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Posted 3/27/2001
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Mutual Funds
How some funds dodge a bear-market bullet Among the wretched results as the first quarter ends, a bright spot: Small-cap funds are in the black, and managers are using agile stock-picking and shorting strategies to keep them that way. By Timothy Middleton And you thought last year was bad. The first quarter of 2001 was marked by a savage crash within a bitter bear market for mutual fund investors. Although value funds declined less than growth, they didn’t escape the carnage. Indeed, there was no safe haven. Income funds, gold, real estate, international -- everything was negative. The 10.9% decline of S&P 500 ($INX) index funds was greater than their loss in all of 2000.
“It’s not too complicated; the economy was growing too fast, and you can’t keep pushing it at that rate,” says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, published in Potomac, Md. The nation’s gross domestic product was growing at an 8.3% annual rate in the fourth quarter of 1999; now it’s probably negative, or close to it. So what began as the dot-com bubble bursting spread throughout technology, and then across the entire economy, and indeed the world. The average international stock fund sank 11.6% in the first quarter, even more than domestic stocks. (All data are preliminary, as of March 15.) Technology, nevertheless, continued to take the worst drubbing. Four of the five funds managed by Garrett Van Wagoner declined between 52% and 53% in the first quarter, or twice as much as they did in the tech collapse of 2000. No refuge from first-quarter meltdown
Source: Lipper Inc. The small-cap advantage The market’s few winners included Russian stocks and a few Asian funds, in both cases bouncing back from extreme poundings in 2000. Among domestic equity funds, winners tended to be value funds, such as Aegis Value (AVALX), which advanced 15.9%. “We dig through the cheapest-looking companies by the numbers,” says Scott Barbee, one of the $2.5 million portfolio’s three co-managers. “A significant portion of those that come up are extra-poor businesses or have inept or unethical managements, but then you find an Andersons (ANDE, news, msgs), which is not only a good business but has a very ethical, Midwestern-values type management.” Aegis targets small-cap companies that Wall Street has overlooked. Andersons, which operates grain elevators primarily in Ohio, Indiana and Illinois, has a market capitalization of only about $64 million and isn’t followed by any analysts. Barbee says the company’s earnings were depressed last year by an expansion into fertilizer manufacturing. He thinks the new venture will succeed, but even if it disappeared the company would stand to earn $1.50 a share this year. It trades around 8.50, giving it a price-to-earnings ratio (P/E) of less than 6. But a few growth funds managed to prosper in the first quarter, including Perkins Opportunity (POFDX), which also gained 15.9%. Perkins also invests in small companies, which caused it to lag the market much of the 1990s, but has helped it since. “Typically, coming out of recession, small stocks will lead,” says co-manager Dan Perkins. “Assume we’ve been in a recession since the latter part of last year. The last nine recessions have averaged about 11 months; typically market bottoms come about six months before the end of a recession. Well, that should be coming up pretty soon, and we would expect small stocks to lead a little bit, and I think that’s what we’ve started to see this quarter.” Like Aegis, Perkins stresses stock-picking above top-down market calls. That’s been good for the fund, because the average small-cap growth fund tumbled 17.3% in the first period. Perkins avoided that by investing in companies like Insignia Systems (ISIG, news, msgs), a $95 million market-cap maker of point-of-sale marketing software. Dan Perkins recommended the stock to readers of Microsoft MoneyCentral last year, and it helped fuel the fund’s gains in the first quarter. Insignia Systems’ stock is up more than 70% in the last three months and about 133% in the last 12. Winning and losing funds
Source: Lipper Inc. Fund profits from bad stocks, too Stock-picking does double duty at Boston Partners Long/Short Equity Fund (BPLSX), which invests in bad stocks as well as good ones. It celebrated its second birthday last November and closed out 2000 with a gain of 60.2%. Its success has drawn so much attention assets are cascading in. The fund had $1.4 million at the end of February, according to Morningstar. By the middle of March, it had $22.4 million, according to manager Edmund Kellogg. The Boston Partners fund seeks to be market neutral -- that is, to do well whether the market is going up or down. In its brief life, it did poorly in the bull market of 1999, declining 14.3%. So the theory may not work, but it is working now, when shorting stocks has been the only momentum play on Wall Street. Shorting involves borrowing stock and selling it in the expectation you can buy it back more cheaply in the future. Kellogg’s strategy is to be 90% long and 80% short; that is, if you give him $100, he will buy $90 worth of stock he likes, sell short $80 worth of stock he doesn’t like, and hold the rest in cash. The tech crash has been good for Kellogg, who is short mostly telecommunications and semiconductor stocks. “There’s an inventory cycle going on at this point, and inventory cycles are very predictable things to invest in,” he says. Last year, telecom companies began to see lower earnings, so they reduced capital spending. That bloated inventories of suppliers, who cut back on orders and so on down the food chain. The Boston Partners fund currently is short Power-One (PWER, news, msgs), which makes power supplies for original equipment manufacturers. Kellogg says he shorted the stock in 2000 at 80, booking a gain when it tumbled to 44. “It was one of the reasons we were up 60% last year,” he says. He shorted the stock again this year around 40; recently it’s been trading around 18. Shorting stocks will obviously not be a profitable strategy if the market recovers, and the odds are increasing that it will, says John Shaughnessy, chief investment strategist of Advest. “The likelihood of the government cutting federal income taxes, and the reality of lower interest rates, bodes well for the economy,” he says. Other positives are energy prices lower than they were in the fourth quarter of last year, and a stronger euro, which benefits the foreign earnings of domestic multinationals. “I think expectations for first-quarter earnings are probably too low,” he adds, “and therefore we could well be in for a pleasant surprise in April.” He says securities analysts tend to overreact to earnings pre-announcements, marking some companies down unnecessarily. If earnings beat expectations, investors will be cheered. The Federal Reserve has slashed interest rates 1 1/2 percentage points in the first quarter, the sharpest and fastest cuts in two decades. “That always bodes well for stocks,” Shaughnessy adds. What managers are buying now Tobacco sans legal woes: Standard Commercial (STW, news, msgs) more than doubled last year, and nearly doubled again in the first quarter, but the Aegis fund still considers it inexpensive. The company processes tobacco, buying from farmers and selling to cigarette companies. “They got caught in the tobacco downdraft, yet nobody is suing Standard Commercial,” says Barbee. The stock has a P/E of 9 on this year’s earnings. Cheap leather: Wilsons the Leather Experts (WLSN, news, msgs), not the sporting goods manufacturer, is a favorite of Dan Perkins. The operator of more than 440 mall stores and 30 airport kiosks sells leather garments and accessories. Despite double-digit earnings growth, the shares trade around 8 times their trailing earnings. “This company has revitalized growth by getting into accessories,” Perkins says. At the time of publication, Timothy Middleton didn’t own any securities mentioned in this article.
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