July 27, 2004 — Materials sector funds can outperform their benchmark during periods of strong growth such as we’re now seeing in the U.S., offering investors a way to gain from the rebounding economy. However, good economic growth does not boost all materials funds, therefore selectivity is beneficial.

While recent economic reports such as June’s employment and retail sales figures were disappointing, the U.S. economy is still growing solidly, with GDP expected to climb more than 4% this year. As a result, the materials sector should benefit. This sector includes companies which produce items such as chemicals, steel, aluminum, paper and packaging products. As economic activity picks up, demand for these products increases.

Materials companies could also benefit from continued strong demand from China. While the government there is trying to moderate its red-hot economy (GDP growth recently “slowed” to 9.6% in the second quarter), demand for materials remains robust. According to Business Week, China uses 25% of the world’s supply of aluminum and 27% of all steel products.

However, the rising tide doesn’t always lift all boats. Some materials suppliers are better positioned than others, while others have reached valuations which already reflect the brighter economic outlook. This explains why S&P’s equity research department currently has a market weight, or neutral, recommendation on the sector as a whole. Opportunities exist, but selectivity is needed. This places even more importance on the choice of a good fund manager for this sector.

In order to see how materials sector funds performed under economic scenarios similar to that of today, we looked for historical two-year GDP growth patterns similar to what will likely occur in 2004 and 2005. S&P economist David Wyss expects that U.S. GDP will grow 4.6% in 2004 and 3.8% in 2005. We therefore screened for periods when GDP growth accelerated to more than 4% the first year and then slowed somewhat in the second year while still remaining close to 4%. This pattern occurred twice since 1990. The first took place in 1997, when GDP growth jumped 4.5% before easing slightly to 4.2% in 1998. Then in 1999, GDP re-accelerated to 4.5% before moderating to a still solid 3.7% pace in 2000. We then reviewed 77 materials sector funds (including multiple share classes) for their historical performance through June 30, 2004, and compared that with the performance of both the materials sector of the S&P 500-stock index and the S&P 500 itself.

Interestingly, the materials sector of the S&P 500 only managed to outperform the index itself in one of those four years: 1999. The sector not only trailed the S&P 500 in the other three years, but did so by a wide margin. Meanwhile, the 77 materials sector funds we reviewed as a group only outperformed the Materials sector itself during one year: 2000. Even then, the funds, on average, lost money. Furthermore, the one year when the sector beat the S&P 500 (1999) saw these materials funds as a group badly trail not only the sector but the S&P 500 as well. See Table 1 below.

However, while the materials sector and related funds usually lagged during each one-year period with economic growth similar to that of today, they did excel over the recent longer term period when the economy was rebounding. More specifically, U.S. GDP growth plunged from 3.7% in 2000 to 0.5% in 2001, but then bounced back to 2.2% growth in 2002 and further accelerated to 3.1% in 2003. During the three-year period through June 30, 2004, the materials sector jumped 9.2%, trouncing the S&P 500′s 0.7% loss during that period. More importantly, the materials funds posted a stunning 25.0% average gain. Of the 77 funds reviewed, 51 were in existence during this three-year time frame. Even more striking than the 25% average gain is the fact that 45 of the 51 funds easily outperformed the sector, meaning that the impressive overall performance of the group was not simply due to a few star performers. Even the six funds which trailed the sector performance all still posted positive results and beat the S&P 500′s 0.7% decline by a wide margin.

Of the 77 funds reviewed, we screened for ones which outperformed both the S&P 500 and the materials sector for the one-, three- and five-year periods ended June 30, 2004. We then furthered narrowed the list down to funds which had also outperformed the S&P 500 and the materials sector in 1999 and 2000, two years which saw GDP growth similar to what’s expected in 2004 and 2005. The results are listed in Table 2 below. One of the funds, RS Investment Trust: Global Natural Resources (RSNRX), actually trailed the Materials sector in 1999; however it still managed to beat the S&P 500.

Table 1

Historical Performance

Annual Returns (%)

Periods Through 6/30/04 (%)

1997

1998

1999

2000

One-Year

Three-Year

Five-Year

U.S. GDP Growth +4.50% +4.20% +4.50% +3.70% N/A N/A N/A
S&P 500 +33.35% +28.58% +21.04% -9.10% +19.10% -0.69% -2.20%
S&P 500 Materials +8.42% -6.18% +25.26% -15.72% +31.87% +9.19% +3.32%
Materials Sector Funds -32.18% -12.70% +9.94% -13.49% +28.59% +25.02% +14.15%

Table 2

Fund

Annual Returns (%)

Returns Through 6/30/04 (%)

S&P Star

1999

2000

One-Year

Three-Year

Five-Year

Ranking

RS Investment Trust Glbl Natural Resources (RSNRX)

+22.39%

+25.85%

+32.32%

+18.22%

+15.49%

5

Fidelity Select Paper & Forest Products (FSPFX)

+30.51%

+1.66%

+30.11%

+7.47%

+7.24%

4

Vanguard Precious Metals Fund (VGPMX)

+28.82%

-7.34%

+30.03%

+25.12%

+18.27%

4

Franklin Gold & Precious Metals Fund/A (FKRCX)

+25.39%

-7.38%

+22.83%

+20.33%

+14.87%

4

S&P 500

+21.04%

-9.10%

+19.10%

-0.69%

-2.20%

N/A

S&P 500 Materials

+25.26%

-15.72%

+31.87%

+9.19%

+3.32%

N/A

Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Data as of 6/30/04.

Contact Robert F. Keane with questions or comments at: bkeane@investmentadvisor.com.