Tweddell’s NewFund Focus

Issue # 31 March 2001

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When buyers don’t fall for prices, prices must fall for buyers.

Anonymous

Recommended Funds Performance-Prices for week ending Mar. 2, 2001

Recommended NAV When NAV Gain (Loss)/

Funds Recommended 03/02/01 Holding Period

Diversified Funds

Oppenheimer MnSt Sm Cap 10.00 13.64 + .83* 44.7 % 19 months

Marsico 21^st Century 10.00 7.94 (20.6) % 12 months

Janus Strategic Value 10.00 10.75 + .25* 10.0 % 12 months

Nationwide Value Opp 11.41 13.22 15.6 % 8 months

Managers Small Co 9.98 8.14 (18.4) % 8 months

AIM Small Cap Equity 10.00 8.93 (10.7) % 5 months

Oppenheimer MnSt Oppty 9.81 9.89 1.0 % 5 months

Invesco Global Growth 10.17 6.71 (34.0) % 3 months

Van Kampen SmCapGr 10.34 8.11 (21.6) % 2 months

Sector Funds – Technology

MFS Technology 19.34 13.59 + .50 (29.7) % 10 months

Calamos Convert Tech 10.00 7.54 (24.6) % 5 months

* Distributed gains

Year-to-date Returns

DJ Industrials: - 2.97 % S & P 500 - 6.52 % Nasdaq Comp – 14.28 %

Russell 2000 - 1.38 % MCSI EAFE (Foreign stocks) – 8.31 %

The Death of Growth

As the market continued its downward spiral, startlingly grim numbers are coming from plummeting growth funds compared to value funds that are holding their own. All the former value managers, who were too dumb to understand new era economics have become savants, and the previously sagacious growth managers are donning dunce caps. Few observers seem to factor in the fact that almost all of them graduated from the same few business schools.

The Schwab and the No-load Fund Analyst’s studies showed that while the new-fund effect is potent with small-cap growth, it provides no boost to value funds. However, I have tried to keep a reasonable balance between the two because sector strength/weakness dwarfs any other investment factor (I’ve certainly preached enough about it) – including the new-fund effect.

Overall, the path of least resistance still seems be down. If the S & P 500 slips just a few notches more, it will have dropped 20%, qualifying it as being in an official bear market, belatedly joining the Nasdaq that has lost 58%. The Wilshire 5000, an index of all US stocks is in official bear market territory – down 22%. The Nasdaq’s decline qualifies as one of the biggest ever, comparable to the brutal 1974 bear market. At the bottom in December 1974, according to Worth magazine, the Dow was down 45%, the S & P 500 48% and the Nasdaq 60%.

Comparing this bear markets to past ones is difficult because of this market’s multiple personalities. Growth funds – particularly large-cap - have taken stunning losses. However, their valuations are still dear. The table below shows two valuation measures, price/earnings and price/book ratios of the nine Morningstar fund categories as of 12/31/00, grouped by investment style. If you adjusted the table for the declines in the major market indexes since year-end, they would still be historically expensive compared to an average price/earning ratio of around 14 and the price/book ratio that fluctuated between 1 and 3 during most of the last century:

Category Price/Earnings Price/Book

Large-cap growth 43.5 12.0

Mid-cap growth 43.4 11.0

Small-cap growth 37.1 8.1

Large-cap blend 34.6 8.9

Mid-cap blend 31.1 6.9

Small-cap blend 23.8 4.3

Large-cap value 24.0 12.0

Mid-cap value 22.9 4.0

Small-cap value 18.6 2.7

Source: Morningstar Principia Pro For Mutual Funds 12/31/01

Friday’s Wall Street Journal story, “Bursting of the Tech Bubble Has a Familiar ‘Pop’ to It” compared the Nasdaq’s decline to Japan’s Nikkei drop and the U.S. 1929 Crash. An accompanying chart graphed their similarities. The subtitle emphasized one of the two hazards still facing investors: “It Can Take a Long While for Shares to Come Back.” Japanese stock investors remain down by 2/3 from prices reached well over a decade ago.

The other hazard is the valuation problem - if one exists. If we are not in a “new era,” with permanently higher valuations, further reductions to old economy valuations are going to inflict much more damage. The Journal, citing the Nasdaq Composite’s 121 p/e ratio - down from 400 a year ago – comments, “Nasdaq stocks would have to drop by more than half just to get back to their average.”

So if you haven’t been paying attention to asset allocation, unless you are an unbridled optimist, it’s still not too late. While investing in bond, convertible, equity REIT and value sectors may seem dull, it is “exciting” in one respect: It is original, because judging by fund cash inflow/outflow figures. And if you want know when to “get back into tech” one of the best clues will be when the public is finally getting out.

Tech Wrecks - Bouncing Biotechs

As funereal as the stock market seems, one sector refuses to wither: Biotechnology. On Monday of last week, as stocks recovered from the dreadful prior week’s performance, the Biotech Index (BTK – Amex) soared 6.8 % - more than tripling the gains scored by the S & P 500 and the Nasdaq Composite.

There was good news, of course, from a few biotech companies, but the news wasn’t that good or new. As the two-year chart shows, something more is going on more than just irrational exuberance. After all the sound and fury of the last two years, the S & P 500 Index and the Nasdaq Composite made a complete round trip, providing a zero-zip-nada return. The average investor, who pays commissions, and buys nearer peaks than valleys, undoubtedly did worse.

chart

One reason for the enthusiasm is that some aggressive investors believe that biotech is the next wave of the future, compared to plain old technology. Old stuff like slowing – or no - sales, shrinking margins and the like caught up with most tech companies. Beside the fact that many will simply disappear, tech stocks’ problem is that there are still too many folks calling CNBC to find out when “it’s time to get back into tech.” Fortunes have not been made trying to win the next war with battle plans from the previous one.

Another weed in the cranny is that in many cases, valuations of the larger former tech favorites are still very high. For example, even though Cisco Systems, (NFF June 00 –Retirement Planning with Cisco Systems), has lost over 2/3 of its value, it still sports a price earnings ratio of 65, a price to book ratio of 6.5 and sells at 8.3 times sales. And with revenues of almost $24 billion, it is a big company. While it will probably provide future growth, the hyper-growth of the last decade is very unlikely to be repeated. Last August I pointed out that in 1990, before Fidelity Select Technology Fund began its extraordinary run, the median capitalization of companies in the portfolio was $495 million. Ten years later, after providing a sixteen-fold return, the median capitalization was $19.5 billion – 40 times larger.

Most biotech companies, on the other hand, are still small. The two largest are probably Amgen and Genentech, with sales of $3.6 billion and $1.7 billion respectively. Many smaller ones have virtually no sales as they race with their cash burn ratio to produce products that generate revenues and earnings before their cash is depleted. However, when a new drug is approved, as Alan Carr, portfolio manager for two H & Q health care funds points out, $100 million in sales can materialize very quickly. In many cases new drugs provide cures or relief for illnesses that were previously untreatable.

Shortages of newly approved biotech drugs are not unusual. A friend of mine had to get on a waiting list for a new arthritis drug developed by a biotech company – costing $1,100 per month – to see if it helped his condition (it didn’t). The Wall Street Journal (2/27/01) reported that Genzyme was projecting that their new drug Renagal – that helps dialysis patients – would sell over $130 million, adding 20% to its annual revenue in less than a year.

Simple math dictates that unlike behemoths like Intel, Microsoft and Cisco Systems, successful new products have a much larger impact on the destinies of still-small companies. That’s part of the bet the bulls are making.

Bulls are also encouraged by the number of drugs in the final stage of testing before potential Federal Drug Administration (FDA) approval - measured by those in “Phase 3”of the approval process. Fidelity Advisor Biotechnology Fund provided the following statistics showing a 266% increase in drugs in the final testing stage during the last six years:

1994 75 1997 180

1995 125 1998 240

1996 150 1999 267

Not all will be approved or be successful, but there is a good possibility – or maybe probability – that one or more will be a mega drug; one that cures a type of cancer, AIDs, or heart disease. And while hand-held gizmos that allow you to watch your stocks go down on a real-time basis are nice, you could probably do without. A new drug that relieves suffering or even saves lives is a necessity if there is any way you – with help from your health insurance – can get it.

When I wrote about biotech last April, I quoted a Worth magazine article, The Next Wealth Machine: “Thanks to technology, medicine faces unprecedented change. For investors, this means unprecedented opportunity.” Since then, while new economy stocks have collapsed, biotech stocks have been holding their own as more new drugs are approved or approach approval. At this point, the strength in biotech stocks seems to be telling us that “The Next Wealth Machine” story has not unraveled.

Later in the decade, if it becomes obvious that biotech is the place to be, it will be the place to have been; many of the gains will be behind you. So if you’re going to invest, start before “everybody” likes biotech, unlike latecomers in technology and dot-com stocks in the late 90s.

As always, reasonable asset allocation comes first, so eventually, a maximum 5% stake is probably enough. If the “wealth machine” performs as advertised, the 5% will grow to be a much bigger slice of your portfolio and also, your diversified stock funds will have increasing weightings in biotech. And if the wealth machine turns into a bio-bust, it will only shave 3 % or 4% off your portfolio’s total value. I would commit only half of your biotech allocation now, because even though it is holding up well, if the Nasdaq drops in a final capitulation phase, it could drag biotech stocks down with it – they don’t have much “value” to fall back on.

Three funds were mentioned last April: Dresdner RCM Biotechnology (DRBNX), Fidelity Select Biotechnology (FBIOX – 3% front-end load) and Rydex Biotechnology Fund (RYOIX). A relatively new fund should be added to the list: Fidelity Advisor Biotechnology Fund (Class A load-waived shares available through advisors). Two closed-end funds, H & Q Healthcare (HQH NYSE) and H & Q Life Sciences (HQL) with a very experienced manager, have over half of their portfolios committed to biotech, many of which are private placements. Both sell at 20% plus discounts to NAV. If you have a stainless steel stomach, look at high octane ProFund Biotechnology UltraSector Fund (BIPSX) that is structured to capture 150% of the movement of the Dow Jones Biotechnology Index – in either direction.

In – or out of – Control?

Even though I get preachy, compared to my book-writing partner, Jack Pierce, I’m a smart aleck. As the book unfolded, Jack constantly urged investors to invest “properly.” I exorcised “proper investing” so many times that towards the end, I left it in just because I couldn’t think of yet another way to say it and after all, it is better than, say, swearing.

More recently, there was some lively preaching by James W. Michaels, Editor Emeritus of Forbes magazine in a column titled, Trade Less, Think More. “Web trading creates the impression that you are – as the brokers’ ads put it – “in control” of your investments. In fact you are out of control. Trading is good for the brokers but bad for the investors… Don’t be seduced by those low Web commissions. Just because your favorite saloon cuts the price of martinis doesn’t mean you double your daily consumption.” Michael’s recommendation: “Think of the Web as a library, not a lottery.”

Charles Schwab, Inc. has reported recently that investors are trading stocks less and investing in funds more, a reversal of the pattern in recent years, which brings up the old question about whether individual stocks or stock funds are a better way to invest. Declining dividend yields, less government regulation, stumbles by former blue chips such as Xerox, Proctor & Gamble and PG & E and increasing volatility (more than double 1962’s), have caused some investors to abandon the old “buy ‘em and put ‘em away” strategy. A recent study by Sanford C. Bernstein & Co. showed that the average investor holds a stock for only 10 months – that’s considerably less than the average fund holding period shown by most studies.

The question of whether stocks or stock funds are better will never be answered, other than whichever keeps you from getting out of control.

Reconsidering Rebalancing

One of the ways folks in the investment business earn their keep is revisiting their customers’ portfolios periodically to “rebalance” them. Rebalancing gets portfolios back to an agreed upon split between bonds, stock sectors and sub-sectors. Since over the long term most sectors eventually rebalance themselves, there is some debate whether rebalancing is really a good thing. Critics contend that too much rebalancing yanks out the flowers and encourages the weeds. For example, the percentage of the Standard and Poor’s 500 Index, devoted to technology swelled from less than 20% a decade or so ago, to around 35% when the tech sector was at its zenith. If the index had been rebalanced every year, it would not have provided such salubrious returns. Even with its 9.1% decline last year, it would be hard to argue that the “out of balance” S & P 500 Index was a bad thing the last decade.

Recently, Highmark Funds provided a hypothetical example of Mr. Smith (groan), who started in his early 40’s with a $100,000 portfolio allocated 60% to stocks (Russell 1000 Stock Index) and 40 % to bonds (Lehman Brothers Aggregate Bond Index). Over the twenty year period 1978 to 1998 with rebalancing, Mr. Smith’s average annual return was 14.55%; without it, the return was higher – 15.55%. But the “problem,” as Highmark sees it, was that Mr. Smith’s portfolio allocation ended up as 15% bonds and 85% stocks. “Although there was little difference in performance between the two scenarios, Mr. Smith would be heading towards retirement with much more risk in his portfolio than he started out with 20 years earlier…”

Although Highmark points out that Smitty, now in his early 60s, is heading towards retirement with “much more risk,” I don’t know where they got the “little difference in performance between the two portfolios.” There was a big difference: $287,305. $100,000 compounded over twenty years at 14.55% comes out to $1,513,219; at 15.55%, it increases to $1,800,524.

Obviously, had stocks not provided such bountiful returns over the period, the “little difference” might have indeed been little – or not at all. And if stock returns had been awful,

rebalancing, which would have shaved equities and boosted bond allocations, might have actually provided higher returns.

Three things are clear. One is that the more the rebalancing, the more likely are costs incurred, to say nothing of increased taxes. The example included neither. The second is that “little differences” compound over long periods and result in big differences in final returns. And the final one is that in order to keep themselves on the payroll, folks in the investment business will continue to insist that rebalancing is vital to the investment process.

The New-Fund Effect

A subscriber has asked whether I can provide some kind of new-fund index, to try and gauge performance. Easier said than done.

One question is whether we should track all new funds or just those have been recommended or all those that fit – or come close to – the “ideal fund profile.”

If we include only recommended funds, how do we account for the different holding periods? In real life, if you sold two funds in one month, do you split the proceeds equally between the next two recommendations sequentially, or put them all in the next recommendation? In real life, investors don’t have finite resources.

The eminently sensible suggestion was made to compare each fund with a benchmark, which is easier, but not that easy because there are various benchmarks provided by Standard & Poor’s, Dow Jones, Lipper and Morningstar and different funds use whatever benchmark suits their fancy. And some are cavalier about tracking since-inception returns until many months have passed.

But I’m trying to cobble something together. So far, I’ve computed the average realized returns of recommended diversified funds since NFF’s inception: A $10,000 investment in each of the ten recommended funds garnered total proceeds of $142,648 for an average return of 42.6%. The best return (Invesco Endeavor) was $25,090 – the worst was GE MidCap Value that returned $8,750.

Obviously, those returns are inflated because most were garnered on the way up. More recent recommendations were made as prices came down the other side, so adding gains and losses from funds still held will obviously – and substantially - reduce the average return as the bear market has deepened. Those will be reported next issue and an attempt made to reach a logical conclusion.

A new fund recommendation is attached

J. K. Lasser’s PICK WINNING MUTUAL FUNDS (John Wiley & Sons), by Jerry Tweddell with Jack Pierce is now available at major book stores and on both the AMAZON (amazon.com) and Barnes & Noble (bn.com) Web sites