Fund Managers Position for 2002

For a stock mutual fund manager, beating one’s category average was tough in 2000, and tough in 2001. But beating the average both years--amid the longest and deepest bear market on Wall Street in a generation--may be considered a true feat.

In a so-called stock-picker’s market, that kind of track record suggests genuine talent in stock-picking.

Here are five fund managers who outperformed their category average, as calculated by Morningstar Inc., by at least three percentage points in both of the last two years, and how they’re positioning their portfolios for 2002:

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Richie Freeman, Smith Barney Aggressive Growth Fund, in New York: Freeman’s fund gained 19.2% in 2000 and lost 5% in 2001, compared with average returns of negative 14% and negative 24% for large-cap growth stock funds overall in those years, according to Morningstar.

Freeman has managed the portfolio from its inception in November 1983. The fund’s 10-year annualized return ranks it in the top 1% of Morningstar’s large-cap growth fund category.

Freeman said he looks for companies that “can control their own destiny to some extent, whose success is determined by their own products and not the economy.”

That focus most recently has led him to more health-care stocks, especially biotech companies. The biotech sector can be highly volatile, but Freeman said he has emphasized profitable companies such as IDEC Pharmaceuticals Corp., Amgen Inc. and Chiron Corp.

“We’re interested in dynamic, exciting companies,” he said. “We follow trends, not fads, and there’s a powerful trend that has to do with treating diseases heretofore untreatable. These are companies that are able to prolong people’s lives.”

Other health-care holdings in the fund include generic-drug maker Forest Laboratories Inc. and managed-care company UnitedHealth Group Inc.

Though Morningstar classifies Freeman’s fund as large-cap growth, he considers it an “all-cap” fund: “We buy them as small- or mid-cap stocks and [hope] eventually they grow larger,” he said.

Forest Labs and cable television company Comcast Corp., for example, have been in the fund since its launch 19 years ago, he said.

Indeed, with only about 1% annual portfolio turnover, Freeman is a buy-and-hold adherent. “There’s a lot to be said for Warren Buffett’s philosophy that the ideal holding period is forever,” he said.

In recent months, Freeman has put new cash into existing holdings such as IDEC; into the financial sector, including asset manager Neuberger Berman Inc. and brokerage firm Lehman Bros. Holdings; and into defense contractor L-3 Communications Holdings Inc., “whose business prospects improved, unfortunately, because of the Sept. 11 tragedy.”

Freeman believes that investors should take one basic lesson away from the market’s initial dive, then recovery, following Sept. 11: “Even if the market seems a little scary, in the final analysis you are buying ... an individual company, and it pays to buy low.”

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Ken Heebner, CGM Focus Fund, in Boston: Heebner guided this four-year-old fund to a 53.9% gain in 2000 and a 47.6% surge in 2001. Its three-year annualized return of 35.1% is in the top 1% of Morningstar’s small-cap “blend” category. Blend funds hold a mix of “growth” and “value” stocks.

Heebner’s fund charter gives him broad leeway in running this concentrated fund, which typically holds just 15 to 20 stocks, compared with more than 100 for most funds in this category. He also employs other techniques that may increase the fund’s risk level.

In 2000, Heebner cleaned up by “shorting,” or betting against, tech stocks whose valuations had gotten out of touch with the companies’ earnings potential, he said. Last year he unwound all his short positions by Sept. 30 but has remained light on tech stocks, he said, and has benefited from hefty weightings in the home-building and recreational-vehicle industries.

Home builders such as NVR Inc., Beazer Homes USA Inc. and Ryland Group Inc. have done well as the housing market has remained resilient despite the recession. The same has been true of recreational-vehicle companies Winnebago Industries Inc. and Monaco Coach Corp.

Yet stocks in both industries remain cheap, Heebner said. “Home building used to be a business of hit-and-miss entrepreneurs, but these are established national enterprises, leaders that can continue to grow market share as the industry consolidates,” he said of his building stocks.

The fund also has stakes in Frontier Airlines Inc., a regional airline operating from Denver, and in Continental Airlines Inc. The well-known woes of big industry players such as United parent UAL Corp., which recently reduced its capacity in Denver, will benefit the more efficient Frontier, Heebner said.

Though Continental continues to lose money, Heebner believes it is better managed and has fewer labor problems than most of its major competitors.

Other holdings include consumer stocks such as Gart Sports Co., a sporting-goods retailer that recently bought rival Oshman’s Sporting Goods; Tweeter Home Entertainment Group Inc., an upscale electronics retailer; and Wilsons the Leather Experts Inc., a clothing retailer.

Another chunk of the portfolio is in trucking stocks such as Yellow Corp., Arkansas Best Corp. and Roadway Corp.

“If you step back and look at the portfolio, it’s a strong statement on a consumer-led recovery,” Heebner said.

But with his concentrated style, volatility is a given with this fund, he warned. “If the home building industry has a bad day, it will be hard for this fund to do well.”

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Peter Higgins, Dreyfus Midcap Value Fund, in Boston: Higgins, whose fund gained 27.5% in 2000 and 17.1% in 2001, has managed the fund since its September 1995 launch. Its five-year annualized return of 18.6% is in the top 9% of Morningstar’s mid-cap value category.

Investors have noticed, as the fund has seen hefty cash inflows. Higgins said the fund, which now has more than $1.2 billion in assets, will be closed to new investors when assets hit $1.4 billion. He said he wants to stay nimble enough to maintain a true mid-cap fund.

Whatever money comes in usually gets put right to work: Higgins stays nearly fully invested, with only about 1% of the portfolio in cash.

“We don’t try to time the market. We have no particular skill in doing that,” he said. “Some managers hold 15% to 20% cash, which makes little sense to me--you might as well give the money back to your clients.”

Higgins said the secret to successful value-stock investing lies in “not looking at things as Wall Street does.”

“Typically, when a stock is moving down we may be looking at buying it, and when it’s moving up we may be selling it.”

Copier giant Xerox Corp., which tumbled from more than $60 in late 1999 to $5 by last spring and now is at about $10, exemplifies the Higgins approach. “The company has been through various trials and tribulations over the past 24 months, with accounting issues, concerns about liquidity, etc.,” he said. “There has been a lot of skepticism over [a] turnaround, and probably justifiably so. But we think Xerox is making progress. The company has solid-enough assets and has secured financing from partners such as GE Capital. Its balance sheet is getting better, and there’s also progress on the cost-cutting front.”

Higgins thinks Xerox can earn more than $1 a share by 2003.

Another Higgins holding is fuel refiner Valero Energy Corp. Wide swings in gasoline prices in recent years have meant volatile profits for companies in the sector, but with gasoline production down, demand will eventually catch up with supply, Higgins said.

Valero shares trade for about seven times Wall Street analysts’ consensus earnings estimate of $5.21 a share for 2002, Higgins said. That’s less than half the price-to-earnings ratio of the average blue-chip stock.

Other fund holdings, as of Nov. 30, included Stilwell Financial Inc., parent of the Janus and Berger mutual fund groups; Cendant Corp., a franchiser whose brands include Howard Johnson, Avis and Century 21; and Agilent Technologies Inc., a maker of measuring instruments.

On the flip side, Higgins said he sold all his shares in semiconductor company Conexant Systems Inc. after the stock more than doubled in the post-Sept. 11 rally. He also trimmed his holdings in communications equipment maker Scientific-Atlanta Inc., he said.

“We’re disciplined sellers. We have a target price for everything we own.”

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Karen Reidy, Janus Core Equity Fund, in Denver: Reidy took over this large-cap growth fund in January 2000 and held its losses to 7.2% in 2000 and 12.1% in 2001--far smaller declines than most Janus stock funds incurred.

Core Equity, formerly known as Janus Equity-Income, was in the top 21% of Morningstar’s large-cap growth category in 2000 and in the top 10% in 2001, both brutal years for the large-cap growth sector.

Reidy, who joined Janus in 1995, had worked as an analyst and assistant portfolio manager at the flagship Janus Fund.

Core Equity has become more conservative since Reidy took over: In early 2000, for example, 9% to 10% of the portfolio was in corporate junk bonds, she said, an allocation now closer to 1% to 2%.

“I want this to be a fund that gets you where you’re going but lets you sleep well at night,” she said.

Though Morningstar still classifies Core Equity as a large-cap growth fund based on its history, the current portfolio is considered large-cap blend. The fund typically holds 55 to 65 stocks across a broad mix of industry sectors.

Reidy said she looks for companies with consistent, predictable business models; accelerating cash flow and return on capital; sharp management; and attractive valuations--as she put it, “the right risk-reward trade-off.”

“There’s a special place in my heart for consistent business models, as opposed to companies scrambling to make their quarterly numbers in the last week of the third month,” she said.

Major holdings that have the steady revenue streams Reidy likes include Automatic Data Processing Inc., a payroll processing company; and global banking giant Citigroup Inc. Other sectors she likes include manufacturing and media/advertising, two areas walloped by the recession but that may be bottoming out, she said.

“As an investor, you have to anticipate turnarounds,” Reidy said. “You can’t wait for the [positive] data points to present themselves, because by then the stock prices will have moved up.”

Reidy, who held 12% to 13% of the portfolio in cash early in 2001, has spent that position down to 8% or 9%, she said. “It may not sound dramatic, but for my style of investing, that’s evidence that I’m a bit more constructive about the market.”

Other large positions in the fund as of Oct. 31 included such blue-chip names as General Electric Co., insurer American International Group Inc., Exxon Mobil Corp. and 3M Co.

Still, Reidy cautioned that she is a bit less enthusiastic about stocks’ prospects overall than she was three months ago. “The market’s bounce was not really based on fundamental valuations, but on anticipation, asset allocation [shifts by fund managers] and liquidity,” she said. “The market needs to digest all that.

“It’s great to anticipate, but don’t chase stocks--and don’t forget about valuations.”

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John D. Spears, Tweedy Browne Global Value Fund, in New York: Spears, whose fund gained 12.4% in 2000 and slipped 4.7% in 2001, is part of a four-member team managing Global Value. He and his partners have guided the fund to a five-year annualized total return of 12.9%, landing it in the top 3% of Morningstar’s foreign stock fund category.

For the most part, major foreign stock markets suffered a worse bear-mauling than the U.S. market in 2001. But Tweedy Browne’s cautious, value-oriented style minimized the damage for its investors.

The Global Value fund, which concentrates its investments in Europe, Japan, the U.S. and Canada, keeps portfolio turnover low in an effort to avoid taxable capital gains distributions, so it hasn’t been making any dramatic moves, Spears said. Its annual portfolio turnover rate of about 12% is far below average for a stock fund, according to Morningstar. “We’re very cognizant of that big tax bully out there,” Spears said.

When they buy stocks, Tweedy Browne managers pay strict attention to valuations to help limit risk of loss, Spears said. The idea is that, when lofty expectations aren’t priced into a company’s shares, the downside from potential disappointment may be minimal--as long as the company is financially healthy, of course.

Spears said Tweedy Browne managers look for companies they believe are undervalued relative to their intrinsic worth, typically based on a piece-by-piece analysis of the business’ units.

Though the managers rely on a “bottom-up,” or stock-by-stock, selection process, one area they especially like these days is the drug industry, Spears said. Large holdings include Germany’s Bayer, as well as Pharmacia Corp. and Schering-Plough Corp.

“We like the nature of the business, where patents allow for great pricing flexibility,” Spears said. “And many of these companies have a strong pipeline of [new] products.” Many major drug stocks have largely been stuck in neutral over the last year, even as the companies’ earnings continued to rise.

Other large positions in the portfolio as of Dec. 31 included global food and consumer products giants Nestle and Unilever and British food and alcohol conglomerate Diageo.

One newer holding is ABN Amro Holding, a major Netherlands-based bank, which is priced at about nine times Tweedy Browne’s estimate of 2002 per-share earnings. Also, the stock’s annualized dividend yield is about 5%.

The financial sector has long been a Tweedy Browne favorite, Spears said, and the hit the stocks took immediately after Sept. 11 provided a good buying opportunity. The fund also holds shares of MBIA Inc., the largest insurer of municipal bonds in the U.S.