Popular Sectors Run Into Tough Sledding

The stock market’s woes in the first quarter hit many mutual fund investors where they live.

The average U.S. stock fund lost a relatively modest 2.6% in the first three months as Wall Street was beset by rising interest rates and record oil prices.

But few investors own the “average” fund. They’re more likely to hold portfolios in categories that were zapped harder by the market’s latest troubles.

Among funds that focus on specific industry sectors, for example, the three largest by assets -- healthcare, real estate and technology -- lost 6.1%, 6.6% and 8.9%, respectively, in the quarter, according to data compiled by Morningstar Inc.

By contrast, the quarter’s biggest winner among stock fund categories was the natural resources sector, which was fueled by gains in the energy stocks those funds favor. The average natural resources fund jumped 12.6% in the three months.

Yet that sector holds relatively few investor dollars. Natural resources fund assets total about $25 billion, according to Lipper Inc. That’s less than one-fifth the total of $132 billion in healthcare, real estate and tech funds.

A recurring disappointment for fund investors in the first quarter was the growth-stock sector, which led the bull market of the late 1990s and then led the bear market plunge of 2000-2002.

Growth stocks are issues that are considered to have faster earnings growth prospects than the average stock. Technology and healthcare are two major growth-stock sectors.

In the first quarter, funds that own big-name, blue-chip growth stocks slumped 4.3%, on average, Morningstar data show. That was particularly grating to investors who, by late last year, had been expecting the growth sector to finally show a sustained turnaround. The large-growth-fund category still holds about $250 billion in assets, despite its mostly dismal performance since 2000.

Funds that look for small-company growth opportunities fared worse in the quarter, losing 4.9%, on average.

Despite the losses in most stock fund sectors in the first quarter, some veteran fund managers say the declines were nothing more than a modest setback in a bull market.

The Novato, Calif.-based Hennessy Cornerstone Growth fund lost 1.4% in the first three months after gaining 16.6% last year. Fund manager Neil Hennessy doesn’t see the big deal.

The economy is healthy, and businesses and consumers continue to spend, Hennessy said. “I think this market is in great shape. People just don’t believe it.”

Bernie Schaeffer counts himself among the nonbelievers.

“I don’t see a heck of a lot that’s compelling here,” said Schaeffer, head of advisory firm Schaeffer’s Investment Research in Cincinnati.

With the Federal Reserve continuing to raise short-term interest rates, Wall Street automatically becomes less willing to pay up for many stocks, Schaeffer said. That’s because investors realize that interest returns on bonds and other fixed-income accounts are becoming more attractive compared with what riskier stocks might provide.

Rising interest rates can be especially damaging to stocks that have above-average price-to-earnings ratios -- which still describe many tech issues. That’s a big reason that sector took a tumble in the first quarter, analysts say.

Higher rates also took a toll on funds that own real estate investment trust shares because of concerns that the booming property business could slow.

An overriding concern, Schaeffer said, is that the pace of corporate earnings growth is slowing. Operating earnings for companies in the Standard & Poor’s 500 index are expected to have risen 8% in the first quarter from a year earlier. For all of 2004, earnings of the S&P; 500 companies rose 20% compared with 2003.

Although earnings were expected to slow, they may face a greater headwind in high oil prices and rising interest rates, Schaeffer said.

What many investors fear, of course, is another bear market -- a deep decline in stock prices that could wipe out all or much of the gains achieved since October 2002, when the current bull market began.

But the first-quarter losses in the market, and in most stock fund categories, didn’t suggest a rush for the exits. Many investors, like Hennessy, seem content to hold on for better times.

“People are unenthusiastic about the market, but it’s not panicky like in 2002,” when stocks were plunging to their bear market lows, said Russ Kinnel, director of fund research for Morningstar.

“Value” stock funds, which focus on finding shares that are relative bargains, slipped only modestly in the first quarter, a sign that investors continue to look to that sector for shelter. Value stocks have been the market’s leaders since 2000.

Among major stock market indexes, the S&P; 500 lost 2.2% in the quarter, measuring total return (price change plus dividend income, which is how mutual fund returns are calculated). The tech-dominated Nasdaq composite fell 8%; the Russell 2,000 small-stock index gave up 5.3%.

Although investors obviously don’t like to lose money, “A gentle cooling-off period might a good thing for the stock market” after the double-digit gains of 2003 and 2004, Kinnel said. A modest pullback, while the economy continues to grow, could set the stage for another run-up later in the year, some analysts say.

Barring a sudden, broad-based decline in share prices, many stock fund investors may be looking to fine-tune their portfolios, trying to identify sectors that have a better chance of gaining ground, or at least holding steady, even if the average stock doesn’t.

The utility sector was one of the first quarter’s winners. The average utility-stock fund gained 2.8% in the period.

Maura Shaughnessy, manager of the Boston-based MFS Utilities stock fund (up 1.1% in the quarter), said investors are once again appreciating that the electric utility business generates a lot of cash -- some of which is returned to shareholders via hefty dividend payments.

In a time of rising interest rates, those dividends are a bigger draw for investors, she said.

Some utilities also have attracted investors because the firms have divisions that explore for oil or natural gas, Shaughnessy said.

But the sector’s gains have made it tougher to find bargains, she said: “It’s not as easy to find good relative value in the group.”

Overseas, however, can be a different story, Shaughnessy said. Foreign utilities in the electric, gas and telecom industries often are overseen by regulators that are much friendlier to the companies, she said. One example, she said: Enagas, a Spanish natural gas utility.

In general, foreign stocks have provided a haven for U.S. investors in recent years and did so again in the first quarter.

The average international-stock fund was flat for the quarter, in contrast to the losses in most U.S. stock funds.

Some foreign-fund sectors posted gains in the first three months. The average European fund, for example, was up 1.3%, according to Morningstar.

Funds that focus on foreign small-company stocks also were positive in the quarter, on average.

The surprise was that foreign funds held up well even though the dollar has strengthened.

For most of the last three years, the dollar was falling, which was a boon to Americans who owned foreign stocks. A weaker dollar lifts the value of foreign shares when translated from their stronger local currencies into dollars. When the dollar rises, however, the currency translation cuts into returns on foreign stocks.

Amit Wadhwaney, manager of the Third Avenue International Value stock fund in New York, said he had “no strong opinion” about what the dollar might do next. Good stock picking, he said, is more important for long-term investment success than currency swings.

His fund, which rose 4.8% in the first quarter, is focused on stocks that are out of the mainstream compared with what investors might see in other foreign portfolios.

Norway, for example, has become one of Wadhwaney’s favorite investment locations. He owns a number of companies involved in the North Sea oil business, as well as shares of the company that controls the Oslo Stock Exchange.

In Singapore, he found Boardroom Ltd., a firm that helps other companies get their stocks listed in Asian markets.

The appeal of foreign markets, compared with the U.S. market, is that many overseas stocks still are substantially less expensive than their U.S. counterparts, Wadhwaney said.

In many cases, he said, “you can buy the same kinds of companies way, way cheaper overseas.”