Stock funds trail benchmarks

By Tom Petruno

Jan. 8, 2007 12 AM PT

Times Staff Writer

The U.S. stock market last year had its best showing since 2003, but your mutual fund may not be able to say the same.

Despite a broad advance in share prices, it was a tough year for many funds actively managed by stock pickers. Among funds that owned shares of large U.S. companies, for example, fewer than one-third topped the 15.8% total return of the Standard & Poor’s 500 index.

Among small-company stock funds, fewer than 1 in 6 beat the gain of the Russell 2,000 index of that universe of shares.

Beating a market index isn’t everything, of course. And with the average U.S. stock fund producing a 12.6% total return, according to Morningstar Inc., 2006 marked the third time in four years that investors enjoyed a double-digit advance, as the market recovered further from the deep decline of 2000 to 2002.

But with so many funds trailing market benchmarks last year, it raises the question of what went wrong for fund managers -- and for the investors who pay often-hefty management fees for their services.

The answer, in part, is that in 2006 many pros continued to expect a resurgence in “growth” stocks, or shares of companies whose earnings are projected to grow at an above-average pace over time.

Instead, “value” stocks -- those that appear cheap relative to earnings or other measures -- outperformed growth issues, as they have for most of this decade.

“A lot of the traditional value sectors have been the market leaders of the last few years,” noted Russ Kinnel, director of fund analysis for Morningstar in Chicago. Those sectors include heavy industry, natural resources and utilities.

The ongoing rally in value stocks made for a strong year at the Pioneer Equity Income fund. The Boston-based fund posted a total return of 23.3%.

John Carey, the fund’s veteran manager, had big winners last year in stocks of companies such as truck maker Paccar Inc., which surged 41%; AT&T; Inc., up 46%; and packaged food producer H.J. Heinz Co., up 33%.

The road was a lot rougher for Bill Miller, one of Wall Street’s most celebrated stock pickers. His 15-year streak of beating the S&P; 500 index ended in 2006, when his Legg Mason Value fund gained 5.9%.

Despite its value label, Miller’s fund owns many stocks usually lumped into the growth category. Some of those issues bombed last year. Amazon.com Inc. and computer maker Dell Inc. both fell 16%. Insurance titan American International Group Inc. added a mere 5%.

Fidelity Magellan -- one of the most famous growth-stock funds -- also had a poor year. Magellan’s gain was 7.2%, less than half the S&P; 500 return.

Waiting for a turnaround in U.S. growth stocks this decade has been like waiting for a train that is constantly delayed. The longer the delay, the greater many investors’ conviction that the train is just around the bend.

Likewise, many on Wall Street believe that large-company stocks are poised to take the lead from smaller-company shares, which have mostly led the market since 2000.

On that count there were some signs of a shift last year. The average large-capitalization value stock fund rose 18.1% in 2006, topping the 16.3% gain of the small-cap value sector.

But it’s large-cap growth that has been the most unloved of any major sector in this decade -- and the one considered ripest for a turnaround. A survey late last year of 87 major money management firms by Russell Investment Group showed that their favorite market sector for 2007 was large-cap U.S. growth.

Morningstar’s Kinnel believes that growth stocks are overdue for a recovery. If the U.S. economy is relatively sluggish this year, earnings could shine at growth companies whose fortunes depend less on the economy’s swings than on their ability to provide products people want or need.

Yet Kinnel conceded that the economic slowdown in the second half of last year didn’t turn the tide for growth stocks. In the fourth quarter, large-cap growth funds gained 5.6% on average, compared with a 7.2% average gain for large-cap value funds.

For the year, the large-cap growth sector was up 6.9%, trailing well behind the 18.1% advance for large-cap value.

All mutual fund returns measure principal change plus any dividend or interest income.

One factor helping value stocks, Kinnel said, has been the boom in takeover activity -- cash-rich companies and private-equity firms have been scouring the market for bargains. “Buyouts certainly tend to work in favor of value managers,” he said.

On the flip side, Kinnel said, the burgeoning scandal over the backdating of executive stock options jarred investors’ perceptions of the technology industry, one of the classic growth-stock sectors and a big grantor of options historically.

Tech also suffered as the industry’s earnings growth failed to meet expectations. The average tech stock fund was up 7.2% last year, near the bottom of all fund categories.

By contrast, the average utility stock fund soared 26%. Utilities are traditional value plays.

One hallmark of many value stocks is their substantial cash dividends. Pioneer’s Carey believes that more investors are coming to appreciate the buffer that dividend income can provide for a portfolio.

Still, things have been so good for value stocks for so long that many value-fund managers are concerned about the near-term outlook.

Carey, for example, says the prices of some utility stocks have reached heights that strip them of bargain status compared with underlying earnings.

At the same time, he said, “I think we’re reaching peak prices in commodities,” another value sector that has boomed in this decade. Carey cut back on energy stocks a year ago, he said.

Crude oil peaked at $77 a barrel in July and last week fell to an 18-month low of $55.59. Warm weather in much of the U.S. has dimmed demand for heating oil.

Frank Holmes, head of fund company U.S. Global Investors Inc. in San Antonio, has ridden this decade’s commodities boom with funds that focus on precious metals and natural resources. But Holmes said he expected a “lull period” for many commodities in the first half of this year, as investors hedge their bets against the possibility of weaker U.S. economic growth.

That could mean trouble for natural resource funds, which were up 10.5% on average last year -- a sharp deceleration from their 38.1% gain in 2005.

Still, Holmes said, “I think a second wave for commodities will come in the second half,” when, he figures, U.S. interest rates will be declining and investors will be betting on a pickup in economic growth to follow.

Weakness in commodity prices could hurt another highflying sector: emerging markets, including countries such as Russia and Brazil that are big commodity exporters.

The average emerging market stock fund rallied 32.6% last year. Foreign stocks in general remained at the top of the fund industry leader board, which is where they’ve been since 2002.

The 25.5% gain in the average foreign stock fund trounced the 12.6% return of the average U.S. fund. Foreign funds were helped by a weaker dollar, which makes securities denominated in stronger currencies worth more to U.S. investors.

The continuing rally in overseas stocks reflects the underlying strength of many foreign economies and optimism about their long-term potential, said Mark Headley, president of Matthews International Capital Management in San Francisco, a big investor in Asian markets.

Even so, he said, U.S. investors who have been pouring record sums into foreign funds may be forgetting just how volatile foreign stocks can be.

Headley is concerned about the prices some Asian stocks, in particular, have reached. He said he found it “terrifying” that some Chinese and Indian stocks were trading at 35 times annual earnings per share, about twice the valuation of the average U.S. blue-chip issue.

“Any negative news is going to be a pretty powerful shock to these markets,” he said.

tom.petruno@latimes.com

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2006 favorites

Here are the most popular Morningstar mutual fund categories in 2006, ranked by estimated net cash inflows through November.

Net cash flow (in billions)

Foreign large blend stocks: $43.8

Intermediate-term bonds: $33.9

World stocks: $23.9

Foreign large growth stocks: $21.3

World allocation: $18.9

Large value stocks: $17.8