Light at the End of the Tunnel?

Some fund managers are worried about valuations as 2002 kicks off. S&P says the best opportunities now are small- and mid-cap growth funds

Like many New Year's revelers, shareholders of the average domestic equity fund may be glad that 2001 is over. With the typical U.S. stock fund down nearly 11% last year, losses were widespread among domestic equity funds, ranging from a steep 21.6% average drop for large-cap growth funds to a modest 1.1% average decline for small-cap blend funds. Value clearly stood out last year, with the average small-cap value fund rising 13.7% and the average mid-cap value fund up 7.2%.

But the best news generally came last in 2001. A late-year market rally spurred a 14.7% gain in the fourth quarter for the average domestic equity fund, generating double-digit advances for all nine domestic equity style categories. This rebound stemmed from investor confidence that monetary and fiscal policies would spark an economic recovery in 2002, according to Rosanne Pane, a mutual fund strategist at Standard & Poor's.

The fourth quarter also saw growth investments regain the lead that value investments held earlier in 2001, although the rising tide in the fourth quarter lifted all boats. In part, growth stocks seem to have gained from the better prospects for the technology sector, traditionally a crucial growth segment. Investors apparently bid up technology issues on hopes that an improving economy would boost capital spending.

While the growth style sprinted past value in the fourth quarter, smaller-cap issues generally held up better than large-cap issues in 2001 regardless of style, due, in part, to smaller-cap's more attractive valuations. The discrepancy between large- and smaller-cap valuations widened considerably during the 1990s, when market enthusiasm pushed the price-earnings ratios of many large-cap growth stocks to record levels.

The valuation differential between large- and small-cap stocks has narrowed, "but it's still there," said Todd McCallister, manager of Heritage MidCap Stock Fund (HMCAX ). McCallister believes small-cap companies also have better prospects than large-cap companies because bigger companies tend to be more mature. Among small-caps, McCallister prefers companies in industries with high barriers to entry, because these companies generate high cash flows. "With high entry barriers, you don't have to constantly plow money into your business to keep your advantage," he said.

Cash flow is important to Eric Olstein, manager of Olstein Financial Alert Fund (OFALX ). "In 2001, people started to realize cash flow and valuations mattered, while in the 1990s, investors thought they were buying lottery tickets rather than stocks," Olstein said. He feels blowups, such as Enron Corp. (ENE ), increase the importance of accounting standards.

Robert Rodriguez, manager of FPA Capital Fund (FPPTX ), also looks for strong balance sheets. He characterized 2001 as "the year of the return to fundamental value rather than psychic value." The Internet bubble was largely responsible for "psychic value," according to Rodriguez.

Another fan of traditional investment criteria, David Corbin, manager of Corbin Small Cap Value Fund (CORBX ), looks for businesses likely to gain regardless of economic cycles. Although he takes a long-term view, Corbin said some of his holdings gained "sizzle" from the events of September 11. He points to Vtel Corp. (FORG ), a video teleconferencing company; Titan Corp. (TTN ), a defense contractor; and Thomas Nelson Inc. (TNM ), a Bible publisher.

THE OUTLOOK. September 11 showed that "you have to stay in the game," said Olstein. Despite the dislocations, Olstein feels the U.S. economy is still the strongest in the world. He believes investors with reasonable expectations will find that "value is always occurring somewhere."

Currently, small- and mid-cap growth funds offer the best opportunities due to attractive valuations and a history of providing the best returns coming out a recession, according to S&P's Pane.

While optimistic about the near term, McCallister says "it bothers me that the market multiples are still historically high." Looking ahead, McCallister sees "decent" growth for the market, but cautions, "don't bet on big increases of multiples."

Rodriguez also feels "valuations are getting ahead of themselves." This concern has prompted Rodriguez to raise his cash stake to 13% currently, from a low of 4% last September. He expects earnings disappointments to lead to market "difficulties" by the second quarter of this year.

Corbin is more optimistic, believing "we are in the top of the second inning in a multi-year run for the market in general and small-cap value in particular." For 2002, he predicts, "low single-digit" growth for the broad market and 15% to 20% growth for small-cap stocks.

With the economy set to rebound, Thomas Giles, manager of Dean Large Cap Value Fund (DALCX ), believes stocks could rise 20% this year, although high valuations will limit growth-stock appreciation to about 15%.

By Bill Gerdes at S&P FundAdvisor

Before it's here, it's on the Bloomberg Terminal.