(MONEY Magazine) – David Brady may manage money for children, but you won't find their favorite playthings in his Stein Roe Young Investors Fund. Brady doesn't have a single toy stock among his top 25 holdings, and when his pint-size shareholders (average age: 12) write to him, they want to know about Cisco and Lucent, not Mattel and Hasbro. It's been years, Brady says, since one of his young clients asked him to buy Toys R Us.

Smart kids. Lately, toyland has been a scary place for investors of any age. Hampered by lousy demographics, changing play patterns and (in the case of Mattel and Toys R Us) poor management, toy makers and sellers have been very unpopular with the big kids on Wall Street. Shares of Mattel have fallen harder than Ken for Barbie, dropping 65% since the end of 1997. Hasbro, the No. 2 toymaker behind Mattel, is down 46% over that time, while retailer Toys R Us is off 45%. Standard & Poor's 500 gained 60% over the same period.

Now, though, with the Christmas shopping season approaching and Hasbro, Mattel and Toys R Us all well off their highs, the toy sector is starting to attract attention from bargain hunters. Mattel--parent company of Barbie, Fisher-Price and Hot Wheels--has been the biggest beneficiary, its stock climbing from $9 in March to more than $13.50 in mid-July, before dropping to $12.25 on July 21. Our advice? Take a look at Toys R Us and Hasbro, but steer clear of the Barbie bandwagon.

Mattel is still digging out from its disastrous purchase of the Learning Company in 1999, a $3.8 billion debacle that cost Mattel CEO Jill Barad her job. Though Wall Street seems to support new CEO Robert Eckert's plan to sell the Learning Company--even if it means accepting 10? on the dollar for the educational software firm--the Learning Company is not Mattel's biggest problem. More troubling is the shrinking market for traditional toys. The number of children in the U.S. under age 14 will increase less than 1% between now and 2005. Making matters worse is a phenomenon known in the toy biz as "age compression." Today's children are playing with toys for fewer years than their parents or even their older siblings. "Barbie used to reach up to age 11 or 12," says Salomon Smith Barney analyst Jill Krutick. "Today's girls are outgrowing Barbie by six or seven." The prime culprit is the personal computer. With more and more software and websites being aimed at younger and younger children, playtime is going virtual.

Hasbro has adapted to the new environment more quickly than Mattel, and for this reason we think Hasbro is the better stock to own--despite its recent overdependence on profit-monster Pokemon cards. Home to venerable low-tech brands such as Monopoly, Tonka and G.I. Joe, Hasbro also ranks a surprising fifth in the entertainment software business, with hits like Frogger and Centipede. At $11 as of July 21, Hasbro is also a lot cheaper, with a price/earnings ratio of 8 vs. 16 for Mattel.

Along with Hasbro, the other toy stock we like is Toys R Us, though we view it more as a short-term turnaround play than a long-term holding. Toys R Us has been undercut on price by Wal-Mart and outclassed on service by the likes of F.A.O. Schwarz, yet for the longest time management refused to tinker with the stores' no-frills format. Shareholders have paid dearly for this intransigence. Toys R Us made less money last year than it did in 1991, and Wal-Mart has overtaken it as the nation's No. 1 toy retailer, with a 17.4% market share vs. 15.6% for Toys R Us. "Management issues have always made me want to stay away," says Brady, the Stein Roe fund manager.

In former F.A.O. Schwarz head honcho John Eyler, Toys R Us finally has a CEO with the right pedigree. On the job since January, he is revamping the stores to make them friendlier and less warehouse-like. Stealing a page from F.A.O. Schwarz, Eyler is also increasing the number of toys sold only at Toys R Us. His goal is to have 12% of his products be exclusives by this holiday season, and 20% by Christmas 2001.

Regaining market share from Wal-Mart won't be easy, but investors aren't expecting miracles. At $17 a share, Toys R Us is so cheap that even a modest improvement in earnings should give the stock a boost. Certainly that's what Federated Investors is banking on. Since March, the Pittsburgh money manager has upped its stake in Toys R Us to 3.7 million shares from 2.8 million. Federated analyst Angela Auchey expects Toys R Us to reach $24 by year-end, and with shares now trading at a mere 12 times earnings, Auchey sees little downside to taking a flier on John Eyler.

We agree--with the following caveat: The Christmas shopping season rarely lives up to its advance billing, which is why, historically, late summer has not been a great time to invest in toy stocks. But this year could be different. With such low expectations already built into Toys R Us stock, last-minute shoppers may wind up paying full price.

--JON BIRGER