Amid the Carnage, It’s a Scavenger’s Paradise

Stocks got a lot cheaper in the third quarter.

But are they cheap enough?

With the typical domestic equity fund down 15.2% during the quarter and the average foreign stock fund off 16.3%, from a price standpoint you have to like many funds more now than you did in June.

“There’s truth to the old saying that in searching for top mutual funds for the future, you’re better off bottom-fishing than picking the one that had the best returns last quarter,” said Luke Collins, director of KPMG Peat Marwick’s investment consulting practice in Chicago.

Adds Hamilton Lewis, president of Hamilton Lewis Capital Management in Houston: “With prices on their knees, investors can step in and start scaling into the market--and into different parts of the market.”

Still, scavenging for mutual funds amid this rubble--with the economic scene worldwide still so dicey--is not for the faint of heart.

Though the vast majority of the nation’s stock funds lost money during the quarter, they could lose even more in a severe bear market.

Even so, it’s difficult to avoid wanting to pick for bargains, especially if you have a long-term time horizon. After all, a $10,000 investment in a fund with a net asset value per share of $20 a few months ago would get you 500 shares then.

If that fund lost a quarter of its value during the third quarter, that same investment now would net you 667 shares.

So how should you go about bargain hunting?

Here are some fund sectors and groups in which to prospect:

* Wish-list funds. Mutual fund analysts say the easiest place to start is with your own personal wish-list of funds--strong performers that you always wanted to invest in but haven’t, for fear of getting in near the top.

Guess what? Many of those funds’ share prices aren’t at their tops anymore.

One example is White Oak Growth, a concentrated fund that invests in 25 blue-chip growth companies. During the quarter, the fund fell 19.1%--71% more than its large-cap growth peers--in large part due to its stake in financial names like Citicorp.

Yet Jim Oelschlager’s $672-million no-load, low-expense fund is still up a stunning 20.1% a year for the last three years.

Abroad, investors may want to take a second look at Helen Young Hayes’ Janus Worldwide fund. This $12.5-billion fund, which invests in foreign and U.S. companies, sank 16.1% last quarter. But over the last one, three and five years, it has beaten at least 93% of its peers.

As the fund has grown in popularity over the years--its assets tripled in the last two years--concerns have been raised that Hayes would find it increasingly difficult to employ that cash. Now that the fund’s cash flows have slowed considerably, and with European and U.S. stocks so much cheaper now, that shouldn’t be as much of a problem for Hayes.

Another fund to consider is Tweedy Browne Global Value, whose shares plunged 17.9% last quarter. Over the last three years, this fund--which employs the traditional rules of “value” investing--has delivered total returns of 13.5% a year. That’s 65% better than its peers. Yet, the fund is 56% less risky than its peers, according to Morningstar’s proprietary risk scoring system.

* Europe funds. “Assuming we don’t get a global recession, I think Europe still looks good,” said Leila Heckman, managing director in charge of global asset allocation for Salomon Smith Barney in New York.

Earnings for large blue-chip companies in Europe are slowing, just as they are in the U.S. But relative to other regions, earnings growth in Europe is still robust, Heckman says. Plus, given the financial discipline imposed by the move to a single currency starting Jan. 1, European nations are expected to keep interest rates relatively low, she adds.

Which makes the fact that the typical Europe fund lost 18.2% of its value this last quarter all the more appetizing.

A couple of highly rated European blue-chip funds on sale are: Scudder Greater Europe Growth, which fell 16.2% during the quarter; and Vanguard International Equity Index Fund European Portfolio, down 14.4%.

By investing in “restructuring plays” throughout the continent, especially in the services sectors, Scudder Greater Europe has averaged total returns of 23.1% a year for the last three years. Yet Morningstar considers this $11-billion fund 60% less risky than its peers.

As for Vanguard International Equity, by keeping fees and turnover down, this index fund has advanced a respectable 19.1% a year for the last three.

* U.S. small-cap funds. It’s clear that bargains abound in the small-cap sector--for those with patience.

Since the Russell 2,000 index of small-company stocks peaked April 21, small-caps have fallen into an official bear market, dropping 25.6% on average.

“If you’re bargain hunting, and have some tolerance for risk, small caps are a great place to be,” said Dan Coker, emerging-growth strategist for Schroder & Co. in New York. “Usually, small-cap out-performance cycles begin out of these types of corrections. They kind of rise out of the ashes.”

Of course, analysts have been predicting this Phoenix-like rise since the final days of the Bush administration.

Investors might want to consider some small-cap growth funds, since they’ve been hit harder in recent months than small-cap value funds.

One name to consider might be Managers Special Equity, which lost a fifth of its value in the last three months. Over the last three years, though, the fund has delivered annualized gains of almost 11%, versus just 3.1% for its peers.

How did the fund do it? Through diversification. The fund’s assets are split among four managers with distinct styles: Gary Pilgrim is a momentum investor; Andrew Knuth is value investor; and Tim Ebright and Robert Kern tend to go for micro-cap stocks, which represent the tiniest of the small-cap sector.

If you’re looking for a pure value play, Stratton Small-Cap Yield, a small-cap fund that only invests in companies that pay out dividends (rare among small firms), may be worth a look. It fell 19% during the quarter, yet is up 12.8% a year over the last three years. * Emerging markets. Talk about scavenging.

According to Morningstar, the average diversified emerging-markets fund is down 36.5% year-to-date. The average Latin American fund has plunged even more--43.4%.

Yet Paul Merriman, editor of the Fundadvice.com newsletter in Seattle, argues that now is exactly the time for investors to reconsider this beaten-down sector.

“Remember, if you’re a contrarian, you’re supposed to invest when there’s blood in the streets.”

He recommends Warburg Pincus Emerging Markets, because of its broad diversification among regions and low fees. KPMG’s Luke Collins thinks Templeton Developing Markets, run by Mark Mobius, the godfather of emerging markets investing, might not be a bad idea. That’s because while other emerging-markets funds have seen significant redemptions, this fund’s shareholders have not fled, which means Mobius won’t be forced to sell his winners to meet redemptions.

Salomon Smith Barney’s Heckman agrees that there are bargains to be had in the emerging markets. But she said all bets are off in the event of a global recession. And, she warns: “You really should have a five-year time frame to be investing in this sector.”

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Biggest Gainers and Losers Among Stock Funds Overall

The third quarter, the worst in eight years, was tough for most funds, but it still produced a few winners. Here are the mutual funds with the highest and lowest returns for the most recent quarter, along with returns for other periods and their category and “star” ratings from Morningstar. Rating descriptions can be found with the special tables beginning on C12.

Winners

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Obj Cat 3-yr Total % Return Category Cat Rtg Star 3rd Q YTD 3-yr Prudent Bear DH NA NA 21.9 -6.9 NA Comstock Partners Cap Val A IH 1 2 17.5 1.6 -10.9 Comstock Partners Cap Val B IH 1 2 17.3 1.1 -11.5 ProFunds UltraBear Inv LB NA NA 16.4 -10.1 NA Comstock Partners Strategy O IH 2 3 14.2 7.1 -2.8 Rydex Ursa LB 1 1 10.9 -2.4 -13.2 American Cent-Ben TarMat2025 LG NA NA 10.9 24.0 NA American Cent-Ben TarMat2010 LG 3 2 10.4 17.5 13.4 Rydex US Government Bond GL 1 1 10.3 15.8 10.9 Fidelity Sel Prec Met & Min SP 2 1 10.1 -3.1 -18.7 Fidelity Sel Computers ST 4 2 8.8 40.8 17.3 Wasatch Hoisington US Treas GL 5 5 8.8 15.9 13.7 American Cent-Ben TarMat2005 LG 2 2 8.7 13.9 10.2 American Cent-Ben TarMat2020 LG 5 5 8.6 19.5 17.8 Rushmore US Govt Bond GL 2 2 8.5 14.6 11.0 American Cent-Ben TarMat2015 LG 1 1 8.4 17.3 15.5 Smith Barney A Telecom Inc SC 5 5 8.1 22.2 24.5 US Global Inv Gold Shares SP 1 1 7.9 -28.1 -41.7 Vanguard Admiral LgTm US GL 3 3 7.9 14.4 11.5 Vanguard Fixln LgTm US Treas GL 3 2 7.8 14.2 11.4

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Losers

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Obj Cat 3-yr Total % Return Category Cat Rtg Star 3rd Q YTD 3-yr Vontobel Eastern European Eq ES NA NA -40.5 -52.5 NA Excelsior Latin America LS 2 2 -37.1 -50.9 -8.9 Fidelity Sel Energy Service SN 3 1 -34.8 -43.2 11.6 Aim B Latin Amer Growth LS 1 2 -34.4 -49.5 -14.9 Aim A Latin Amer Grow LS 1 2 -34.4 -49.4 -13.6 Safeco Small Company Stock SB NA NA -34.0 -24.3 NA Dreyfus Aggressive Growth SG NA NA -33.9 -47.2 -11.2 Crabbe Huson Special Prim SB 1 1 -33.6 -42.8 -12.7 Gintel MV 1 2 -33.4 -31.7 6.3 Fidelity Sel Broker & Invest SF 4 5 -33.1 -18.2 20.4 Dreyfus Premier Aggr Grow A SG 1 1 -32.8 -43.1 -21.7 Govett Smaller Companies A SG 1 1 -32.6 -32.2 -16.3 Goldman Sachs Sm Cap Val B SV NA NA -32.4 -27.1 NA Montgomery Small Cap R SB 2 1 -32.4 -28.6 3.1 Texas Capital Value Val & Gr SV NA NA -32.3 -19.3 NA Goldman Sachs Sm Cap Val A SV 2 2 -32.2 -26.7 3.9 Crabbe Huson Small Cap Inst SB NA NA -31.9 -37.2 NA Van Eck/Chubb Capital Apr MV 2 2 -31.8 -27.5 6.9 Morgan Stanley Inst Latin A LS 5 3 -31.4 -41.9 4.3 Van Kampen A Latin Amer LS 5 2 -31.2 -41.7 3.7

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