Despite Daunting Obstacles, a Steady Ascent

The picture looked bleak for mutual fund investors 12 months ago, with the stock market smarting from three years of losses and war with Iraq looming on the horizon.

In reality, everything was starting to fall into place for a dramatic recovery on Wall Street.

“If I had come to you at the start of 2003 and said corporate profits and dividends would be higher, we’d have low inflation and low interest rates and we’d catch Saddam Hussein, you would have been thinking, ‘Bull market,’ ” said Neil Hennessy, manager of the Hennessy Cornerstone Growth and Hennessy Cornerstone Value funds in Novato, Calif.

And what a bull market it turned out to be, even as geopolitical tensions remained high and the mutual fund industry was engulfed in scandal.

As major stock benchmarks enjoyed their first up year since 1999, the average domestic equity fund surged 32.9% in 2003, according to data tracker Morningstar Inc., ending the 2000-02 losing streak and marking the first year since 1999 that stock funds beat bond funds.

In the fourth quarter alone, the average U.S. stock fund rallied 12.2%. Hennessy’s funds boomed, too, gaining 45.8% and 28.4% for the year, respectively.

Investors who still had a stomach for risky bets after three years of bear market losses were amply rewarded. Funds that focus on volatile small-company stocks outperformed those specializing in more stable blue chips, and growth-oriented funds beat so-called value funds

It was a broad rebound. Some 98% of U.S. stock funds posted double-digit gains, Morningstar said, and “bear market” funds (which bet that stock prices would fall -- a winning wager in recent years) were the only category of fund that was in the minus column.

Returns were especially sweet for many funds that invest in the shares of fast-growing small and mid-sized companies. Small-capitalization growth funds soared an average 45% in 2003 and mid-cap growth funds jumped 36.1%. Among the groups’ standout performers were Apex Mid Cap Growth, up 165.3%; Reynolds Fund, up 121.9%; and Oberweis Micro-Cap, which climbed 108.9%.

Given the U.S. economic recovery, which gathered steam in the third quarter and continued in the fourth quarter, the heady gains in the small- and mid-cap growth categories came as no surprise to analysts.

“Smaller companies are more nimble and more leveraged to the economy,” said Don Cassidy, senior research analyst at fund tracker Lipper Inc. in Denver. A few extra orders “means more to their well-being than it does to a General Motors.”

Still, blue-chip portfolios notched sharp gains too, including many of the nation’s biggest funds. Funds that buy shares of large growth companies -- one of the biggest fund categories -- returned 28.6% last year.

The $71-billion Vanguard 500 Index fund, which tracks the benchmark Standard & Poor’s 500 index, rose 28.5%; the $65-billion Fidelity Magellan climbed 24.8%; the $55-billion American Funds’ Investment Company of America gained 26.3%; and the $26-billion Dodge & Cox Stock fund surged 32.3%.

Growth funds, which look for companies whose earnings are rising rapidly, beat value funds, which look for underpriced or overlooked stocks and often hold up well in weak markets.

But the edge was slim. Mid-cap growth funds, for example, climbed 36.1% on average, versus 34.4% for mid-cap value. Such narrow margins are unusual for a bullish year.

“Normally, in a good year like 2003, growth beats value handily,” Cassidy said, “but there is a hangover effect from people’s losses of the previous few years. People are still a bit cautious,” and value stocks still have plenty of fans among investors.

By contrast, in 1999 -- the stock market’s last winning year before 2003 -- mid-cap growth funds gained an average of 62.1%, versus 8.1% for mid-cap value.

Among sector funds in 2003, the precious metals and technology categories were strong, with gains of 59% and 55.9%, respectively.

ProFunds Semiconductor rocketed 146.6% and Jacob Internet rallied 101.3%, for example, while Scudder Gold & Precious Metals jumped 94.5%.

The brighter economy is spurring robust growth in tech industries such as chip manufacturing and Internet advertising. Semiconductor sales are expected to grow 19.4% for 2004.

The surge in gold prices is being driven by several factors, including production cuts by mining companies in recent years and increased demand from the booming economy of China, said manager Frank Holmes, whose U.S. Global World Precious Minerals fund soared 92.7% last year, in a recent note to clients.

In addition, gold, which is priced in dollars worldwide, has become cheaper for foreign buyers as the greenback weakens against other major currencies.

Meanwhile, funds investing in foreign stocks outperformed domestic funds in 2003, gaining 39.2% on average, thanks to improving global economies combined with the dollar’s steep slide against currencies such as the euro and the Japanese yen. A weak dollar benefits U.S. investors in foreign stocks when shares denominated in a stronger foreign currency are translated back into dollars.

In the fourth quarter, the average foreign fund gained 15.5%.

On a local currency basis, international stocks slightly underperformed shares traded on U.S. exchanges, but the weak dollar gave them a big edge, said Jamie Doyle, portfolio manager of the Causeway International Value fund in Los Angeles.

Doyle, whose fund climbed 45.9% in 2003, noted that the MSCI EAFE index of foreign stocks rose less than 20% in local currency terms -- but 35% when factoring in the dollar’s tumble.

Even the long-suffering Japan stock fund category recovered, gaining an average of 38% last year.

Among other notable individual performances, the L.A.-based Hotchkis & Wiley team had several big winners, including its All-Cap Value fund, which rose 69.6%, and its Large-Cap Value fund, which gained 42.8%.

William Miller of the Legg Mason Value fund extended his record streak of beating the blue-chip benchmark Standard & Poor’s 500 index to 13 straight calendar years. Miller’s fund, an eclectic portfolio categorized as a blend of large growth and value stocks, rose 43.5%.

Miller’s younger offering, Legg Mason Opportunity, zoomed 67.9%.

No one seems to be betting against Miller in 2004, but strategists say investors shouldn’t expect this year’s stock market to be a replay of 2003.

For one thing, the momentum may shift from small-cap shares to those of large, well-known companies, they say.

“The early part of the economic recovery is played out,” Cassidy said. “Everybody has got a computer, and they can see that the valuations are relatively good for a lot of the blue-chip names.”

Continued inflows of cash into stock mutual funds and a persistent shift toward equities and away from bonds by institutions such as pension funds would also boost blue chips, he said. Institutional investors often shy away from smaller stocks because they have little effect on their huge portfolios.

Hennessy agreed, saying the 2003 dividend tax cut also could boost blue chips’ popularity -- especially after taxpayers file returns for last year and consult their financial advisors.

“What people are going to figure out is that dividends are 85% tax-free,” he said, noting that taxes on dividend payouts were trimmed to 15%. “They are going to start to buy those companies, and more companies are going to start paying dividends too.”

Hennessy said the volatile Nasdaq composite index, which includes many tech shares and a slug of smaller stocks, was unlikely to soar 50% as it did in 2003.

“I don’t see anything in technology that’s going to revolutionize the industry the way chips did in the 1980s, the way the Internet did in the 1990s,” he said. “I think people are going to look instead to old-line companies with customers, products, earnings and dividends. If people keep it simple in 2004, they’ll make money.”

As for international funds, Cassidy said he expected them to continue to outperform their stateside rivals. Some economists believe the dollar will continue to weaken, he said, amid dissatisfaction with the U.S. trade and budget deficits.

Doyle said the dollar could recover, however, if the U.S. economy continued to strengthen.

Regardless, with most global markets higher last year, bargains are harder to find these days, he said.

“Overall,” Doyle said, “values are not nearly as impressive as they were on Jan. 1, 2003.”