Reign of the Value Funds

Small-cap specialists, in particular, have an edge.

We are all value investors now. Three years into a bear market that wasn't supposed to last this long, mutual-fund managers have finally admitted that only the most buttoned-down strategies will save the day. The best stick with quality companies that have free cash flow, recurring revenues, and heavy insider ownership. "It's more like a religion than an investment approach," says Charles R. Dreifus, manager of the $300 million Royce Special Equity Fund, which had just $6 million in assets a year ago. Smart investors who flocked to Dreifus' fund could see that his disciplined approach to small-cap value investing was paying off: The diversified equity fund--No. 1 in a cast of thousands--is up 16.5% through Dec. 12. Dreifus looks for companies with a high return on assets and low debt. Says the 34-year investment veteran: "I hate to lose money."

Everybody does, but it hasn't been easy to dodge disaster. Even the most cautious fund managers have been mauled of late. The Auxier Focus Fund--up 12.7%, vs. the 13% loss of the Standard & Poor's 500-stock index--was a standout in 2001 because of manager J. Jeffrey Auxier's sensitivity to price and his penchant for steady growth securities that the market neglects. The fund's 7% loss in 2002 beats most equity funds by a mile, but it has been a rough haul: "It's not as much fun, and it's a lot more work," he says. He's still buying beaten-down stocks with long track records of quality earnings growth--such as oil-and-gas contractor Willbros Group Inc. (WG ) and Concordia Investment, a bill processor--to boost next year's returns.

There's no quick payoff with Auxier's level-headed style. Still, it's a stockpicking strategy that seems to have finally caught on among managers of all stripes, even those running aggressive growth and telecom funds. In the November rally, when tech funds gained 17%, value funds beat growth funds--the opposite of what had happened throughout the 1990s. Analysts say that points to two important changes: Growth managers have shed risky tech stocks, and managers in search of inexpensive picks are dominating the market. The argument goes that if investors oriented toward fundamental analysis and nitty-gritty balance-sheet work are a major force, then the rally will be broad and lasting.

Growth managers readily admit they are weaving a value thread into their stockpicking. Says Robert W. Smith, manager of the $4 billion T. Rowe Growth Stock Fund, down 22%, vs. 25% for the average large-cap growth fund: "If we are buying Citigroup (C ) at $30, we sure hope it's good value--and that it's going to grow." He's sticking with companies that trade at low-double-digit price-earnings ratios and use cash to buy back shares, such as Republic Services Inc. (RSG ) and Waste Management Inc. (WMI ), both waste-handling companies. "We look for business models that just chug along," he says.

The more managers who adopt Smith's steady-as-she-goes thinking, the better off investors may be. But there's still a long way to go: So bleak is 2002's performance that the 1% gain in lowly money-market funds clobbered an army of stockpicking pros. The average actively managed U.S. diversified fund lost 20.4% through Dec. 12, vs. a 20.3% decline in the S&P--certainly nothing to brag about. The only stock funds to best 19 categories of chart-topping bond funds were those that buy gold-mining and other precious-metal stocks, up 56%. Real estate funds' 3.3% gain offered the only other positive return among stock funds. Everything else was under water.

Only one fund among the nation's 50 largest--which buy both U.S. and foreign stocks and account for 42% of the industry's $6.2 trillion in assets--made a penny for investors this year. The $8.3 billion Vanguard Wellesley Income Fund gained 3.5%, primarily because of a 60% stake in bonds. Managers argue that accounting fraud and other corporate misdeeds at the big companies they tend to buy are still working through the market. "These weren't even on the table when we started the year," says Bartlett R. Geer, lead manager of the $2.2 billion Putnam Equity Income Fund. "Just because it's the end of the year doesn't mean we aren't still having to deal with that legacy."

But the future holds promise for small-company specialists. Value-oriented funds, such as the Royce Special Equity Fund and the value-growth blend of Bridgeway Ultra-Small Co. Fund, up 5.3%, have eclipsed large-cap offerings since 2000. Small-cap value funds collectively posted losses of 10.7% through Dec. 12. That doesn't sound like much, but it beats other value funds of all market-cap sizes and is miles ahead of growth-stock funds. Most managers expect more of the same because small stocks tend to outperform in recoveries. What's more, many large companies--aside from blue-chip, U.S. multinationals that will get a boost from a falling dollar--are still projecting less than modest growth.

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By Mara Der Hovanesian

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