Small-Value Funds' Performance May Be Invitation to Diversify

By JOSH FRIEDMAN

July 25, 2000 12 AM PT

Talk about eating the bull market’s dust: Over the last three years, the average mutual fund that focuses on small “value” stocks has generated an annualized return of just 3.5%.

But this year, small-value investing has suddenly become respectable again. The question is can it last.

At the very least, the volatile second quarter on Wall Street should have served as a stark reminder that investing themes are cyclical.

Growth stocks--richly priced shares of companies with fast-rising sales and/or earnings--had reigned for so long that many investors had given up entirely on value stocks, which tend to be bargain-priced issues of slower-growing companies or firms that have fallen on hard times.

While growth-stock mutual funds fell sharply in the second quarter, value-stock funds held up well. And small-value funds performed best of all major fund categories in the quarter, eking out an average gain of 0.8%, according to fund-tracker Morningstar Inc.

So far this year, the average small-stock value fund is up more than 7%. While small- and mid-size growth stock funds are beating small value, the latter is far ahead of big-stock funds and the Standard & Poor’s 500, which is up less than 2%.

Historically, value stocks have outperformed growth stocks over long periods: From 1929 through 1999, small value stocks returned an annualized 14.7%, versus 10.3% for large growth, 12.7% for large value and 9.6% for small growth, according to research firm Ibbotson Associates.

But past performance guarantees nothing, of course. And who has a 71-year horizon, anyway?

Growth-stock proponents argue that in the “new economy,” investors are sure to keep favoring emerging technology companies that hold the promise of being the next big thing. Why buy also-rans or slow-growing businesses, which is typically what you find in the small-value-stock universe.

Chuck Royce, founder of the New York-based Royce Funds--perhaps the best-known small-value investment firm--naturally begs to differ. He believes that small value stocks are finally regaining their edge and could outperform the broad market for the next two to three years.

In large part, Royce is betting that the market overall is going to be far less generous with returns in coming years than in the 1990s.

“Growth funds generally do better in a high-return environment, with all that momentum fueling them,” Royce said. “But if you think the lower recent returns overall are likely to continue--and we do--then small value is an asset class that should shine.”

When Royce says value, he means it: He favors small stocks such as women’s clothing retailer Charming Shoppes (ticker symbol: CHRS), which at $5.81 a share is priced at 11 times its expected earnings per share this year. He also likes Fleetwood Enterprises (FLE), the mobile-home maker, which at $13.44 is priced at about nine times earnings.

Contrast those price-to-earnings ratios with the S&P; 500 index’s P/E of about 26.

The value investor looks at stocks such as Charming and Fleetwood and figures they’re bound to recover someday. The growth investor looks at those stocks and figures, why bother--there are a lot more exciting places to invest right now.

Still, if your portfolio could use more diversification, the small-value sector’s performance this year might be an invitation. A small-value mutual fund might be your best bet: Researching individual small value stocks can be tricky, and once you buy them, they can be volatile and illiquid.

To find small-value funds worth considering, we screened Morningstar’s database (https://www.morningstar.com) for funds that: beat their peers year-to-date and over the last 12 months and three years; have managers with tenure of at least a year; have expense ratios below the category average (1.6% of assets per year); have no load, or sales charges; and have initial investment minimums of $3,000 or less.

Eleven funds emerged, as shown in the accompanying chart. Though their individual stock-picking styles vary, these funds tend to buy stocks of firms with less than $2 billion in market capitalization (stock price times number of shares outstanding) and with valuations (P/Es, for example) well below those of the S&P; 500.

Chuck Royce’s fund family has four funds on our list.

Royce, longtime co-manager of the Royce Micro-Cap, Royce Low-Priced Stock and Pennsylvania Mutual funds, has been eclipsed in terms of recent performance by colleague Boniface “Buzz” Zaino: His Royce Opportunity fund is one of the few small-value funds to have beaten the S&P; 500 over the last three years, and the fund’s 23.4% return so far this year is borderline scary for a value fund.

Zaino, who took over the fund in April 1998, hunts for stocks selling at discounts to their per-share true asset values. But he’s also willing to pay up for faster-growing companies that he still considers values.

The fund’s sizable technology weighting (compared with its peers) might leave it vulnerable to swings in that sector, according to Morningstar’s latest report. But the tech weighting is below that of the S&P; 500. Despite the fund’s relatively high octane level, Zaino seeks to mute the risks by maintaining more than 200 holdings, generally without letting any account for more than 1.5% of net assets.

“It’s a little more high-risk than most of our other funds,” Royce said, “but Buzz is just a darned good stock-picker with a bias toward companies that can double.”

W. Whitney George, who took over Royce Low-Priced Stock in January after six years as co-manager, also is clobbering his peers. In trying to find hidden gems, he buys only stocks that sell for less than $15 a share--hence the name.

By their nature, value investors must step up and buy the unloved--such as sunglasses maker Oakley (OO), which Low-Priced Stock bought in 1997 when sales turned sour.

Finally, this year, Oakley is back in favor, up 151% year-to-date. Which also demonstrates another value-investing trait: You’ve got to be patient.

The nominal dollar price of a stock has nothing to do with its intrinsic value, of course, but Low-Priced Stock’s basic idea is that a $15 price cutoff helps point the fund’s managers to beaten-down or ignored treasures that can make good long-term holdings.

Meanwhile, Royce’s flagship small-value fund--Pennsylvania Mutual--also is its weakest performer. Its returns in recent years has been as drab as the name might imply. Still, the fund holds up better than most when the market turns south, according to Morningstar, making it a decent choice for very conservative investors.

Here’s a look at some of the other funds that made our screen:

* Deep-value specialist Marty Whitman, who calls himself a “vulture investor” and once told an interviewer, “Diversification is for amateurs,” relies on painstaking financial analysis in seeking companies selling at half their private market or takeover value.

His Third Avenue Value Fund, up 18.2% this year, recently held large stakes in semiconductor-equipment makers, Japanese insurers and stocks in the financial and real estate sectors.

With even smaller stocks and a more concentrated portfolio, Whitman’s Third Avenue Small Cap Value carries a higher risk rating from Morningstar. But the fund, co-managed with Curtis Jensen, adheres to a buy-and-hold strategy and scores well on tax efficiency.

* T. Rowe Price Small Cap Value also skews toward the micro-cap end of the market. And though its recent performance hasn’t been spectacular, the fund has a solid 10-year mark with annualized returns of 12.9%. Preston Athey has managed the fund since 1991.

* Babson Shadow Stock’s Tony Maramarco maintains a diversified portfolio of more than 200 small stocks to temper risk. Holdings such as oil explorer Prima Energy (PENG), up 209% in 2000, and telecom equipment maker Symmetricom (SYMM), up 133%, have helped the fund post strong returns.

They also aren’t cheap stocks anymore--which illustrates the classic value-investing dilemma: When to sell your winners.

* Armada Small Cap Value, co-managed by Mary Jane Matts and Daniel G. Bandi since May 1999, has returned 11.9% in the last 12 months, well above the S&P; return. With a median market cap of $973 million, it skews toward bigger stocks than some of its peers in the small-value arena.

* The team-managed Victory Small Company Opportunity seeks companies with above-average or improving earnings growth that are undervalued based on the fund’s proprietary model. Though the fund is having a good year, its longer-term performance isn’t exactly blazing.

* Likewise, Northern Small Cap Value won’t appeal to investors looking to make a killing, but the fund is tax-efficient and consistent. Manager Susan French uses a quantitative model to find stocks trading cheaply relative to earnings, cash flow or sales, and maintains a highly diversified portfolio that recently had nearly 900 names.

Times staff writer Josh Friedman can be reached at josh.friedman@latimes.com.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Small-Value Funds: Some Ideas

The Times screened Morningstar’s database for small-cap value stock mutual funds that have produced above-average results. We required: peer-beating performance year-to-date and over the last 12 months and three years; manager tenure of at least a year; annual expense ratio below the category average of 1.6%; no load, or sales charge; and initial investment minimums of $3,000 or less. These 11 funds, r anked by year-to-date return, made the cut.

Fund name/ Total returns* Assets Minimum

phone number YTD 12-mo. 3-yr. (mlns.) investment

Royce Opportunity 23.4% 34.8% 22.4% $154 $2,000

(800) 221-4268

Third Avenue Value 18.2 24.8 13.1 1,640 1,000

(800) 443-1021

Royce Low-Priced 17.8 32.1 19.1 40 2,000

Stock (800) 221-4268

Royce Micro-Cap 17.0 28.0 12.1 123 2,000

(800) 221-4268

Babson Shadow Stock 14.7 11.1 10.1 44 1,000

(800) 422-2766

Armada Small Cap Value 13.0 11.9 7.6 352 500

(800) 622-3863

T. Rowe Price 12.9 8.7 3.7 1,168 2,500

Small Cap Value (800) 638-5660

Third Avenue 10.6 13.7 6.1 130 1,000

Small Cap Value (800) 443-1021

Victory Small 10.1 6.2 4.2 93 500

Co. Opportunity (800) 539-3863

Pennsylvania Mutual 9.9 9.3 9.4 353 2,000

(800) 221-4268

Northern Small Cap Value 8.9 12.7 7.7 189 2,500

(800) 595-9111

Avg. small value fund 8.1 4.6 3.5

S&P; 500 index 1.5 6.6 19.1

* Through July 19. Three-year figure is annualized.

Source: Morningstar Inc.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Value: Playing Catch-Up

Mutual funds that focus on smal value stocks have been among the worst performers in the last three years, as investors have favored big stocks in general and growth stocks in particular. But so far this year small-value funds are back in the race. Average gains by stock fund category through last week:

3-Year Returns

Mid-cap growth: + 31.3%

Mid-cap growth: +27.2

Large growth: +27.2

Small growth: +23.6

Large value: +8.9

Mid-cap value: +7.0

Small value: +3.5

Year-to-Date Returns

Mid-cap growth: +13.6

Small growth: +10.8

Small value: +7.3