Domestic Equity Funds -- Third Quarter 2002 Review

Oct. 2, 2002 — Despite this year’s unforgiving bear market, certain fundamental principles still apply.

Investors need to know that mutual funds “aren’t bank accounts where your money grows at a set amount each day,” says Harold Levy, manager of First Eagle Fund of America (FEAMX). Levy believes many investors who enjoyed outsized gains in the 1990s bull market forgot about the risks inherent in owning mutual funds. Losing 10.3%, First Eagle Fund of America is the third best-performing mid-cap blend fund for so far this year.

With the average domestic equity fund down 27.3% this year, fund shareholders may be tempted to throw in the towel. But that would be a mistake, says Richard Driehaus, president of Driehaus Capital Management, a Chicago-based asset management firm that oversees more than $3 billion in assets.

Driehaus advises that investors who avoid equities actually take on more risk because of stocks’ long-term record of capital appreciation. But looking at recent market declines, he suggests that equity fund shareholders may have to stay invested for at least 10 years to realize solid gains.

Investors should focus on the basics, such as sensible valuations and cash flow, says Charlie Dreifus, manager of Royce Special Equity Fund (RYSEX). In many cases, market expectations are simply returning to more reasonable levels, he says.

Reasonable expectations going forward are understandable in light of this year’s steep fund losses. While all domestic equity fund categories show double-digit losses this year, the growth segments were hardest hit. But value funds’ sizable losses, too, indicate that “in a bear market, there is no place to hide,” says Sam Stovall, chief investment strategist at Standard & Poor’s.

Fund losses were particularly acute in the third quarter because the economy and corporate earnings didn’t revive as expected, Stovall notes. Investor disappointment was so severe during the third quarter that even small-cap value funds, the only fund category with positive returns as of mid year — a modest 2.5% gain — dropped a steep 18.9% during the period.

On The Brighter Side

Lower expectations can be a plus because lower growth rates are usually more sustainable than higher ones that are often more volatile, says Tom Pence, manager of Strong Discovery Fund (STDIX). Companies with moderate growth rates are more likely to hold up better through good markets and bad, he adds. Stocks of these kinds of companies can be found in many sectors, Pence notes, pointing to holdings such as Lee Enterprises (LEE), a newspaper company; Legg Mason Inc. (LM), an asset-management firm; and Education Management (EDMC), which provides post-secondary education. Down 16.5%, Strong Discovery is the 12th best-performing small-cap growth fund this year.

Market corrections, in fact, can be overdone, causing “very good things to get dumped for the wrong reasons,” says Laura Linehan, co-manager of Gabelli Westwood Mighty Mites/AAA (WEMMX). Media companies, in particular, are currently trading at lower values than their actual values, she says. Her media picks include Gray Communications Systems (GCS) and Granite Broadcasting (GBTVK). Falling 3.3%, Gabelli Westwood Mighty Mites is the fifth best -performing small-cap blend fund so far this year.

Mark Mulholland, manager of Matthew 25 Fund Inc (MXXVX) agrees that the market has overreacted on the downside. “It’s a great buyer’s market because everything has been decimated — it’s like being a kid in a candy store,” he says. Mulholland feels that valuations have fallen so sharply because two bubbles have imploded — the tech bubble and an indexing bubble fueled by investors wanting to hold the components of the S&P 500. Ultimately, the manager believes this pain will lead to more sustainable returns since “in the long run, price matters.” Falling 4.5%, Matthew 25 Fund is the second best-performing large-cap value fund so far this year.

Cliff Hoover, Jr., co-manager of PIMCO Small Cap Value Fund (PCVAX), recommends buying solid companies with simple balance sheets, regardless of sector, because of the recent corporate governance scandals. Hoover is currently spreading his bets across 50 industries. In general, he thinks the market will gravitate toward dividend-paying companies. That’s led him to Cooper Cos. (COO) and Fresh Del Monte Produce (FDP). Declining 1.5%, PIMCO Small Cap Value Fund was the third best-performing small-cap value fund this year.

Outlook

Markets generally rebound after steep losses, says S&P’s Stovall. He notes that after poor Septembers and poor third quarters, the market has usually rallied in the following Octobers and fourth quarters. Specifically, after the market’s ten worst third quarters in the past 50 years, the S&P 500 rose an average 7.1% in the subsequent fourth quarter, according to Stovall. “History is on our side,” he believes.

Stovall forecasts that growth segments of the market will outperform value segments going forward because growth tends to outperform in improving economic and earnings environments. Small-cap stocks typically do better in market rebounds too, says Stovall, because investors are more willing to shoulder risk.

Jordan Alexander, manager of Evergreen Small Cap Value Fund (ESQAX), predicts that small-cap stocks will outperform, but not as much as they have recently because of small-cap stocks’ relative appreciation. He thinks the growth and value segments of the market will show similar results since growth stocks have been hit hard in the bear market. “We should see less of a divergence between growth and value,” Alexander says. His fund is down 17.4% this year.

High-quality companies are likely to outperform going forward because of their more attractive valuations, says Bill Nolan, manager of Principal MidCap Fund (PEMGX). He points to an average p/e ratio of 19 for high-quality companies, versus a p/e of 27 for low-quality companies. High-quality companies also look promising because they tend to take market share from weaker companies during difficult times, Nolan says. Dropping 12.5%, Principal MidCap Fund is the second best-performing mid-cap growth fund this year.

But make no bones about it, the current downturn could be the “bear of all bears” because valuations got so far out of line in the 1990s, says Pimco’s Hoover. At minimum, bubbles take several years to unwind, he cautions.

Fund Investment Style2002 Returns Through 9/30/02 (%)

Large-Cap Growth Average-31.22%

Large-Cap Value Average-25.71%

Large-Cap Blend Average-27.84%

Mid-Cap Growth Average-29.05%

Mid-Cap Value Average-20.12%

Mid-Cap Blend Average-24.81%

Small-Cap Growth Average-32.28%

Small-Cap Value Average-16.54%

Small-Cap Blend Average-23.99%

Domestic Equity Funds Average*-27.28%

S&P 500-28.26%

Fund Investment StyleThird Quarter 2002Returns (%)

Large-Cap Growth Average-16.15%