Weighing the Opportunities

To make money in the first half of this year, some stock mutual fund managers found it helpful to have an open mind--and to know how to read a balance sheet and income statement.

Though many funds shot the lights out in the late 1990s with a “momentum” strategy that entailed simply owning what was going up, this year fundamental stock analysis once again ruled on Wall Street.

The Times singled out four stock fund managers who posted gains for their shareholders in the first six months--a period when the average U.S. fund fell nearly 6%--to look for a common thread.

The four: Robert Olstein of the Olstein Financial Alert fund, which surged 20.1% in the half; Peter Trapp of Needham Growth, up 18.1%; John C. Thompson of Thompson Plumb Growth, up 8.8%; and Ira Unschuld of Schroder U.S. Smaller Companies, up 7.4%.

Each of the four men has his own approach to stock picking and portfolio management, but they share at least two key traits that have helped them shine: They stress fundamental stock valuation that includes, but also looks beyond, price-to-earnings ratios, the most widely followed “value” measure; and they play defense, striving to avoid big mistakes that can blow a portfolio to shreds.

Here’s a closer look at the four funds and the strategies their managers employ:

* Robert Olstein, Olstein Financial Alert (toll-free phone: [800] 799-2113; initial minimum investment: $1,000 regular, $250 IRA).

Olstein has managed the $472-million, Purchase, N.Y.-based fund since 1995. With an annualized return of 24.4% over the last five years, the fund has beaten 98% of its mid-cap value stock fund peers, according to Morningstar Inc.

But Olstein, a longtime self-appointed watchdog of Wall Street who published the Quality of Earnings Report newsletter before launching his retail fund six years ago, would prefer that investors look behind the numbers, as he tries to do.

“We’re getting a lot of attention now, but there’s too much focus on our performance and not enough on our discipline,” Olstein said.

His discipline is one of “buy the numbers” rather than spend time hobnobbing with company management. “I’d rather spend one night with a financial statement than two days with management,” he said. “Management is never going to tell us where we can lose.”

And though most investors focus on searching for winning stocks, Olstein said, “the avoidance of losers is what leads to good long-term performance.”

Case in point: telecom giant Lucent Technologies (ticker symbol: LU), which he sold at $60 a share in 1999 because his balance-sheet and income-statement analysis showed management straining to make the numbers look good.

Since then, Lucent has seen its stock price collapse to under $7, weighed down by heavy debt amid sinking demand for telecom equipment and by controversy over its accounting.

Not surprisingly, balance-sheet analysis also leads Olstein to stocks he likes. Among the positive signals he looks for in the fine print of company filings: high inventory turnover, improving cash flow, low debt, conservative cash reserves, forthright management and earnings reported to the Securities and Exchange Commission that match those reported to the IRS.

Olstein calls cash flow “the engine of any company,” saying many investors focus too heavily on bottom-line earnings per share. Cash flow measures the money generated by a business in a given period, before deducting such noncash charges as depreciation.

Though Morningstar labels his fund mid-cap value, Olstein scoffs at such labels. “We don’t pick stocks by size,” he said. “We go anywhere that cash flow takes us.”

This year, he has reaped the benefits of a contrarian bet that he began making late last year on battered semiconductor stocks.

Lately, he also has been buying cigarette makers R.J. Reynolds Tobacco Holdings (RJR) and Philip Morris (MO), along with PNC Financial Services Group (PNC) and Bank of America (BAC) in the financial sector.

But no matter how much he likes a stock, Olstein spreads his bets around, typically holding 100 or more names in the fund to limit risk, he said.

“Remember, if you’re up 80% one year and down 50% the next, you’re down 10% [for the two years]. That’s what a big loss does to you,” he said.

Olstein’s efforts don’t come cheap: The fund’s annual expense ratio is about 2.2%, well above average for a U.S. stock fund.

* Peter Trapp, Needham Growth ([800] 625-7071; initial minimum: $5,000 regular, $1,500 IRA).

Trapp, who has managed the $231-million New York-based fund since January 1998, has generated an annualized return of 35.1% in the last three years. That was better than 99% of his mid-cap growth stock fund peers, according to Morningstar.

Trapp hunts for small and mid-size stocks selling for price-to-earnings or price-to-cash-flow ratios of half the company’s projected earnings growth rate for the next three years, he said. He focuses on sectors he knows best: Tech makes up

about half the portfolio, which also includes health care, biotechnology, specialty retail and media-entertainment stocks.

Like a lot of managers, he calls his approach “growth at a reasonable price,” or GARP. But Trapp also employs some strategies similar to hedge funds--such as “short” sales and options transactions--that set him apart from the mutual fund crowd.

Trapp said such strategies help temper volatility in the fund and minimize taxes. In a short sale, an investor borrows shares and sells them, betting on a drop in the stock’s price. Options, which give the purchaser the right to buy or sell a stock or index share at a set price by a set date, often are used to hedge stock bets.

With as much as 25% of his portfolio, Trapp will short stocks he deems overvalued, especially those with “challenged management” or accounting issues, he said.

Hedging maneuvers, meanwhile, help Trapp maintain tax efficiency. If a stock gets ahead of itself, for example, he might use an options strategy to protect gains without selling the shares--in effect allowing a short-term capital gain to mature into a long-term gain.

Short sales also can hedge the fund’s exposure to a particular industry, Trapp noted. In the past, for example, he has owned Foundry Networks (FDRY) while shorting rival Extreme Networks (EXTR).

Current short-sale targets include restaurant stocks, luxury retailers and advertising firms, three industries in which many companies will “have a hard time making their numbers as consumers continue to pull in their horns,” Trapp said.

Hefty cash reserves (currently about 20% of assets) also have muted the fund’s volatility. Trapp said he is concerned about current stock valuations and wants to be ready “to let stocks come to us”--meaning he wants to be able to pounce if a stock he’s interested in sinks to a more reasonable level.

As for stocks he likes, Trapp’s current holdings include networking software maker Packeteer (PKTR), whose products help stagger traffic through the “choke point of the broadband pipe.” The company is likely to post a slight loss this year, but Trapp expects revenue to grow at about 50%.

He also likes clothing retailer Pacific Sunwear (PSUN) and Genta (GNTA), a biotech company developing cancer drugs.

* John C. Thompson, Thompson Plumb Growth ([800] 999-0887; initial minimum: $1,000 regular, $250 IRA).

Like Olstein, Thompson can be eclectic in his stock picking. About half his fund’s assets are in mid-cap stocks--not by design but because that’s where bargains have appeared, he said.

“We go anywhere trying to make money with the lowest risk possible,” Thompson said. “If we can do that with a $1-billion company, great; if we can do it with General Electric [which has a market value of about $500 billion], we’ll do it that way.”

Thompson has run the $127-million fund from Madison, Wis., since 1994. He has notched an annualized return of 22.3% in the last five years and is tied for first place in Morningstar’s large-cap-blend fund category. Blend funds hold a mix of growth and value stocks.

In late 1999 and early 2000, Thompson sold many of his technology stocks and bought financial names--a move that helped him stay ahead of his peers.

Emphasizing “free” cash flow, which is a firm’s gross cash flow minus capital expenditures, has led him to stocks such as radio and billboard company Clear Channel Communications (CCU), which has surged 29% this year. Though the company is expected to lose money this year, Thompson finds the shares reasonable on a price-to-cash-flow basis, he said.

Value-minded investors often shop where others fear to tread. So even though long-distance telecom has become disdained by many investors as a commodity-like business, Thompson couldn’t resist recently picking up shares of WorldCom’s tracking stock for its MCI Group (MCIT), the annualized dividend yield of which is more than 14%.

“The stock has been drastically mis-priced,” he said.

He recently added to insurer Conseco (CNC) when that stock plunged from about $20 to $14 partly on concerns about Chief Executive Gary Wendt’s health, fears Thompson called “an overreaction.”

He also added to Compaq Computer (CPQ), sensing a bottom approaching in the hard-hit PC industry.

* Ira Unschuld, Schroder U.S. Smaller Companies ([800] 464-3108; initial minimum: $10,000 regular, $2,000 IRA).

Unschuld has managed this $26-million fund since September 1998, generating an annualized return of 11.2% since then and beating about two-thirds of his small-cap growth fund peers, according to Morningstar.

But more investors may know him as manager of the $129-million Schroder Ultra fund, a micro-cap stock fund that has gained an annualized 97.1% in the last three years--the best mark in Morningstar’s database for any kind of fund. That fund is closed to new investors.

Boston-based Unschuld, whose fund defines “smaller companies” as those with market capitalizations of $500 million to $2.5 billion, is a growth-at-a-reasonable-price investor, like Trapp.

He looks for “under-followed, underappreciated companies” but, like most GARP investors, shies away from “the really cheap stuff” as being too dangerous.

A typical holding might be a company posting earnings growth of 20% to 30% a year and selling for a P/E ratio of 15 to 20, he said.

Because Unschuld focuses on attractively priced growth stocks, he steered clear of many of the tech sector’s greatest casualties over the last year, said Morningstar analyst Heather Haynos.

“We want to win two ways: earnings growth and [P/E] multiple expansion on those profits,” Unschuld said. In other words, he wants a company that will eventually be rewarded for its healthy growth with a higher P/E--juicing the stock’s return.

Like Olstein, Trapp and Thompson, Unschuld takes the view that investing mistakes are unavoidable no matter how many details you sweat. So he spreads his bets around to lower risk, he said. The fund recently held just 16% of assets in its top 10 holdings.

Earlier this year, Unschuld was buying financial stocks such as Federated Investors (FII) and Greater Bay Bancorp (GBBK). He also picked up beaten-down jewelry retailer Zale (ZLC), up17% this year, and slot machine maker Anchor Gaming (SLOT), up 44%.

Although the fund now is light on tech stocks, Unschuld also bought Amphenol (APH), which makes electronic and fiber-optic connectors.