Domestic Equity Funds -- October 2002 Review

Oktoberfest

Nov. 4, 2002 -- U.S. stock funds enjoyed a nice party last month, but the $64,000 question is: Will the good times last?

Hopes for a sustained rally have been dashed before -- most recently last August -- so fund managers generally appear to be cautious about the future.

"My gut instinct is we are pretty close to a bottom, and in the future, people will say 2002 was a good time to put money into the market," said Bill D'Alonzo, manager of Brandywine Blue Fund (BLUEX). While upbeat, D'Alonzo cautions: "I don't see the market soaring. If we see growth in the market, it will be fairly steady." Brandywine Blue, which rose 4.8% in October, was the second-best-performing mid-cap growth fund so far this year.

The market has bottomed, agrees Stacey Thomas, co-manager of USAA Small Cap Stock Fund (USCAX), but believes it will probably be in a trading range until corporate profits improve. The economy is a potential road block, according to Thomas. She notes that some recent economic statistics have been mixed, such as jobless claims. USAA Small Cap Stock, up 0.1% in October, was the fifth-best-performing small-cap growth fund so far this year.

Earnings growth is likely, but at just regular rates, said Kathy O'Connor, co-manager of Eclipse Small Cap Value Fund (EEQFX). A positive sign, in O'Connor's view, is that valuations are getting close to their traditional mean, though she doesn't believe that stock prices have bottomed. Down 1.1% in October, Eclipse Small Cap Value was the 11th-best-performing small-cap value fund so far this year.

Stock declines have been so broad-based this year that there are attractive investments in most sectors, said Scott Moore, co-manager of American Century Equity Income/Inv (TWEIX). "Today, there are roughly equal opportunities across all capitalization spaces," Moore added. The sixth-best-performing mid-cap value fund this year, American Century Equity Income rose 5.3% in October.

Growth and value were "neck and neck" for the last several months, although they generally suffered declines, said Sam Stovall, chief investment strategist for Standard & Poor's. In October, growth stocks beat value stocks, he noted, largely because the growth category had been hit hardest over the last several years.

Stovall also pointed out that the October rebound favored large-cap issues. This category benefited from last month's rebound in tech and telecom stocks, which he said are generally large-cap names. Based on October's rally, Stovall said he is "cautiously optimistic about the market, although we're not heading back to the races."

In fact, while all domestic-equity fund styles had positive returns in October, growth led in each category. Growth funds haven't seen such gains since the 1990s boom, when some say the party got out of hand.

Though most U.S. stock funds showed healthy gains in October, the average domestic equity fund has lost 23.0% so far this year as stocks were battered from all sides by corporate governance scandals, a slow economy, disappointing earnings, and global terrorism.

Overcoming Adversity

Despite a challenging market, Midas Special Equities Fund (MISEX) saw gains from "normal household names," such as Berkshire Hathaway`A` (BRK.A), Philip Morris Cos. (MO), Johnson & Johnson (JNJ), and Procter & Gamble (PG), said manager Basset Winmill. The fund also benefited from hedging the Standard & Poor's 500-stock index, Winmill added, though he's says he's now "very bullish" on the market through next January. Rising 4.8% in October, Midas Special Equities was the eighth-best-performing large-cap growth fund so far this year.

American Century Equity Income has had success this year with stocks of selected utilities unduly tarnished by scandals involving Enron and Dynegy Inc. (DYN), said Moore. WGL Holdings (WGL) and Ameren Corp (AEE) were particularly helpful, he noted. Because of the year's pitfalls, Moore said "being flat in a down market is very good."

Stocks of gaming companies recently boosted USAA Small Cap Stock, said Thomas, pointing to positions in GTECH Holdings (GTK) and Alloy Inc (ALOY). These picks stem from Thomas' preference for staying defensive during volatile times.

Housing, one of the few bright spots in the economy this year, helped Eclipse Small Cap Value, said manager Kathy O'Connor. Small banks, a key theme in the portfolio, have seen strong margins in mortgage lending, O'Connor said.

Sensing difficulty in technology earlier this year, Brandywine Blue's D'Alonzo said he gravitated to areas of the market with visible earnings, such as the health-care, retail, and consumer-related sectors. Despite recent gains by technology issues, D'Alonzo doesn't think fundamentals will support a sustained rally in the sector. Stocks he likes include defense contractors Alliant Techsystems (ATK) and L-3 Communications Hldgs. (LLL), as well as managed-care provider Coventry Health Care (CVH) and medical services firm Quest Diagnostics (DGX), which provides diagnostic testing for the health-care industry.

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