From the February 2005 issue of Investment Advisor • Subscribe!

A Value(s)-Driven Year

All the mutual fund sectors were up again last year, but the biggest growth was among value funds, regardless of cap or sector

If a single word can be used to sum up the year 2004 it has to be value. We were told throughout the months of political campaigning and in the aftermath of the election itself that the process was a referendum on family values, cultural values, and religious values. In the retail marketplace, consumers looking for ever-lower prices when they shopped refused to buy unless they got good value. The same held true for investors in mutual funds, where the big winners last year were value funds, regardless of component company capitalization. (See "The Past Year's Highest Fliers" chart, below, listing the top-performing funds in 12 S&P categories for 2004.)

Last year marked the second consecutive one when all mutual fund sectors exhibited increased returns, but unlike 2003 when the action was centered around growth stocks, last year it was all about value. In the first three quarters of 2004, a case could well have been made that the word of the year was uncertainty because there was more than enough to go around. There was uncertainty over the economy, as employment figures promised as part of the recovery never materialized. There was the uncertainty of the election, too. That prevailing uncertainty was probably a driving factor in the actions of many investors who chose to continue their behavior of 2003 by sticking with small-cap stocks, belying the predictions of many market forecasters at this time last year. To the chagrin of many market "experts," staying the same course in 2004 appears to have been the most prudent action as small caps (16.2%) outperformed large caps (9.8%) and mid caps (15.3%) among growth, value, and blend funds. In a shift from the standard difficulty that funds have repeating top-tier performance year after year, seven of the top-performing funds by category in 2003 remained in the top 10th percentile in 2004. (See "Sophomore Jinx No More?" chart, below.)

A look at the S&P Indexes helps illustrate the dominance of small caps in 2004. Growth of the S&P SmallCap 600 Index last year was 21.59%, virtually double the 10.88% growth enjoyed by the S&P 500 and considerably better than the impressive 15.16% return of the S&P MidCap 400.

Small Caps' Lure Continues

Sam Stovall, Standard & Poor's chief investment strategist, points out that in a typical bull market, investors tend to move toward companies with large capitalizations and more stable earnings. "That pattern didn't materialize in 2004, when the current bull market entered its second year," he said. "The attractive earnings of small-cap stocks, coupled with low interest rates, may have helped [small caps] stave off the traditional challenges of mature bull markets."

"As far as last year's market, in the first ten months of the year you had a market with really no conviction, very range- bound," adds Rosanne Pane, an S&P director and mutual fund strategist, who attributes the success of small-cap value funds, which on average returned 19.51%, primarily to the combination of fairly attractive valuation and a good growth rate. The market went up and down, she points out, but never really made any significant moves in either direction. "I think it's because everyone was just very cautious over the whole global political environment. With the uncertainty regarding Bush vs. Kerry, no one wanted to make big bets because you didn't know how the election was going to turn out. The day after the election, the market starts to pick up because you have a very good idea of what's going to happen to various industries and tax policies, and so you're more comfortable having some conviction."

The removal of that political uncertainty certainly seemed to break the logjam holding back performance, leading to impressive fourth quarter performance across the board, with growth funds outpacing the pack.

"The S&P 500 in the fourth quarter returned 9.2%," noted Pane. "For all of 2004, the S&P 500 was up 0.9%, so 85% of the return last year came in the final months. During the fourth quarter, we saw growth [funds] leading, and mid caps and small caps also continued to lead because the growth rates in those categories typically tend to be higher."

Pane points out that the stronger performance of mid-cap value and small-cap value funds in the first nine months allowed them to come out on top for the year as a whole. In fact, according to S&P figures at the end of the third quarter, domestic equity funds were up only 1.04%. In the last quarter, however, oil prices moved lower, Wall Street got the election results it wanted, and the Federal Reserve continued with its policy of carefully measured rate hikes.

This Year's High Achievers

During an overall positive year there were some particularly positive developments in certain segments of the mutual fund universe. They included:

  • Better results from global than domestic equity funds. The average global equity fund rose 14.5% last year, with Standard & Poor's reporting that the best performer, Oppenheimer Global Opportunities Fund (OGIYX), showed a 30.4% increase. Like the overall market, this top performer saved the best for last: the fund was up 27.4% in the fourth quarter alone.
  • Strong performance from emerging- markets funds, particularly those focused on Latin America and the Far East, but not on Japan.
  • A better-than-expected year for high-quality bond funds, which according to S&P offered an average return of 3.1%, not much worse than 2003's performance (4.5%). The top performing fund in the style, reports S&P, was Loomis Sayles Fixed Income Fund (LSFIX), which finished the year with a 12.2% gain.

And in 2005 . . .

For those looking forward, it's a good bet that 2005 will not be a mirror of either of the two previous years. They may have been the years for small caps, but don't expect that trend to continue, according to S&P's Pane. "We have an environment where the earnings growth rates are slowing and [interest] rates are rising," she says. She predicts a slowing of earnings growth rates to a more normal level (in the 8% to 10% range) in conjunction with a rise in interest rates, and expects the S&P 500 to demonstrate high single-digit returns. "That type of an environment is going to favor high-quality stocks and more stable ones. That's also going to favor large cap versus small cap." While value has been winning the style competition for the past couple of years, she notes, "in a slowing, normal-pace environment for growth, growth becomes very important. So we believe that there will be a changeover from value to growth dominating in 2005."

Staff editor Robert Keane can be reached at bkeane@investmentadvisor.com.

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