When Bad Things Happen to Good Value Plays

Clients of some of the largest fund houses--Alliance Capital Management, Wellington Management, and Fidelity Investments--could be in for a nasty surprise. Value managers at these firms normally bet on out-of-favor but fundamentally healthy companies. Now, they're stuck with something that looks more like a vulture play: big bets on some of the most vulnerable telecommunications companies.

In the first quarter, these firms jumped headlong into the cheap stocks and bonds of Adelphia Communications (ADLAC ), Qwest Communications International Inc. (Q ), and WorldCom (WCOM )--troubled, highly leveraged companies whose businesses were still considered viable. Lately, those bets look pretty bad. This quarter, Qwest reported higher-than-expected losses of $698 million, and its credit rating was cut to junk. WorldCom was cut from the Standard & Poor's 500-stock index on May 13, and its bond rating also fell to junk. The Securities & Exchange Commission and federal prosecutors are investigating Adelphia. Its CEO and chief financial officer resigned in May.

Now, investors are dumping the whole sector--the S&P telecom index is down 17% since Mar. 31, vs. 6% for the S&P as a whole. But those fund managers have little choice but to hold on and hope the companies turn around--or lose hundreds of millions for investors. Alliance, a unit of publicly traded French insurer AXA, bought 102 million shares of WorldCom and 117 million shares of Qwest. The stock was worth $2.3 billion on Mar. 31, but just $745 million as of May 22.

Three months ago, the buys may have looked like classic value plays. The stocks were 50% to 80% off their 52-week highs, as investors fled the sector. Still, few believed the companies were near collapse. "In the first quarter, these stocks looked overly punished," says William Harding, a Morningstar analyst.

Despite the recent turn of events, Alliance stands by its investments. "We believe the investments that we are now making in this area are laying the foundation for the next period of outperformance," says Lewis A. Anders, Alliance's vice-chairman and chief investment officer. Still, this is the second time the New York shop has come under fire for a big contrarian bet in recent months. Alliance bought nearly 3 million shares of Enron Corp. stock six weeks before the company filed for bankruptcy. Florida's pension fund sued over the transaction. Alliance claimed in court that Enron executives misled its fund managers.

Alliance isn't the only telecom enthusiast. Wellington Management Co. bought nearly 30 million shares of WorldCom in the first quarter and increased its stake in Adelphia by 50%, becoming the largest shareholder, with 32 million shares. The value of the Adelphia stake alone has dropped by about $400 million, to $180 million, since Mar. 31. Fidelity Management added 17.5 million shares of Qwest in the first quarter. Spokespeople for Fidelity and Wellington say their respective companies don't comment on investments.

Such risky bets can pay off spectacularly. In the late 1970s, legendary investor Peter Lynch took a sizable stake in Chrysler Corp. at $3 a share, recalls William Dougherty, president of fund consultant agency Kanon Bloch Carre. "I told him then I was worried about him keeping his job," says Dougherty. "A year and a half later, it was worth $30 a share."

Value-fund managers that bet big on telecoms look just as crazy now. They--and their investors--had better keep their fingers crossed.

Corrections and Clarifications ``When bad things happen to good value plays'' (News: Analysis & Commentary, June 3) incorrectly identified Alliance Capital Management's chief investment officer. He is Lewis Sanders.

By Heather Timmons in New York

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