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Style Universe: Small Value Keeps Its Momentum in 2002

The small-value and small-blend categories still have some fuel left.

Karen Wallace, 04/04/2002

<P>Even as buzz of economic recovery grew louder, the bear market seemed to plug its ears in the first quarter of 2002.</P> <P>Fund managers who, thinking technology stocks had bottomed, rummaged around in the bargain bin for beaten-down tech names at the start of the period, probably wish they had left them there. The storm clouds looming over the chronically lagging technology and telecommunications categories have yet to clear: They lost 11% and 18.8%, respectively, through April 3.</P> <P>Most domestic-stock fund groups managed to post a slight gain or finish roughly flat in the first quarter, though. Notable standouts included the small-value and small-blend categories, with respective 7.5% and 3.2% gains for the year to date through Wednesday. As Morningstar's Investment Radar map below indicates, while most areas of the domestic-stock fund universe looked sluggish, the highest gains were concentrated in these two squares of the style box. Funds that trawl the small-cap universe for stocks that look cheap according to fundamental measures like price/earnings and price/book ratios have put up impressive numbers in the first quarter of 2002.</P> <P></P> <TABLE cellSpacing="0" cellPadding="0" width=422 border="0" > <TD><IMG height=224 src="http://publish.morningstar.com/im/SU_040202_1.gif" width=422></TD> Funds are graphed based on their median market cap and relative P/E and P/B scores. The gridlines in the center of the graph represent a Morningstar style box. </FONT></TD></TABLE> <P>After two years of  hefty gains (18.1% and 17.3% in 2000 and 2001, respectively), the small-value group is still going strong. Many smaller companies have handled the recession better than larger companies, because growth and performance expectations for them aren't as high, explains Morningstar fund analyst Laura Pavlenko Lutton. In the absence of market expectation and large sales bases, it's easier for smaller companies to plug along under the radar and even flourish during economic recoveries, Lutton said.</P> <P>In addition, smaller companies' less-complicated balance sheets may offer a reprieve to investors wary of Enron-style accounting subterfuge.</P> <TABLE cellSpacing="0" cellPadding="0" width=422 border="0" > <TD><IMG height=224 src="http://publish.morningstar.com/im/SU_040202_2.gif" width=422></TD> <TD height="1"0></TD> <FONT face="Trebuchet MS" ><FONT color=#006600>(1) </FONT>Babson Enterprise, <FONT color=#006600>(2)</FONT> Wasatch Small-Cap Value, <FONT color=#006600>(3) </FONT>Schroder Ultra Inv, <FONT color=#ff3300>(4) </FONT>ProFunds Ultra OTC Inv, <FONT color=#ff3300>(5) </FONT>Fidelity Aggressive Growth, <FONT color=#ff3300>(6) </FONT>Nevis Fund, <FONT color=#ff3300>(7)</FONT> TCW Galileo Small Cap Growth.</FONT></FONT></TD></TABLE> <P>The best-performing fund in the small-value category, Babson Enterprise <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>BABEX</MSTR:SECURITY>, has added more than 16% for the year to date through Wednesday. Though the fund's strategy has paid off in recent markets (it finished 2001 with a nearly 30% return), it's not likely to be a consistent winner, cautions Morningstar fund analyst Bridget Hughes in a recent analysis. Lead manager Lance James is very conscious of price multiples, especially price/sales, and tends to keep the fund heavily weighted in industrial cyclicals, Hughes said. Such a concentration can be a burden when growth is going strong, as in the late 1990s. When large-cap growth stocks were booming in 1998 and 1999, the fund not only trailed big stock benchmarks like the S&P 500, but also the more relevant Russell 2000.</P> <P>Many of James' picks, such as small banks and real-estate investment trusts in the financial sector and defense contractors in cyclicals sector, have been big winners in a recessionary environment and in the wake of Sept. 11, but they are economically sensitive and  can be volatile, Hughes cautions. For example, the fund's largest holding according to the most recent portfolio in Morningstar's database, defense product manufacturer Cubic <MSTR:SECURITY>CUB</MSTR:SECURITY>, is up 32.4% through Wednesday. The stock has been somewhat of a wild ride, however, falling 42% in 1998 and gaining almost 103% in 2001.</P> <P>Wasatch Small Cap Value <MSTR:SECURITY>WMCVX </MSTR:SECURITY>is up an impressive 12.9% through Wednesday, on the heels of a 33.6% gain in 2001. The secret to the fund's success is management's focus on either growth stocks that have stumbled or relatively undiscovered names that are selling at a discount to management's estimate of their growth rates, said Morningstar senior fund analyst Peter Di Teresa. Unlike Babson Enterprise, however, the fund is closed to new investors to keep assets in check, and even existing investors can't add to their accounts, he said.</P> <P>Small-blend offering Schroder Ultra <MSTR:SECURITY>SMCFX</MSTR:SECURITY>, which gained 12.7% through Wednesday, is much more aggressive than the other leaders. Like a hedge fund, Schroder Ultra's main focus is protecting its assets from losses, said Morningstar's Hughes. To do this, manager Ira Unschuld employs a strategy that combines buying undervalued micro-caps, keeping a highly concentrated portfolio, and actively trading, she said. In addition, Unschuld is not afraid to short stocks and regularly buys put options on the Russell 2000 index. Aggressive as the tactics are, Unschuld has kept volatility in check, Hughes said. Unschuld also has been a phenomenal stock-picker, she said.</P> <P>Technology seems to be the common thread among the quarter's laggards. Both TCW Galileo Small Cap Growth <MSTR:SECURITY>TGSCX</MSTR:SECURITY> and Nevis Fund <MSTR:SECURITY>NEVIX</MSTR:SECURITY> are down around 20% and  have almost half their portfolios in technology stocks. Fidelity Aggressive Growth <MSTR:SECURITY>FDEGX</MSTR:SECURITY> devotes one third of its assets to tech, and ProFunds Ultra OTC <MSTR:SECURITY>UOPIX</MSTR:SECURITY> puts two thirds of its money in the sector. These offerings had lost 16.5% and 25.5%, respectively, through Wednesday.</P> <P>All of these funds were looking pretty good in the fourth quarter of 2001, when growth stocks staged a mini-rally. ProFunds Ultra OTC for example, which uses futures and options to achieve twice the daily return of the Nasdaq 100, posted a 71.3% return for the quarter.</P> <P>ProFunds UltraOTC is an extremely volatile fund overall. When tech goes south, this fund shows its steep downside, wrote Morningstar fund analyst Alan Papier in a recent analysis. The fund lost almost 70% of its value last year, while the average technology sector fund fell only 38.3%. UltraOTC really isn't suitable for most investors; even the most bullish, long-term tech investors would be wise to "consider a fund with less-dire downside consequences," Papier wrote.</P> <P>Many of the other laggards also are too volatile even for the most aggressive investors. For example, though TCW Galileo Small Cap Growth should do well when growth stocks are in favor, the effects of a bear market on this fund can be too severe, said Morningstar fund analyst Kelli Stebel. "The performance swings are too wild for almost every investor," she said. </P> <P>In addition to a volatile, high-octane portfolio, Fidelity Aggressive Growth fund is hampered by a recent manager change and a large asset base, said Morningstar fund analyst William Harding.</P> <P>Meanwhile, few offerings are as risky as Nevis Fund, Harding said. In addition to holding very few stocks in the portfolio, almost 50% of assets are concentrated in the fund's top five holdings, he said. Initial public offerings also fueled the fund's past stellar gains, and 1999's hot IPO market is not likely to be repeated, Harding said.</P>

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