Stock Funds’ Growth Slows, but They Still Beat Rivals in Second Quarter

Stock mutual funds mostly ran out of gas in the second quarter after a strong 12-month run.

With the third quarter off to a rocky start, the question facing equity investors is, who knew better in the spring -- sellers or buyers?

The average domestic stock fund edged up 0.9% in the quarter ended June 30, after a 3% gain in the first quarter and a 33% surge in 2003, according to fund tracker Morningstar Inc. in Chicago.

Despite their meager average returns last quarter, the most popular stock-fund categories still beat bond funds and money market funds, their two main rivals. Most bond funds posted negative returns as interest rates rose, devaluing older fixed-rate securities; money market returns for the period were about 0.13%, on average.

There was heavy profit taking in some of the biggest equity-fund winners of 2003. Funds that focus on gold and gold-mining stocks, for example, tumbled 18.4% in the quarter, on average. Emerging-markets funds slid 9.5%, on average. Funds that buy real estate investment trust shares lost 5.6%.

Perhaps more significant, after a long period during which funds that own small-company stocks trounced their large-company rivals, there was a hint that some investors were growing wary of smaller issues.

The small-capitalization growth fund category eased 0.3% in the quarter, on average, Morningstar said. By contrast, the large-cap growth fund category was up 1% in the period.

That may not be statistically significant, but in light of the selling in some other formerly hot market sectors, it raised the question of whether investors were trying to reduce the level of risk in their portfolios.

Another warning sign: “You’ve seen a number of managers on the ‘value’ side moving more into cash” this year, said Russ Kinnel, director of fund analysis at Morningstar.

Value stocks -- which typically sell for lower-than-average price-to-earnings ratios and often are out of favor with Wall Street -- have far outpaced growth stocks the last few years as many investors turned more conservative amid the 2000-2002 bear market. Value again beat growth in the second quarter.

The problem now, some value-fund managers say, is that it’s a lot harder to find cheap stocks anywhere.

“There aren’t a lot of outstanding values around,” said David Dreman, head of Dreman Value Management in Jersey City, N.J.

Market optimists say none of this is new. And despite the stock market’s struggle in the second quarter, and the slide so far in the new quarter, some say there are no strong reasons for fund investors to worry that the bull run is over barely 15 months after it began.

John Kornitzer, whose Kornitzer Capital Management in Shawnee Mission, Kan., manages the Buffalo group of mutual funds, said the mounting concern he had heard in recent days gave him more confidence that stocks have hit a temporary air pocket at worst.

“If everyone was enthusiastic about the market, I’d be worried,” he said. The “contrarian” view is that the market is more likely to pleasantly surprise investors when they least expect it.

One of the funds Kornitzer manages is the Buffalo Balanced portfolio, which owns a mix of stocks and bonds. The fund, which now has about 56% of assets in stocks, gained 2.9% in the second quarter and 6.7% in the first half.

His stock strategy with the balanced fund, Kornitzer said, is to focus on blue-chip issues that pay hefty cash dividends. He said he had not had a problem finding decent candidates.

“There are a lot of good companies out there with good earnings growth and good dividends,” Kornitzer said.

Expectations of continued strong earnings growth, amid an expanding economy, provided the key underpinning for the stock market in the first half.

But a number of reports over the last few weeks have raised questions about whether the economy might be decelerating at a faster pace than many analysts had expected.

Those concerns have been compounded by gloomy June sales reports from many retailers, by warnings from a host of software companies that expected business purchases failed to materialize in the final days of the last quarter and by another jump in oil prices.

With the Federal Reserve at the beginning of a campaign to boost short-term interest rates from the lowest levels since the 1950s -- the central bank’s first move came last week as it raised its benchmark rate to 1.25% from 1% -- the concern is that the economy may not be strong enough to handle even marginally higher rates.

Those worries have made for a dreary beginning to the third quarter on Wall Street. The Dow Jones industrial average lost 68.73 points, or 0.7%, to 10,171.56 on Thursday and is down 2.5% since June 30.

The tech-dominated Nasdaq composite index, which slid 30.76 points, or 1.6%, to 1,935.32 on Thursday, has tumbled 5.5% since the quarter began.

The market’s losses have left many stock funds in the red year-to-date, or barely clinging to positive returns, after their first-half gains.

Yet even some managers who have struggled to find attractive stocks this year say it’s too early to give up on the idea of a continuing economic expansion, further gains in corporate earnings and higher stock prices.

Vincent Sellecchia, co-manager of the New York-based Delafield stock fund, a small-cap value portfolio, said his $280-million fund had more than 15% of assets in cash, which reflected a shortage of great new ideas.

But he said he was still excited about the prospects of the companies the fund owned, including manufacturers such as toolmaker Stanley Works and measuring-instrument company Thermo Electron Corp.

“I think we’re a lot closer to having a cyclical economic expansion,” Sellecchia said -- meaning one in which corporate capital spending is robust and many basic manufacturers do well.

The Delafield rose 5% in the second quarter and was up 8.8% in the half.

Rather than try to guess which mutual fund sectors might be stars from this point, analysts say investors may have to accept that the market is more likely to produce winners -- and losers -- stock by stock within each industry sector. That puts more pressure on fund managers to pick well and show shareholders they’re worth the management fees they’re earning.

“There aren’t any major anomalies in the market,” said Charles McQuaid, co-manager of the Columbia Acorn Fund, a Chicago-based small-cap growth fund. That means he doesn’t see stock sectors that are severely underpriced or overpriced relative to their earnings potential.

In an environment like this, “You have to knock them out one by one,” McQuaid said, referring to stock picking.

The Acorn fund’s Class A shares were up 1.5% in the second quarter and 8.7% in the half.

Although small-cap growth funds, as a group, lost money in the quarter, McQuaid said it might be premature to say that smaller stocks now will take a back seat to big-name stocks.

“I think there’s a reasonable chance that small caps keep going,” he said.

Optimism about smaller companies’ prospects in a growing economy isn’t misplaced, he said. “The long-term trend in the economy has been that basically all of the jobs have come from small companies.”