It was April 2000, and Edward B. White, manager of the GW&K Equity Fund, was still on the fence. Here's the question he was wrestling with: What to do with the fund's technology stocks? Aside from driving the entire market in 1999, technology equities had served White's large-cap growth fund well, helping fuel a 31.3% gain.
The year 2000 started out with a flourish as well. Then the Nasdaq plunged in March, leaving investors to wonder if it would bounce back again, as it always did in recent years. Plus, there were the nagging doubts-about sky-high valuations and dubious financials. "We all had this feeling that something strange was happening," White recalls.
One day, he picked up an analyst's report on Oracle, one of the fund's stellar holdings. It was an upbeat report. A buy recommendation. But what struck White the most about it was how the analyst justified the conclusion: It was based on the company's price-to-revenue ratio. And Oracle was a highly profitable concern.
By the time he finished reading the report, White's whole market view had changed. "It just clicked for me that this analyst couldn't make a case to buy these shares based on price-to-earnings ratios," White says. "It was clear to me that to stay on the positive side, they had to do a paradigm shift, and I said, 'Wrong.'"
Shortly after, the fund sold Oracle. Several other technology stocks, including SDL Inc. and Enron Broadband Services, also were dumped-enabling the fund to finish 2000 with a gain of 12.8%.
If only the rest of the growth-fund industry were so fortunate. Nearly a year and a half after the collapse of technology equities, most growth funds still are foundering. After five straight years in which gains of 20% or more were the norm, growth managers, especially those dealing with large caps, suffered a shocking reversal of fortunes almost overnight. Most seem still numbed by the experience.
As of the end of May, the S&P 500/Barra Growth Index was down 25.9% from a year earlier, compared with a 7.13% gain for the value index and a 10.55% loss for the broad S&P 500 Index. The Russell 1000 Growth Index was down 42.72% over the same period.
Growth managers and analysts cite a number of reasons for the dismal performance. The economic slowdown and depressed earnings are especially painful for growth investments, they note. Funds that either stuck with technology or reverted to it in hopes of a rebound have continued to bleed. And because of the lackluster market, even those funds that sought an escape from technology were hard-pressed to find another place to put their money.
What it amounts to is a growth-fund market without a clear direction, stuck in a fight-or-flight freeze as it waits for some type of positive signal.
Caused by more than an economic downturn, the woes of growth funds also are exacerbated by a crisis in confidence, says Christine Benz, senior analyst at Morningstar. "I can't remember a time when growth-fund managers seemed to have as little conviction as they do now," she says.
There is some hope on the horizon, Benz says. The growth micro-cap market had something of a rally in late spring. January and April proved to be good months for growth, although they turned out to be "head fakes" for anyone hoping for a run of good gains, she says.
In the late 1990s, growth-fund managers with heavy tech weightings couldn't help but fall over a 20% annual gain, but their jobs are different now, says Donald L. Cassidy, senior research analyst at Lipper & Co. "When momentum was great, and it was clear that it was one or two groups doing well, it didn't take much skill," he says. "You just bought it all."
This is a time of returning to reality for managers who simply rode the technology wave to success in recent years. "In times like this, when the economy is more difficult than average, it's probably easier to separate out the smarter analysts and money managers," he says.
Fund managers who were heavily reliant on the technology sector during the go-go years still are trying to recover from the trauma of seeing their world go topsy-turvy, Benz says. Managers who kept the faith deep into 2000 received the worst hurt, she adds. "We saw some fund managers reloading in the second half of 2000, kind of thinking the worst was over, which proved to be a terrible decision," she says.
Arthur J. Bonnel, manager of the Bonnel Growth Fund, admits he was one of the many growth managers "suckered" into waiting for the bounce that never happened in 2000. Bonnel had good reason to wait. In 1999, technology had given the fund a spectacular 81.4% return.
By December 2000, however, Bonnel gave up any hope of a bounce and began the process of dumping technology stocks. By March, 90% of his technology holdings were gone. From a high 70% technology weighting in 1999, the fund's technology stocks now constitute only 5% of fund holdings. Replacing the technology holdings have been names such as Coca Cola, Abercrombie & Fitch, Amgen and America Italian Pasta.
Despite losing 17.2% in 2000, and falling 26.86% this year as of June 27, the fund's love affair with technology still has amounted to an overall plus for investors. It's three-year annualized return is 7.13%.
Still, Bonnel expresses regret at not getting out earlier. He expects it will take seven to 10 years for technology stocks to return to their highs of 1999. "Technology is dead," Bonnel says. "It's going to grow, but it's going to grow at a realistic rate. Maybe 10% to 15% per year."
Not surprisingly, then, some of the funds that have managed to keep their heads above water weren't knee-deep in technology to begin with.
The Buffalo Small Cap Fund, which finished with a 33.7% gain in 2000 and was up 16.08% year-to-date as of June 22, has only dipped into technology equities it has identified as fundamentally sound through in-house research, says manager Kent Gasaway. The fund, with $53 million in assets, was started in April 1998.
Gasaway says he focuses on identifying long-term trends and then finding good companies that could benefit from them. "That gives us a strong feeling that the companies we own have the wind at their backs," he says.
The mass transfer of wealth expected to occur as the baby-boom generation enters retirement has prompted the fund to buy financial service and advisory companies and trust companies. The swelling of the 45 to 65 age group has led the fund to purchase stock of leisure and entertainment businesses, including the casino companies RDC Gaming and Argosy Gaming.
Pharmaceutical companies developing drugs that treat geriatric diseases also are high on the fund's list, as are the publicly traded education companies that can be expected to benefit from the millions of baby boomers' children entering their college years. Strayer Education and ITT Educational Services, two technical and business schools held by the fund, had year-to-date gains of 90% and 100% respectively as of May 1.
"We really haven't changed our strategy from day one," Gasaway says. "What differentiates us is that we're pretty long-term oriented. All of our holdings stay in the fund three to five years."
Todd McCallister, manager of the Heritage Mid Cap Stock A Fund, admits that even his firm wasn't immune to the technology boom. Over the past three to four years, he says, the only analysts hired by his firm have specialized in technology. The fund closed 2000 with a 19.5% gain and was up 8.66% as of June 22.
He hasn't shunned technology, but he hasn't embraced it, either. McCallister says high projected growth rates are not mandatory for a company to become a fund holding. Good management and financials are the priority, he says. "We buy companies, not growth rates," he says.
That's why companies he considers some of his best holdings have a projected earnings growth rate of 7% to 9% per year. These include companies such as Commonwealth Telephone, a small, ruraltelephonecompanythat McCallister considers solid because it is one of the companies exempt from the deregulation mandated in the U.S. Telecommunications Act of 1996. Another solid holding, he says, is Apogent Technologies Inc., a maker of lab equipment that has been growing through acquisition. A key reason McCallister owns Apogent stock: About 20% of its product line is related to the emerging genomics industry. Low debt is another company attribute.
"They've done nothing but pay cash for their acquisitions," he says. "In the go-go '90s, they never once issued any equity. Their attitude was, 'Why give equity value to other people? We'll keep it for ourselves.'"
McCallister believes that too many growth managers ignored the concept of diversification and are now paying the price. "It seems that investors have a frame of reference, and it's sometimes slow to change," he says. "Diversification in this environment is very smart. I question almost anybody who wants to load up."
Many investors forgot that technology historically has been a cyclical business, says Gerald W. Peterson, manager of the Westcore Select Fund, which focuses on mid-cap growth equities.
The boom of the 1990s was fueled by a flurry of capital spending that is unlikely to be repeated any time soon. "We're not going to see 20% returns for a long, long time I think," Peterson says, adding that the worst may not be over. "I think the valuations are way too high. The numbers are going to continue to get worse."
He's guided the two-year-old Westcore fund to a 15.3% gain in 2000 and a 3.9% return this year as of June 22, with an investing style that relies on both fundamental and technical analysis. Cendant, Headwaters, Stations Casinos and Barr Labs are among the fund's top holdings. "I'm trying to move my assets into those areas, sectors or themes that are in vogue or will become leaders in the future," Peterson says.
Richard Drake, co-manager of the Alleghany/Chicago Trust Growth & Income Fund, is among the managers who feels there's some life left for technology. He was among those who got burned by holding onto technology blue chips, such as Dell and Microsoft, in 2000, but still managed to finish the year with a gain of 2.1%. "Growth investors don't want to be completely out of technology," he says. "There's always the danger of being left behind."
He notes Microsoft and Dell are up more than 55% and 36% this year, although Dell still is valued at roughly half what the fund paid for it in February 2000. The fund was down 8.66% as of June 22. "We just believe in the long-term story," he says, expressing confidence that Dell will continue to increase its market share.
Growth managers are practically forced to take a long-term view of things because the short-term view is so uncertain, Lipper's Cassidy says. He noted that most segments of the market aren't fairing that much better than technology. Even Heinz has announced slower earnings growth-partly because of slower sales of tuna fish. "They just don't know where the weakness is likely to be. It could be just about anywhere," he says. "I think what managers are afraid of is when the companies come out with June 30 numbers, they'll say, 'Oh, by the way, our September and December numbers don't look so hot either.'"
Robert Kern, manager of the Fremont Micro Cap Fund, which was down 0.67% as of June 22, notes that the spread between value and growth in the Russell 2000 over the past year is about 60 points. That's practically a reversal of what the spread was like a few years ago.
"We've gone to extremes," he says. "I think things in this world changed a lot faster than anybody anticipated."