Value, Blue Chips Up in Shifting Economy

“Goldilocks” proved to be a profitable tale for stock mutual fund investors in the third quarter. Most categories of equity funds rose as many investors bet the economy would turn out just right -- neither too hot nor too cold.

Stock markets around the world advanced in the quarter, shaking off their spring slide, as the Federal Reserve stopped raising interest rates and energy prices plunged.

Many investment pros believe there’s more to come for stocks, if the Fed can engineer an economic soft landing for the U.S. -- the sweet spot of just-right growth that would allow the central bank to hold rates steady, or even begin cutting them.

But after hefty gains since 2002 in fund categories such as smaller stocks, real estate shares and bargain-priced “value” issues, some financial advisors continue to warn that investors should be paring back in those sectors and steering money into fund categories that have been relatively out of favor in recent years.

In particular, funds that own large-capitalization “growth” stocks, one of the most unloved sectors this decade, ought to begin to shine, many experts say.

“If growth is going to have its day, this is it,” said Kurt Brouwer, a principal at financial advisory firm Brouwer & Janachowski in Tiburon, Calif.

In the third quarter, however, value stocks -- those of companies that tend to grow more slowly and whose shares are priced at relatively low levels compared with underlying earnings -- continued to dominate growth stocks, those of faster-growing companies that tend to sell for higher price-to-earnings ratios.

That may have reflected an undercurrent of fear in the market, some analysts said: Investors who worried that the economy was headed for recession may have sought refuge in value shares, figuring they were less vulnerable than growth shares if things went sour.

For the average U.S. stock fund, the gain for the three months ended Sept. 30 was 2.1%, according to investment research firm Morningstar Inc. It was the fifth advance in six quarters and put the year-to-date gain at 5.2%.

The average foreign stock fund rose 3.7%, continuing to outpace the domestic average. Through the first nine months, the average foreign fund was up 12.3%.

Fund returns are share price change plus any dividends.

Rallies in emerging markets, financial stocks and technology issues in the quarter suggested that many investors again were counting on an economic soft landing. Those sectors could be particularly vulnerable if the economy slid into recession.

The average emerging market stock fund rose 5.3% in the period after tumbling 5% in global markets’ second-quarter sell-off. The third-quarter gain left the average fund up 12.6% this year.

The average tech stock fund rose 3.9% in the quarter, although that barely put the category back in the black with a 1% year-to-date gain.

Doubts about a soft landing had triggered a plunge in global markets from mid-May to mid-June. But buyers had returned by late July and were egged on after Fed policymakers voted Aug. 8 to halt their two-year credit-tightening campaign.

What’s more, a surprise drop in oil prices bolstered investors’ confidence.

Among other trends in stock fund sectors in the quarter:

* Funds that own real estate-related securities posted the biggest gain of any category, rising 8.3% on average.

Most of the funds buy shares of real estate investment trusts, which own and manage commercial properties. Although the residential housing values have begun to slide in many parts of the country, the commercial real estate business remains robust -- although some investors believe it, too, is becoming pricey.

* Utility stock funds ranked second in the quarter, with a 6.3% average gain. Utilities are classic value investments and also are considered defensive. If the economy were to stumble badly, utilities’ sales and earnings would be expected to hold up well compared with other companies’ results.

* Foreign funds generally outpaced domestic funds, and U.S. investors continued to pump more cash into foreign funds than domestic funds, a trend for the last two years. The average fund that invests in European stocks rose 4.5% in the quarter. Latin American funds were up 5.2%.

Foreign returns were strong even though a rising dollar worked against them -- a change from recent years, when a weaker U.S. currency helped bolster foreign portfolio gains.

The U.S. currency strengthened slightly against the euro in the quarter, for example, clipping the returns on European stocks when the gains were translated into dollars.

* Natural-resource and gold-related funds were broadly lower, as prices of many commodities fell along with oil and as investors’ anxieties about inflation ebbed.

The average natural-resources fund slid 8.6% in the quarter, cutting the year-to-date gain to 2.3%. The average precious-metals fund slumped 6.5% in the three months.

* Large-company stocks significantly outpaced small- and mid-size company shares, and value beat out growth.

For example, the average large-company value fund was up 5.2%, compared with a meager 0.3% gain for the average small-company value fund and 2.6% for the average large-company growth fund.

The resurgence of large-company stocks -- a shift reflected in the record high in the Dow Jones industrial average last week, as the blue-chip index recouped the last of its 2000-02 losses -- has been eagerly anticipated by some investment pros for the last two years.

They’ve argued that blue-chip names have been ignored for too long and have become bargains compared with small- and mid-size stocks.

Over the last five years, large-company growth funds have risen 4.5% a year on average. The return on small-company growth funds was double that pace, at 9.1% a year.

“I think it’s a buying opportunity in the larger-cap area,” said Rick Keller, head of Keller Group Investment Management in Irvine, who has been trimming his smaller-stock fund holdings.

Even if an investor expected similar returns from large and smaller stocks over the next few years, the greater volatility risk in smaller stocks means it makes more sense to tilt toward large stocks now, Keller said.

Brouwer, the financial advisor, says the economic backdrop should favor large growth companies. If the economy’s pace is ratcheting lower and it becomes tougher for businesses to generate sales, big-name growth companies may have an advantage because of the breadth of their businesses -- including operations overseas, where growth may be faster than in the United States.

Many managers of smaller-stock funds concede they’ve had a great run and that it’s harder to find bargains in their universe.

John Damian, co-manager of the Oppenheimer Small and Mid-Cap Value fund in New York, says smaller company shares generally are less attractive than they were a few years ago, as measured by classic valuation barometers such as price-to-book value.

Even so, he said, he’s looking to find bargains among companies that could benefit from the next phase of economic growth. Smaller semiconductor companies are one niche he’s studying now. He also likes healthcare providers such as Coventry Health Care Inc. for the long run.

John Coumarianos, a fund analyst at Morningstar, said investors shouldn’t consider the large-versus-small decision an all-or-nothing proposition.

“We’re really loath to tell investors, ‘Sell all your small caps, it’s over,’ ” he said.

Even so, he said, “it’s certainly time to shave them.”

Under normal portfolio “rebalancing” principles, he noted, investors should be taking profit in some of the stock sectors that have worked well and moving cash into categories that have lagged.

The real estate fund sector also is ripe for trimming, after their spectacular run-up over the last five years, Coumarianos said.

At the First American Real Estate Securities fund in Minneapolis, co-manager John Wenker said there was no doubt that real estate investment trust shares looked expensive.

But there was no sign that the commercial real estate market was slowing, he said, as the appetite for office buildings, apartments and other commercial properties remained robust. After the big gains of recent years, however, it made sense to be prudent, Wenker said.

For fund investors, he said, “we suggest that [commercial] real estate be 5% to 10% of your assets -- no more than that.”

tom.petruno@latimes.com

*

(BEGIN TEXT OF INFOBOX)

Stock fund performance by Morningstar category

--Here are average total returns for equity mutual fund categoriestracked by Morningstar, with returns for major stock indexes listed atthe bottom. All data are through Sept. 30. Total return is principalchange plus dividend or interest income, if any. Figures for periodslonger than one year are annualized average returns. Categorydescriptions appear in the tables on Pages C7--8.

*--* Objective Total return Annualized Category category 3rd-q. YTD 3-yr. 5-yr. Real estate SR 8.3% 21.9% 25.3% 22.0% Utilities SU 6.3 13.9 21.0 8.9 Pacific/Asia PJ 5.6 20.2 23.4 23.2 ex-Japan Financial SF 5.5 9.3 14.3 10.8 Diversified EM 5.3 12.6 29.4 27.4 emerging mkts. Latin America LS 5.2 19.2 45.3 31.8 Large-cap value LV 5.2 10.1 14.3 8.6 Health SH 5.0 1.4 9.5 4.6 Communications SC 4.9 8.1 17.2 4.6 Europe ES 4.5 18.4 24.8 18.6 Large-cap blend LB 4.4 6.8 11.6 6.6 Foreign FV 4.2 14.5 22.4 16.1 large-cap value Technology ST 3.9 1.0 7.7 5.8 Target date TB 3.9 6.2 10.1 7.3 2015--2029 World allocation IH 3.8 9.4 14.2 12.3 Foreign 3.8 13.1 20.7 12.7 large-cap blend FB Target date TC 3.7 6.9 12.2 8.2 2030+ Target date TA 3.6 4.8 6.7 5.6 2000--2014 Moderate MA 3.6 5.9 9.4 6.6 allocation World WS 3.5 9.6 17.1 11.2 Foreign FG 3.2 11.7 19.6 12.4 large-cap growth Conservative CA 3.1 4.6 6.1 5.6 allocation Large-cap growth LG 2.6 1.2 8.6 4.5 Foreign FA 2.4 12.3 23.3 20.4 small-/mid-cap value Mid-cap value MV 2.3 7.4 16.4 13.1 Convertibles CV 2.0 5.6 9.3 8.5 Diversified DP 1.7 7.1 21.3 16.4 Pacific/Asia Foreign FR 1.5 11.4 26.5 20.6 small-/mid-cap growth Mid-cap blend MB 1.1 5.8 14.7 12.4 Long--short LO 0.9 4.6 6.0 4.5 Small-cap value SV 0.3 7.4 16.5 15.6 Small-cap blend SB --0.8 6.1 15.6 13.6 Mid-cap growth MG --0.9 2.0 12.4 8.8 Japan JS --2.0 --5.6 15.3 10.8 Small-cap growth SG --2.4 2.3 10.9 9.1 Bear market BM --3.7 --3.5 --10.5 --11.8 Precious metals SP --6.5 14.6 19.8 29.7 Natural SN --8.6 2.3 28.6 21.3 resources Domestic stock 2.1 5.2 12.3 8.4 fund avg. International 3.7 12.3 21.7 15.8 stock fund avg. Total return Annualized Category 3rd-q. YTD 3-yr. 5-yr. S&P; 500 index 5.7% 8.5% 12.3% 7.0% Large U.S. companies Dow Jones 5.4 10.9 10.4 8.1 industrials 30 large companies Wilshire 5,000 4.3 8.0 13.3 8.6 Broadest U.S. stock index Nasdaq composite 4.2 3.0 8.8 9.2 All Nasdaq stocks (tech-dominated ) Russell 2,000 0.4 8.7 15.6 13.8 Small-cap stocks S&P; 400 --1.1 3.1 15.2 13.1 Mid-cap stocks

*--*

Source: Morningstar Inc.

--

Performance of biggest U.S. stock and bond mutual funds

-Here are the biggest funds, by assets, ranked by their third-quarter performance (measured by price change plus interest or dividends). Thetop performer was Vanguard Group’s Windsor II Fund, which invests inlarge and medium-sized companies whose stocks are considered to be undervalued. The fund’s recent holdings included General Electric, Altria Group (parent of Kraft Foods) and Citigroup. American Funds earned the No. 2 spot with its American Capital Income Builder fund,which focuses on stocks with a knack for increasing their dividends.The fund’s recent holdings included utility company Exelon, AT&T; andSociete Generale, the French banking giant. Category descriptionsappear in the tables on C7-8.

*--* Obj. Ovrl. 3-yr. Total return Fund cat. rtg. star 3rd-q. YTD 3-yr.* Vanguard: Windsor II LV 4 4 6.4% 11.0% 16.9% American: Capital Income IH 4 3 5.8 12.9 15.2 Buildr. A Templeton: Growth A WS 4 3 5.7 12.5 17.4 Vanguard: Institutional LB 4 4 5.7 8.5 12.3 Index Vanguard: 500 Index LB 4 3 5.6 8.4 12.1 American: Income Fund of MA 4 4 5.6 12.8 13.5 Amer. A T. Rowe Price Eq Inc LV 4 3 5.6 10.9 14.5 American: Washington Mutual LV 2 1 5.6 11.0 12.5 A Fidelity: Puritan MA 4 4 5.3 8.7 11.1 American: Capital World G&I; WS 5 4 5.2 12.1 21.0 A Franklin: Income A CA 5 5 5.1 11.9 11.9 Vanguard: Wellington MA 5 5 5.1 9.0 12.3 American: EuroPacific A FB 4 3 5.0 12.1 22.9 Vanguard: Total Stock LB 4 4 4.5 7.9 13.1 Market Idx. American: Balanced A MA 3 2 4.5 6.8 9.4 American: New Perspective A WS 4 3 4.4 10.9 17.7 Fidelity: Blue Chip Growth LG 3 3 4.3 1.3 7.1 Vanguard Total Intl Stk FB 4 4 4.0 13.9 23.1 Pimco: Total Return CI 5 4 3.9 3.0 3.9 Institutional Vanguard: Total Bond Index CI 4 3 3.8 2.9 3.2 Vanguard: Primecap LB 5 5 3.7 7.6 15.6 Amer Funds Bond Fund A CI 4 4 3.5 3.9 4.6 Fidelity: Diversified FG 5 4 3.1 11.6 21.7 International Fidelity Balanced MA 5 5 2.9 6.1 12.7 Fidelity: Growth & Income LB 3 2 2.7 3.7 8.5 American: Fundamental Inv. A LV 4 4 2.2 11.2 18.0 Fidelity: Low-Priced Stock MB 5 4 2.1 7.3 17.5 American: Growth Fund Amer. LG 5 5 1.5 4.2 14.3 A Fidelity: Magellan LB 2 2 0.3 2.1 9.0 Fidelity: Growth Company LG 4 4 0.3 1.0 12.1 Domestic stock fund avg. 2.1 5.2 12.3 International stock fund 3.7 12.3 21.7 avg.

*--*

*Three--year returns are annualized.Source: Morningstar Inc.