Domestic Equity Funds -- July 2002 Review

Aug. 2, 2002 — Ouch! With the average fund down more than 20% so far this year, many fund shareholders may be questioning the wisdom of their investment choices and pondering what to do.

All the main domestic equity fund categories show double-digit losses through July 31, ranging from 10.7% for small-cap value funds to 27.3% for small-cap growth funds. In many style categories, the average decline in July alone was more than half as much as its decline in the first half of the year. The reasons for these steep losses include the high-profile corporate scandals, disappointing earnings, Mideast tensions and an uncertain economy.

Manu Daftary, manager of Quaker Aggressive Growth Fund (QUAGX), thinks the market suffered a “head fake” at the beginning of the second quarter when it realized that strong economic growth in the first quarter wasn’t sustainable. He’s predicting a soft economy for the rest of the year because of lower consumer spending.

Despite the pain and grief that bear markets cause for individual investors, many fund managers see them as opportunities to build for the next bull market. Their advice to fund shareholders seems to take the same tack — wait out the unwinding of the market bubble.

“An awful lot of money was raised and squandered” in the 1990s, notes Bruce Baughman, manager of Franklin MicroCap Value (FRMCX). Baughman feels that this year’s downturn is an inevitable result of previous investor excesses. Baughman’s co-manager, Bill Lippman, adds that bear markets may be rough, “but you can lay the grounds for future gains in downturns… We create good performance by picking up bargains in bad years,” says Lippman. Up 4.0%, the Franklin fund was the fifth-best small-cap value fund for this year through July.

Unlike many fund managers, Baughman says he’s been able to find stocks with improving business outlooks. His focus has been on well-established, financially stable companies that are “easy to understand,” in contrast to some of the fallen stars of the 1990s. In particular, Baughman has avoided companies that “reward an inside group at the expense of everybody else.” The Franklin fund includes “plain, mundane” companies such as Brown Shoe (BWS) and Tractor Supply (TSCO), according to co-manager Lippman.

Investors shouldn’t worry about market fluctuations, says Don Yacktman, manager of Yacktman Focused Fund (YAFFX). Instead, they should realize “volatility is a friend of the value investor.” Recently, Yacktman has found “more bargains than we’ve seen in a long time.” As evidence, Yacktman notes that in the last two months he has built his four largest holdings from scratch, which he says is a “very rare” move for him. These additions were Lancaster Colony (LANC), Tyco International (TYC), Liberty Media `A` (L), and Quest Communications bonds.

Quaker’s Daftary thinks the market will probably face more trouble in August because companies will have to start certifying financial statements under new laws. Faced with this change, Daftary feels “it will be easy to start rumors” sparking stock declines. Lower fund returns in August would follow two quarters of some of the sharpest average fund declines in recent years.

Another disciple of the long-term view is John Montgomery, manager of Bridgeway Ultra Small Company Tax Advantage Portfolio (BRSIX). “As long as you don’t panic and sell out, you tend to get whole again,” notes Montgomery. The small-cap market typically bounces back no more than 39 months after declines — not after ten years as some fear, Montgomery observes. He cautions shareholders against putting money they might need in the short-term into equity funds. “If Wall Street works like it’s supposed to, long-term investors are compensated for risk,” Montgomery says.

Noting that markets don’t always follow steady game plans, Charles Dreifus, manager of Royce Special Equity Fund (RYSEX), believes that the market’s “18 years of compounded returns from 1982 to 2000 suggests we are in for modest markets for some time.” He predicts that the broad market will show 6% to 7% gains for the next couple of years, while near-term returns will probably be weak because of low earnings. His fund’s holdings are “prosaic, nonglamorous businesses that are simpler and don’t have complex financials,” he says. Along with attractive valuations and sustainable franchises, Dreifus said he strives for companies with conservative accounting, because they tend to have little debt and strong cash flow.

Outlook

“We’re only a whisper away from the deepest bear market on record,” notes Philip Edwards, managing director, S&P Fund Services. Despite the widespread losses, Edwards believes that “the good news in July’s turmoil — if there is any — is the market may have reached a bottom, leading to attractive valuations.” He cautions, however, that shareholder withdrawals may frustrate fund managers’ attempts to take advantage of these opportunities.

Fund Investment Style2002 Returns Through 7-31-02 (%)

Large-Cap Growth Average-24.40

Large-Cap Value Average-17.01

Large-Cap Blend Average-20.44

Mid-Cap Growth Average-23.37

Mid-Cap Value Average-12.75

Mid-Cap Blend Average-18.87