Ronald Worobel, who runs the $68 million MainStay Capital Appreciation Fund and the $167 million New York Life Institutional Growth Fund. Among his holdings are Centocor, a biotech company; Conseco, an insurer; House of Fabrics, a specialty retailer; and Microsoft, the software giant.

GOLDBRICK. Although 59%, more than usual, of the funds beat the market in the third quarter, there w fraction of Western estimates could kick much life into gold share prices. Precious-metal funds accounted for 31 of the quarter's 50 worst funds. Other losers were like gold: inflation-sensitive natural-resource funds. International funds focusing on Canada and the Far East rounded out the worst-performers list.

At the moment, top-performing fund managers are selling some of their winners to lock in gains and seek out new winners. "What money I raise I put right back to work," notes Stuart Roberts, who runs the Montgomery Small Cap Fund. "There are lots of underresearched and thus undervalued companies out there." To him and other managers, the streak of superior performance by small companies--and the mutual funds that invest in them--is far from over.