A simple way to capture the essence of the 2001 mutual fund market is to picture the way things were in the high-flying 1990s, and then think of opposites. Gains versus losses, inflows versus outflows, start-ups versus liquidations, hot versus cold, black versus red. The list goes on and on.
But in a year in which eight out of 10 mutual funds showed negative returns, maybe the most telling comparison is between the performance of growth versus value, and large cap versus small cap.
After driving the longest bull market in history in the '90s, large-cap growth funds took a sudden downturn in 2000. In 2001, they hit bottom, with the average large-cap growth fund losing nearly 23.53% in assets, according to Morningstar. Technology and communications, which were the leaders of all the large-cap action in the 1990s, continued downward in 2001, dropping 38.1% and 35.27%, respectively.
For small-cap value funds, which were shunned in the go-go '90's, a rebound that started in 2000 gained further momentum in 2001. Small-cap value funds had an average gain of 17.35% last year, making them the leading mutual fund sector.
The year marked a complete and utter turnaround in value vs. growth investment styles, with value funds of all sizes outpacing their growth counterparts, according to Morningstar. Mid-cap value funds managed to finish with a gain, earning the average investor 6.39%. Mid-cap growth funds, meanwhile, lost an average of 21.33%. Large-cap value, while far outpacing large-cap growth, finished with a loss of 5.47%.
One could almost hear "I told you so" resound across Wall Street as value managers-many of whom were ridiculed for ignoring technology and the Internet just a few years ago-saw their inflows and assets skyrocket as the rest of the market lay in ruins. As David Corbin, manager of the Corbin Small-Cap Value Fund put it, it was the first time in years that investors showed interest in "old fogey" companies that made bricks, pots, pans-and money.
It was also retribution, he says, for value managers who refused to drift from their core principles during the heyday of the 1990s bull market. "This year, we were rewarded for sticking to that," says Corbin, whose fund closed 2001 with a gain of 53.66%, among the top five performers of small-cap value funds tracked by Morningstar. "Three years ago, we had a bunch of great companies in the fund, solid proven moneymakers, and I couldn't find anyone to take an interest in it."
Another reason small-cap value funds stood out in 2001 is that, no matter where you looked, there were few sectors that stood out last year. Investors even got a rude awakening when they tried to flee to what historically could be counted upon as being havens.
Take as an example the health-care sector, which typically is considered a defensive play during down markets. This sector ran into a problem in 2001 because it performed so spectacularly in 2000, when growth funds began dumping their technology holdings and purchasing drug and health-care companies-reasoning that they were more recession-resistant. "People in 2000 who were looking for growth wherever they could find it were snapping them up," says Morningstar analyst Peter Di Teresa. "A lot of them became overextended." All of a sudden, health care was viewed as risky, and health-care funds finished the year with average losses of 13.1%.
Events also caught up with utilities. Deregulation, competition and technology investments have spawned a riskier environment in the sector, shattering their status as a classic defensive play. Utility funds ended 2001 down 21.4%.
One sector that did perform in line with expectations was precious metals, which was up 19.7% in 2001 after a string of losing years. A rebound in gold prices boosted this sector, in which the performance leaders were First Eagle SoGen Gold, up 37.3%, and American Century Global Gold, up 34.1%. "They started showing their strength fairly early in the year," Di Teresa says. "They lost a little ground with the resurgence of the broader stock market in the fourth quarter."
Fixed-income and real estate funds were other sectors in which investors found some comfort in 2001. Both had average gains of nearly 9% last year, with emerging-market bond funds gaining 10.5%. Leading the pack in real estate were Kensington Strategic Realty, up 30%, and Spirit of America Investment, up 28%.
For investors, that was about it for the winners: some, but not all, of the classic defensive-play sectors and value funds. "There generally were not any standout (commercial or industrial) sectors," Di Teresa says. "It was very much a kind of stock-picking story."
In other words, it was a market that played right into the hands of value money managers-who capitalized on the fact that the broader market had neglected many profitable companies in recent years. "We saw a lot of good companies this year," says Nicholas Gerber, co-manager of the Ameristock Focused Value Fund, which gained 60.42% last year. "None of these companies were high-tech, so they got overlooked, and they had their bear markets already."
Like many of the other successful value managers in 2001, Gerber looked for profitable, but relatively unknown, small companies selling at a discount to book value.
Among the companies the fund discovered was TBC Corp., a tire wholesaler and retailer and owner of Big O Tires, the largest independent tire chain in the nation with more than 100 stores in northern California and Nevada.
Among the lures of this company, Gerber says, was that over the last 10 years, it was buying other companies-including Big O Tires-at below book value. It also was a textbook example of a recession-proof company, he says. "Tires don't care if you have a job or not," he adds. "It's not as if you can put off replacing a tire."
Ameristock Focused Value bought TBC on January 2, 2000, less than a month after the fund was started, at $4.56 per share. It sold the company in July at $10 per share. "It was a good company, with good long-term prospects, selling at below breakup value," Gerber says. "All we had to do was wait on that one."
This fund may be offering only a short window of opportunity to new investors. Now up to $10 million in assets, the fund plans to close itself to new investors at about $30 million, Gerber says. At that time, the plan is to ask shareholders for permission to transform the fund into a public holding company. "We wanted to do something that's been done only once before in the investment-management business," he says.
Despite the success of small-cap value investing in 2001, it wasn't always easy for investors to get in on the action, as many funds shut their doors to limit asset growth. Among the funds that closed to new investors last year were Wasatch Small Cap Value, American Century Small Cap Value and Turner Small Cap Value. For much of the roaring nineties, the fund business was criticized for refusing to close funds, even if it hurt performance. The recent spate of fund closings indicates that the bear markets may have made investment companies more responsive to shareholders.
Corbin Small-Cap Value saw its assets grow from $2 million to $28 million last year. "Once we get to the $50 million range, we'll probably start to examine the possibility of closing," Corbin says.
Corbin Small-Cap Value owed much of its success in 2001 to just a handful of picks. Among the most important was Vtel, a video and network teleconferencing company that the fund bought when it opened in June 1997.
Concluding that the company had good long-term growth prospects, while selling at half of book value, the fund continued to boost its position in Vtel stock to the point last year where it represented nearly a quarter of fund holdings. Two events last year led to a breakthrough in the share price, Corbin says. The first was the release of a product that Fortune 100 companies are using to manage video networks. The second was September 11, which led to speculation that companies would be cutting back on business travel and spending more money on videoconferencing. As a result, the company's stock rose from about 90 cents to $4.20 last year.
Another company, Titan Corp., also boosted the fund because one of its subsidiaries sells technology used to irradiate mail-a business that benefited from last year's anthrax cases. Although a confluence of circumstances boosted the share prices of Vtel and Titan, Corbin notes the basic reason they became fund holdings was they were good companies selling at a discount.
And given the number of small companies that have been ignored by analysts in recent years, 2001 was a ripe time to find such companies, he says. "This was a fantastic year for stuff like this," he says. "This is a stock picker's market. I just think going forward, it's who is going to find the Vtels of the world, and who is nimble enough to take advantage of that?"
He sees this type of market environment continuing for the long term. "I think we're in a small market and a value market literally straight through for the next 30 years," he says. "When bubbles burst like this, you don't have that type of market action again on a broad scale for 25 to 30 years."
Hunkering down and buying good, solid companies at low multiples of book value have always been the trademark of value investors. Entering 2000, however, value money managers suffered through the better part of a decade underperforming the broader market. It got to the point in the late 1990s where you either drifted into some growth investing or endured a steady outflow of assets.
Scott Barbee, manager of the Aegis Value Fund, opted not to drift. "We were just about as rigid as they come," he says. "We lost about 25% of our assets doing that." Like a true value investor, Barbee reaped dividends by venturing into an area many other investors dared not touch: tobacco. In March 2000, the fund bought Standard Commercial Corp., which is involved in the processing, storage and delivery of tobacco grown in more than 30 countries.
The reason the company roused the interest of Aegis is that it was selling at three times earnings and about 35% of book value, partly because it was in an industry decimated by lawsuits. Barbee reasoned, however, that Standard Commercial was not a cigarette retailer and was not subject to lawsuits. It was in the business of servicing the Phillip Morrises of the world.
"If you think about what was happening in the industry, nobody wanted to kill the chicken. Everyone was just fighting over the golden eggs," he says. "Standard Commercial was really in the business of providing the chicken feed. We were buying the cash flows of a tobacco company without the litigation risk." That theory paid off in 2001, as the company's share price went from $3 to $17.
In yet another move that on its face appeared risky, Barbee made a play in the telecommunications sector last year. The fund bought shares of IDT Corp. from February to December, at a time when telecommunications companies were getting pounded.
Yet in IDT, Barbee saw a shrewdly managed company that had put $1 billion in cash on the books through the sale of a subsidiary to AT&T during the bull-market mania.
After the technology bubble burst, the company was in a prime position to take advantage of the mistakes made by competitors. "They were using the $1 billion to buy up equipment sold at pennies on the dollar by bankrupt telecom carriers," he says. The company was bought at $10 to $11 per share and was selling at about $20 per share in mid-January.
Says Barbee: "If you want good returns, you have to really be aggressive at playing around the edges."
Some mid caps also found success in 2001, partly by drifting to the smaller end of the capitalization range. The Liberty Acorn 20 mid-cap growth fund, for example, typically holds companies with capitalizations between $2 billion and $12 billion. In 2001, however, the majority of the fund's holdings gravitated toward the $2 billion range, manager John Park says. The fund finished with a gain of 8% in a sector that had average losses of 21.32%. "I think as you get higher in the market-cap range, it's more difficult to find stocks that are mispriced," Park says.