How A Hot Market Forces Managers Into Compromising Positions
(MONEY Magazine) – With his Safeco Growth No Load fund up 63% for the past year and No. 1 in its category, you would figure that small-stock star Tom Maguire is at the top of his game. Problem is, investors have plowed so much cash into his fund--more than $1 billion from September to May alone--that he's had to change his game. "It's a waste of my time to look at very small stocks because the fund has grown too big to benefit from them," says Maguire. "Now I have to buy bigger stocks--it's frustrating."
Maguire is one of many managers scrambling to cope with today's ebullient market. Some skippers who can't find stocks that meet their criteria are simply sitting on their hands, accumulating big cash positions. Others, though, are making significant changes in the way they pick stocks. Of course, the mere fact that a manager is re-tooling his style doesn't mean you should drop the fund; in fact, the shift may lead to better returns. But it clearly makes sense to check up occasionally on how your funds are being run so you can decide whether you still feel comfortable owning the portfolio. Below, we focus on three ways leading managers are rejiggering their investment strategies.
MORE CASH, BIGGER STOCKS
From the late '80s to the mid-'90s, Elizabeth Dater and Steve Lurito of Warburg Pincus Emerging Growth built a solid, low-risk record investing in tiny, fast-growing stocks. But as their fund's assets more than tripled over the past three years to $1.8 billion, the median market value of the portfolio's stocks quadrupled to $2.2 billion. Like many other managers whose small-stock funds have bulked up, Dater and Lurito contend that they climbed into midcap territory mainly because they have held on to their winners. For example, when they bought software firm PeopleSoft four years ago, it had a market capitalization of $1 billion; today, it weighs in at $9.7 billion. "We haven't fundamentally changed our investing style of buying emerging growth companies," says Dater.
But Dater and Lurito now also buy companies with market caps well beyond the traditional $1 billion upper boundary of small-stock territory. Recently, for example, the duo bought shares of Premier Parks ($1.9 billion market cap) and Outback Steakhouse ($1.8 billion). Such new purchases, plus holdings that have grown from small- to midcaps, mean fund shareholders aren't getting true small-stock exposure. Not that owning larger stocks has hurt performance. The fund has gained 27.3% in the past year, topping small-growth funds (23%) and midcap growth funds (25.6%). But to accommodate institutional investors and others who require that funds adhere closely to specific styles, in 1995 and 1996 Warburg Pincus opened two separate portfolios that stick with smaller stocks. Both funds were later closed to new investors to keep the market caps near their average of $800 million.
HIGHER PRICES, FEWER BARGAINS
Since 1986, Janus fund manager Jim Craig has sought to boost returns and limit risk by buying undervalued growth stocks--specifically those with price/earnings ratios lower than their projected earnings growth rate. That approach largely worked until the market shifted into warp speed in 1995, making the phrase "underpriced growth stock" an oxymoron. At first, Craig stuck with his value-oriented approach. But then the fund started landing in the bottom half of its large-blend peer group (which includes funds that own a mix of value and growth stocks). Last fall, he decided to retool his criteria to allow for other barometers of value, such as strong cash flow per share or the likelihood of positive earnings surprises. "Now I'm not too wigged out about P/E multiples," says Craig.
The liberalized strategy appears to be working: Janus has gained 32.7% for the past 12 months, placing it in the top third of similar funds. The fund has transformed itself in other ways too. It used to be that Janus rarely put more than 10% of assets in tech, but today tech companies, including computermaker Dell and software firms like Parametric Technology, make up 24% of assets. Another 12% is in cable companies, such as Comcast and TCI. Craig says that the revamped strategy is likely to make the fund somewhat more volatile. "But given today's high market valuations," he says, "the appreciation just isn't there for defensive, steady growers."
NEW REALITIES, NEW MODELS
In other cases, managers have made less drastic changes to methods that worked in the past but have been failing them during this bull run. Since 1983, for example, the American Century-20th Century Vista fund had relied on a quantitative stock-picking model that identified stocks with the highest annual earnings growth rates. In recent years, however, the model was turning up far more technology shares than anything else. As a result, when last fall's Asian crisis hammered technology stocks, Vista, with nearly 40% of its assets stashed in tech companies, plunged 17.4% in that quarter alone. The fund's model also failed to pick up several other hot growth sectors. "We missed the boom in financial stocks last year almost completely," admits co-manager Glenn Fogle, "because we were focused on companies with the absolute highest growth rates." Overloading on tech and overlooking thriving sectors helped push the fund into the bottom 25% of its midcap growth peers for the past 2 1/2 years.
So late last year American Century modified the fund's stock-picking system to account for additional factors, such as a company's potential as a takeover target and the effect declining interest rates might have on a stock's price. The fund group also shuffled the fund's management team, bringing in Arnold Douville, who had run a similar growth portfolio at Munder Capital. As a result of these changes, Vista's portfolio has already become more diverse: Its tech holdings have dropped from 40% to 25% of assets, while the rest of the fund is spread across a broad range of industries, including environmental services and retailers. One thing the makeover has yet to do, however, is improve performance. Over the past 12 months, Vista has gained only 6.7%, a meager showing that ranks the fund in the bottom 2% of its peers.
The most surprising strategy shift under way is that involving Garrett Van Wagoner at Van Wagoner Emerging Growth. Van Wagoner made a name for himself by being among the first investors to spot small, fast-growing stocks--usually tiny technology companies with hot new products--and then bailing at the slightest hint of an earnings slowdown. That strategy--typically called momentum investing--propelled Emerging Growth to the top of the charts in the first half of 1996. But last year the fund flamed out with a 20% loss. Part of the problem, of course, was the Asian crisis that creamed tech stocks in the fall. But Van Wagoner also believes that too many people had started playing his game with his kind of stocks, making it harder for him to build his positions--and take his profits. So he decided to make some changes. "It's a new reality of today's market that you have to be aware how the news flow might affect a stock," says Van Wagoner. "If a lot of momentum investors own a company, I won't buy as much as I might like because of the volatility." For example, Van Wagoner says that he would like to increase his fund's tiny holding of Citrix Systems (0.5% of assets), a rapidly growing software firm whose share price has risen 400% since he first bought it in 1995. "I still like Citrix's prospects," he says. "But I'm worried about a pullback by momentum investors if there's an earnings disappointment or if tech stocks slow down in the near term."
Van Wagoner is taking other precautions to prevent Emerging Growth from getting slammed if one of his holdings goes awry. He now generally puts no more than 3% of fund assets into any one stock; last year, he would have thought nothing of taking a position of 5% or so. He has also sharply increased the number of stocks he keeps in the portfolio--upwards of 125 today vs. 70 or so a year ago.
To be sure, Van Wagoner still walks on the wild side, buying racy stocks like Avant!, a circuit-design software maker that plunged 47% last year. And it's still too early to tell whether his defensive measures will boost the fund's flagging performance. Over the past 12 months, the fund is down 1.1%. "I can't say exactly when it will arrive, but our time is coming," Van Wagoner says. "I believe our revised strategy will work in the long run."