Active Managers Flex Their Muscles

As indexes fall, the hard work of finding good companies is being rewarded

Active managers of U.S. stock mutual funds have wrestled with a directionless market and an anemic economy. They've contended with earnings shortfalls and warnings of terrorist attacks. And for all that, they have managed to limit losses to 10% on average so far this year. That isn't going to pull investors out of their funk, but it's enough to beat the market through June 14. The Standard & Poor's 500-stock index was down 12.3%, while the Dow Jones industrial average was off 5.5%. The Nasdaq Composite Index has lost 23%, with no end to tech stocks' downward spiral in sight.

Stock-pickers have waited a long time to strut their stuff. Many got the brush-off from investors during the 1990s, when all it took to make big money was to buy an index or tech-sector fund. The low-cost, $69 billion Vanguard 500 Index Fund, for instance, quintupled in value in the 1990s, reaping gains of 17.4% a year. But with the start of the bear market in March, 2000, the pick-and-shovel work of mining for underappreciated companies with clean balance sheets and solid prospects began in earnest.

The excavation work has paid off handsomely for the most conservative value investors, and that will likely continue through the year and beyond. The best managers of sector funds--from real estate to financial stocks--have been rewarded for their tempered style. Still, nobody is taking their edge for granted: "There's no room for error," says value manager Steven J. Lehman, of the $258 million Federated Market Opportunity Fund, a multicap fund that's heavily weighted in mid-cap stocks. Lehman's 85-stock portfolio, which includes agribusiness giant Bunge Limited (BG ) and Potomac Electric Power Co. (POM ), has an average price-earnings ratio of 12--less than half the 30 ratio of the S&P 500, based on the new core earnings measure. Lehman's fund is up 6.4% this year. "I buy washed-out stocks," says Lehman. "It's the antithesis of momentum investing."

All the same, diversified stock-fund's results still look paltry compared with precious-metals funds, which gained 59% so far this year. Meantime, managers who short stocks still rank high among the top-50 funds.

Making money in this market is not just a matter of spurning growth stocks or the tech sector, or even piling into small-company stocks. Managers say it's very difficult to find investing themes that still work. Cyclical stocks tied to economic recovery have long been run up. Battered growth stocks won't pick up steam as long as the earnings rebound is so-so. "Value stocks aren't cheap, and the growth stocks aren't growing," says George Boyd, head of equities at New York's Weiss Peck & Greer, which manages $18 billion in assets. "Looking for companies that generate sales and earnings is just as important as looking for dividend yields and free cash flow."

That's where stock-picking prowess makes all the difference. Managers' most consistently profitable investments have been small- and mid-cap companies. While a yearlong rally has ironed out most of their once-huge disparities in value relative to large stocks, fund managers say there are still gems among them. These companies have mostly avoided accounting and management scandals and regulatory scrutiny. And they're less vulnerable than multinationals to currency fluctuations. "There are really good companies in the middle that have just been ignored," says Mark L. Henneman, lead manager of the $360 million First American Mid-Cap Value Fund, up 6% this year. Henneman says earnings prospects for the mid-cap sector are above-average, and the stocks are still mostly cheap: Companies in the S&P MidCap 400, for instance, sell at a 26% discount to the S&P 500 on a price-to-sales basis, and a 24% discount on a price-to-book value comparison.

The pros say such mid-cap value stocks will continue to have strong momentum. Large-cap managers digging down in their search for growth and small-cap managers reaching up for more liquidity will fuel future gains. Even managers with mandates to buy across all asset classes and geographic markets are honing in on the middle ground. For instance, the RS Contrarian Fund, an all-cap, world stock fund, is up 10.4% this year--without any short-selling, which its charter allows. Manager Andy Pilara is committed to low-multiple, mid-cap U.S. companies. "It's the most promising market right now," says Pilara, whose purchases include companies such as Pathmark Stores (PTMK ) and Chiquita Brands (CQB ).

Growth-stock money managers who are price-conscious and have sidestepped the scandals that have hit many large growth companies are ahead. One of the best, Tom Marsico, has been piling into value stocks such as General Motors (GM ), and owns little technology. He liquidated his Tyco International (TYC ) stake in the first quarter, before its CEO's resignation sent the stock plunging to a low in June. One of his top holdings is Tenet Healthcare (THC ), a Santa Barbara (Calif.) company, which runs high-profit facilities for neurology, orthopedics, and cardiovascular patients. It has paid down debt, Marsico says, and trades at less than 18 times estimated 2003 earnings. Stock picks like that make the $1.5 billion, 27-stock Marsico Focus Fund, which is up 3.5%, the No. 1 large-cap growth fund this year.

Sector managers who buy unpopular stocks have also been amply rewarded--especially if they concentrated on those with earnings and multiples below industry averages. David H. Ellison, who runs Friedman Billings Ramsey's Financial Services fund, which is up 9.6%, is one. He buys plain-vanilla companies such as SunTrust (STI ), Golden West (GDW ), and Charter One Financial (CF ) while going light on "large, complicated corporate customer-oriented companies," like Citigroup (C ) and Merrill Lynch (MER ). "I want guys who make loans that everyone can understand," he says.

Bond-fund managers face real challenges in replicating their strong results of the past two years. Interest rates are unlikely to get any lower. That puts an end to bets on falling rates, such as mortgage-backed securities. The answer, says Eugene Flood Jr., president of the Chapel Hill (N.C.) bond shop Smith Breeden Associates, is to buy bonds maturing in one to three years that will lose less when interest rates rise. Flood prefers bonds backed by auto loans or credit-card fees, which also yield more with the same credit rating than corporates.

However, not all managers are avoiding corporate bonds. Kenneth J. Hart, co-manager of the $97 million Sentinel Bond Fund, says blowups such as WorldCom's (WCOM ) have unfairly tainted the whole corporate market, making it the cheapest in the fixed-income realm. His mandate is to figure out if a company's bond price is down for technical or fundamental reasons. Lately, he has been buying the A-rated debt of Coors Brewing (RKY ), Merrill Lynch, Sears (S ), IBM (IBM ), and General Electric (GE ). So far this year, his fund is up 1.7%.

Active fund managers have made the most of a bad market. But investors are a fickle lot. The flow of new money has been erratic so far this year. And managers won't get much thanks until disgruntled investors start to make real money.

By Mara Der Hovanesian

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