Mutual Funds: Don't Breathe a Sigh of Relief Yet

Value funds shine in a tough market. But for how long?

Beware of optical illusions. A two-month sprint that has lifted the Standard & Poor's 500-stock index by about 10% looks a lot like "the light at the end of the tunnel," says Richard Driehaus of Driehaus Capital Management. "But it might be a train coming from the other direction."

Yes, the market can play more tricks than just conjuring up speculative bubbles. The recent rally has some mutual fund managers--especially value mavens--worried that the market is overvalued and overly optimistic. Even though the outlook for 2001 profits and the economy is dire, the market will surge higher this year, says Jerry Jordan, president of Hellman, Jordan Management, which manages $1.2 billion in hedge funds and value stocks. "We're in a bull market that is driven by liquidity, not fundamentals," he says. "When the Fed stops easing, the economy will have to stand on its own. I have doubts whether it can."

The midyear message to investors: Don't be blinded by the bull. Most investors are slightly better off today than they were three months ago, but they're still losing money. In the first quarter, U.S. diversified equity funds lost 10.4%. Year-to-date through June 15, that loss has dwindled to 7.4%, vs. 8% for the Standard & Poor's 500-stock index (table). A recovery that began in April but faltered on high-tech profit warnings has confused investors. After yanking a record $20.6 billion from stock funds in March, they plowed about the same amount back into the riskiest aggressive growth and sector funds in April and May. Still, estimated net inflows through June total $33 billion, reports Investment Research, down 83% from $196 billion in the same period last year.

LEERY. About the only thing on an even keel these days is the performance of value funds, whose managers are adeptly sifting through the rubble. So far this year, small-cap value funds rose 9.6%, beating small-cap growth, down 11.7%; mid-cap and large-cap value funds are outdoing their growth peers by similar margins. And some value managers are outperforming their benchmarks by a mile: Boston Partners Small Cap Value II fund, Dreyfus Small Company Value Fund (closed to new investors), Franklin MicroCap Value, and Perritt Micro Cap Opportunities are all up 30% plus.

Sweat-the-small-stuff stockpickers were born cautious, so it's no surprise that many winners are leery of staging repeat performances. That's true even of play-it-safe growth managers who temper portfolios with low-key growth stocks: "The easy pickings were a year and a half ago," says J.B. Taylor, co-manager for the $1 billion Wasatch Core Growth Fund, up 25.6%, and one of three at its Salt Lake City shop in the top 50 of 6,509 screened by S&P. All three are now closed to new investors. Howard Mah, co-manager of Ameristock Focused Value Fund, says he isn't aiming for the stars, though he's up 49% through June 15, according to Lipper. Mah is happy with 5% earnings-per-share growth over three years from key picks such as Manpower and Dura Automotive Systems. His near-term prognosis? "The market will tread water."

If there are giant bargains, they're more likely in tiny stocks with market caps of under $200 million, says Bruce Baughman. He co-manages $2.6 billion in value stocks for Franklin Templeton, including the MicroCap Fund, up 32.7% so far this year. Stocks such as Cornell, an outsourcing company for prisons, and Hancock Fabrics, which trade at 5 to 6 times earnings, have soared 156% and 124%, respectively. William Lippman, manager of the Franklin Value Fund, prefers growth stocks disguised as value: D.R. Horton, a national homebuilder, has 94 consecutive quarters of earnings growth. "In a cyclical industry, that shouldn't happen," he says. "It acts like a growth company, but for our purposes it's value, because it's a bargain." The stock jumped to $21, double its 52-week low of last June. Franklin Value is up 14%.

ODDBALL. Many small-cap managers are also getting a boost from stocks formerly known as mid-caps. After Network Associates' market cap fell to $550 million from a $5 billion peak in March, 2000, Boston Partner's David Dabora moved in, buying at $6 a share. The stock now trades at about $11. Boston Partner's Small Cap Value II fund, which invests in companies with market caps of under $1 billion, has rung up 35% gains this year--the best diversified equity fund of 2001. The risk-averse Dabora has 130 stocks in 13 industry sectors; 84 have jumped 20% or more this year. Part of his strategy is knowing when to sell: After Advance PCS jumped to $62 from $35, regaining its mid-cap status, Dabora took profits.

Some oddball funds have managed stellar returns, too. Monterey OCM Gold is up 27.6%; the Matthews China fund is up 40.4%; and the Pilgrim Troika Dialog Russia Fund is up 49.5% (table). But over the past three years, these funds have on average lost money and veered from being leaders one quarter to laggards the next. More traditional funds that invest in companies with proven business models are still outperforming funds that buy untested startups. Tech and telecom fund losses--despite a gangbuster rally since Apr. 4--are ugly. A 22% spike in Nasdaq since its 52-week low two months ago hasn't hauled tech funds--dead last with 27.7% losses so far--out of their black hole. Telecom funds aren't far behind at negative 26%.

For the steely contrarian, this may be the time to buy. "If you have to lean one way or another, lean at the margin toward the most poorly performing sector in the last 12 or 24 months," says Gary Pilgrim, a 30-year veteran of momentum investing. His $3 billion, tech-heavy PBHG Growth Fund is underwater by 22% for the year. Other tech gurus are still willing to go way out on a limb. The Nasdaq has seen its low, reasons veteran manager Alberto Vilar, co-manager of the $150 million Amerindo Technology Fund. He forecasts a "huge rally that's going to blow [the Nasdaq] through 3,000," in the next six weeks and be a precursor to a new, stronger bull market in mid-2002. The reason: Business services will go through the same tech revolution that smokestack America did. Stocks such as Siebel (SEBL ), VeriSign (VRSN ), eBay (EBAY ), and Akamai Technologies (AKAM ) stand to gain. "Not to be optimistic about technology is crazy," says Vilar, whose fund has lost 69% since last June.

Among the best sectors of late has been health, including biotech--but it has had a bumpy ride. climbed almost 34% in the past three months, but still has a 31% loss for the year. "You get unwarranted lows and highs," says GenomicsFund manager Steve Newby. "It's a misunderstood arena." Skeptics say biotech is as much a bubble as the Internet, but Newby and others disagree. They argue that the industry's leaders have huge entry barriers, profits, and $1 billion-plus in cash.

Bonds are still providing shelter from stock volatility. The average tax-free bond fund had a total return of 2.28% through June 15, while taxable funds were up 3.01% (table). With lower interest rates and a slowing economy, total returns for government and investment grade corporates may have peaked. At least bonds shield against equity risk, says PIMCO's Paul McCulley. "Equity risk premiums are skyrocketing and corporate profitability is going to suck canal water," he says. "On a risk-adjusted basis, returns favor bonds." High-yield bond funds, while riskier than their peers, "is about the only place you can get yields approaching double digits," says Margaret Patel, who runs the Pioneer High Yield Fund. Defaults are on the rise, but mainly among telecom and the shakiest of companies, she says. Emerging Markets bond funds topped the charts with an 8.87% gain, but Michael Conelius of the T. Rowe Price Emerging Market Bond fund is bearish. A strong dollar, an energy rally, and low inflation have been short-run catalysts; political reforms overseas are still touch and go, causing concern, he says.

In the meantime, U.S. managers eager to dive deeper into stocks are keeping their eyes peeled for a bottom. Dresdner RCM's Brian Dombkowski, who runs $3.5 billion in mid-cap growth stocks, admits he may not know it when he sees it. "But at least every month we wait, we get a month closer to the turn."

By Mara Der Hovanesian

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