Near the end of 2002 Lange increased his fund's tech weighting to its highest level ever. "Tech stocks were so washed out I figured we'd see a recovery in their fundamentals and that investor psychology toward them would improve," he says.
But in recent months the froth has given Lange second thoughts, and he has cut back his tech holdings to market weight. He's also concerned that the rise in interest rates that most people expect to occur by year-end will hurt high-multiple tech stocks. Nonetheless, he's still sticking with his overweight in the cellular phones business, including both handset manufacturers and suppliers. He expects people will replace their handsets faster than anticipated as new phones come out with high-tech features like cameras and GPS.
The fund also scored big last year with homebuilders such as Lennar, but Lange has cut back on them in part because of interest rate concerns. He's shoveled some of that money into medical devices and pharmaceuticals, two sectors he says have outstanding growth prospects. Drug companies and other large-cap companies with significant international exposure should benefit from the weak dollar, says Lange.
Jack Laporte, manager of the small-cap T. Rowe Price New Horizons fund, shares that view. As currencies rise against the dollar, those foreign profits are converted into more dollars. "It's a very good tailwind for large-cap earnings," he says. Because small-cap companies tend to have less overseas exposure, he adds, "It's a very tough call whether large- or small-cap earnings are going to do better this year."
The New Horizons fund has a sizable mid-cap bent because Laporte likes to let his winners run, contributing to a 49.3% return last year that reversed three years of losses. Among the big winners were two names in post-secondary education-Apollo Group and University of Phoenix.
Laporte points out that the Russell 2000 index's 47% gain in 2003 was the best calendar year return in its 25-year history. Small caps tend to lead the way in economic recoveries, but small caps have been the market pacesetters for five years. "After these five years of outperformance, the small-cap valuations are actually very similar to large-cap valuations on a P/E basis," says Laporte. "In order for small caps to continue to perform well, they are going to have to have compelling earnings gains." Small-cap earnings produced year-over-year earnings gains every quarter in 2003, and Laporte believes the trend will lead to double-digit earnings growth for small caps this year.
Perhaps, but some observers make the case that large-cap stocks are primed to catch up to their small-cap brethren. In Lipper's equity mutual fund outlook report for 2004, company analysts expect large caps to overtake small and mid caps by year-end. "With the economy now clearly into its upswing, the early-phase thesis for smaller companies is already well played out; valuations of larger companies will become relative bargains if they remain laggards," reads the report. It adds that as the swing to larger-cap names begins, momentum followers will pile into the sector. And as the bull market continues, it'll be easier to accommodate significant inflows of investor money in large rather than small stocks.
Michael Hershey, lead manager of the small-cap growth Henlopen fund, isn't averse to putting his money to work in large-cap plays. Recently, more than 9% of this self-described "go anywhere" fund invested in large- and giant-cap companies. "Consultants don't particularly care for us because we don't easily fit into one of the nine style boxes all of the time," says Hershey. "But people are beginning to realize that you can't always find your best investments in one place."
For Hershey, the best place has been, and will probably remain, the small-cap (68% of his fund) and mid-cap sectors (23%). "We wind up in these sectors because that's where we find the best ideas through various cycles over time," he says. The fund's ten-year annualized return of 15.29% placed it the top 3% in its category, according to Morningstar. Last year it gained 65%.
Taking an extremely long-term view, Hershey believes the recent multi-year market downturn closed out the multi-decade, post-World War II expansionary era. He reckons that we're beginning a secular-not cyclical-period marked by low inflation and a moderate interest rate environment. Given that, he expects small caps to do well for a longer period than many people forecast.