May 5, 2004

Fund in Focus: Evergreen Strategic Growth Fund

Jay Zelko, co-manager since April 2000S&P Rank: Not Ranked.Best Expectations

May 4, 2004 -- After suffering double-digit losses in 2001 and 2002, the Evergreen Strategic Growth Fund/A (ESGAX) rebounded last year, returning 28.5% as the climate for large-cap growth stocks improved with a stronger economy and better fundamentals.

For the one-year period through March 31, the fund kept pace with its large-cap growth peers, gaining 29.1%, versus 31.2% for the group. Though the fund's A shares have a short track record, its institutional share class lost an average annualized 0.8% for the three years ended in March, versus a loss of 2.7% for the average large-cap growth fund.

In April 2000, the fund invited Jay Zelko to the management team. W. Shannon Reid serves as lead portfolio manager, and Zelko and David Chow are on board as co-managers.

"We look for stocks with a history of earnings growth, strong fundamentals and rising earnings expectations," said Zelko. The team picks stocks purely from the bottom up and eschews macroeconomics completely. However, the managers like to be within 80% and 120% of the corresponding weightings of the major sectors in their benchmark, the Russell 1000 Growth Index.

As of March 31, 2004, the fund's top five sectors were information technology, 25.8%; health care, 19.5%; consumer discretionary, 14.7%; industrials, 12.5%; and financials, 10.5%. "Although information technology and health care are our top two sectors, they actually represent an underweighting relative to the benchmark," noted Zelko.

While the portfolio is actively managed, the team keeps a close eye on the constituents of the benchmark. As of March 31, the fund's top holdings were Pfizer Inc. (PFE), 4.9%; Intel Corp. (INTC), 4.9%; General Electric (GE), 4.2%; Cisco Systems (CSCO), 2.9%; Electronic Arts (ERTS), 2.6%; Microsoft Corp. (MSFT), 2.5%; PepsiCo Inc. (PEP), 2.3%; Procter & Gamble (PG), 2.2%; Texas Instruments (TXN), 2.2%; and EMC Corp. (EMC), 2.1%. The portfolio typically holds between 50 and 70 stocks, and is currently at the upper end of that range.

Although the fund's top stocks include tech blue chips such as Cisco, Intel and Microsoft, Zelko has been trimming back on technology since last year. Microsoft, for example, represents a significant underweight relative to the benchmark, he noted.

"Microsoft has become a victim of its own success," said Zelko. "They still dominate desktop computing and enterprising software, but they won't be able to repeat their historic growth rates." On the plus side, Zelko notes that Microsoft remains "a very profitable company that generates high cash flow, and also has the opportunity to lower its cost structure and increase operating margins." He believes these qualities warrant having a position in the stock.

Zelko is more sanguine about Intel, which represents an overweight stake. "The company is a beneficiary of mobile computing, a strong secular trend," he said. "We think the Cetrino-based processor used for lap-top computing carries higher margins than the desktop. Intel is also shifting towards new manufacturing architecture, which will significantly cut costs. In addition, we forecast higher PC demand in 2004."

Outside of tech, Zelko is bullish on 3M Co. (MMM), the diversified industrial manufacturing giant. "They have exposure to health care, flat-panel display graphics, consumer products, transportation, and communications, among other businesses," he said. "They enjoy strong fundamentals and consistently exceed quarterly earnings estimates. They have also lowered costs, and are successfully moving into higher-margin businesses."

Over the past year, Zelko has been adding to major pharmaceutical stocks, including Pfizer and Abbott Laboratories (ABT). "We've been underweight in big drug stocks since 2000," the manager said. "But now, these companies should be seeing an increase in new products come to market in 2004 and 2005, which will likely lead to upwardly revised earnings."

The fund has a high portfolio turnover rate, 206% last year versus 97.5% for the peer group. "We are heavily focused on our sell discipline," Zelko said. "We get rid of a holding when a company undergoes some fundamental change in its outlook, which may involve missing a quarterly earnings target, or downwardly revising its forward earnings prospects due to a drop in market share."

Zelko attributes part of the high turnover last year to repositioning the fund into more aggressive investments. "We outperformed the benchmark in 2002 by taking a defensive stance and buying such sectors as consumer staples and health care and selling out of technology," he said. "Tech valuations became too rich and unsustainable, so we unloaded them. However, by late 2002/early 2003, we became more aggressive and raised our stake in technology as fundamentals improved and valuations became more reasonable."

Zelko doesn't necessarily need a disappointing earnings quarter to pull the plug on a stock. A recent sale included ITT Educational Services (ESI), which runs schools that provide post-secondary degree programs. "We sold that stock entirely after the FBI raided the company's headquarters and other facilities looking for records about enrollment and recruitment," he said. "The stock collapsed on that news."

Looking ahead, Zelko forecasts a good year for large-cap growth stocks in 2004. "Large-cap companies, on the whole, have been reducing their cost structures over the past three years, and now stand to benefit from streamlined operations and the strong economy," he reasons. "Large-cap growth stocks, in particular, should show upwardly revised earnings."

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