Stock Funds in ’04 See Double-Digit Gains as Small-Company and Value Issues Lead

For a second year, double-digit returns were the rule for stock mutual funds in 2004.

Wall Street’s slump as 2005 begins may be warning of a tougher road ahead for fund investors. But they at least have two solid years of gains under their belts, after the painful bear market of 2000-2002.

The average domestic stock fund posted a total return of 12.2% last year, a sharp slowdown from the 32% gain in 2003 but nonetheless far better than what investors earned on bonds or cash accounts, according to investment research firm Morningstar Inc. in Chicago. Total return includes dividends.

Most U.S. bond funds earned between 2% and 7% in 2004. The average money market mutual fund earned 0.82%, according to ImoneyNet Inc.

The bulk of stock funds’ returns came in the fourth quarter, as U.S. share prices surged after being held back for nine months by rising interest rates, record high oil prices, and nervousness over the presidential election, Iraq and terrorism.

For the full year, investors scored substantial gains in some relatively narrow stock fund sectors, including real estate, natural resources and utilities.

Among broader sectors, value funds, which focus on finding bargain stocks, beat growth funds, which are weighted toward companies considered to have strong earnings prospects. Also, small-stock portfolios beat blue-chip funds.

And for a third straight year, foreign stock funds in general beat U.S. funds, helped by the falling dollar: The average foreign fund rose 18.5% in 2004, according to Morningstar.

Fund managers faced the ongoing distraction of scandal for most of 2004. Federal and state regulators’ investigations into trading abuses at more than a dozen fund companies began to wind down by mid-year. That gave way to a new probe into brokerage sales practices, and whether many fund companies have in effect been paying kickbacks to brokers to fuel sales.

The rise of exchange-traded funds also challenged the $4.2-trillion-asset conventional stock fund business.

Still, net new cash flow into stock funds totaled $167 billion in the first 11 months of 2004, according to the Investment Company Institute, the industry’s chief trade group. That was the most since 2000.

Four trading days into the new year, however, investors already have seen a chunk of last year’s returns melt away as the stock market has slumped.

“There are good reasons to be sober” about the outlook for stock fund returns this year, said Russ Kinnel, director of fund research for Morningstar.

Wall Street’s main concern is that the Federal Reserve will continue raising short-term interest rates, Kinnel noted. Worries about how fast the Fed might proceed, after five rate hikes last year, have helped to knock the stock market lower since Monday.

Two years of rebounding share prices also have made it tougher to find bargains, many portfolio managers say.

“It is much more difficult to find what we consider excellent risk-to-reward” stock ideas, said Scott Moore, co-manager of the Kansas City, Mo.-based American Century Value fund, which gained 14.4% last year after rising 29% in 2003.

As the new year begins, investors face the perennial question of whether to favor fund sectors that have been performing well or bet on laggards.

Among last year’s winners:

* Funds that focus on Latin American stocks led all Morningstar fund sectors with an average gain of 38.3%. The Mexican, Argentine and Brazilian markets all rallied sharply on optimism about their economies.

Gains in those markets and in those of other so-called emerging economies helped lift the average emerging-market stock fund 23.8% for the year.

Although smaller foreign stock markets are inherently risky, some analysts say the fundamentals remain favorable. “Their economies are in good shape,” said Andrew Clark, an analyst at fund-research firm Lipper Inc. in Denver.

* Real estate funds, which mostly buy shares of real estate investment trusts, rose 31.9% last year, on average, after a 37% gain in 2003.

Although higher interest rates typically are considered problematic for the property business because they raise borrowing costs, real estate funds continue to attract investors who are making a long-term bet, said Kenneth Statz, co-manager of the Security Capital U.S. Real Estate Shares fund in Chicago.

Many institutional and individual investors like the high dividend income generated by real estate shares, particularly in an environment in which long-term bond yields still are relatively low, Statz said.

* Natural resources funds, many of which focus on energy stocks, jumped 28.4% in 2004, as crude oil prices surged.

Frank Holmes, head of fund company U.S. Global Investors in San Antonio, contends that commodities like oil are in a long-term bull market, despite the pullback in energy prices in the fourth quarter. Supplies of many commodities worldwide aren’t likely to increase enough to depress prices in the face of booming economic growth in Asia and ongoing demand from the rest of the world, he said.

Holmes also expects gold prices to resume the bull market that began in 2002. After soaring in 2002 and 2003, funds that own gold-mining stocks slumped last year, losing 8.1%, on average, as the metal’s price leveled off for much of the year.

His investment pitch for gold, Holmes said, is that “you don’t buy it to get rich -- you buy it for insurance” in a dangerous world.

For most investors, the major debate over stock fund investing isn’t about whether to buy specialty sectors, but how to divide a portfolio among four basic building blocks: large stocks, small stocks, value-oriented issues and growth-oriented issues.

Small-company stocks trounced large-company stocks last year, as they have so far in this decade. The average fund that buys a blend of small-company value and growth issues jumped 18.9% last year, compared with a 10% gain for funds that buy a blend of large-company value and growth issues, according to Morningstar.

Among the biggest stock funds by assets, the Fidelity Low-Priced Stock fund was up 22.2% last year. The portfolio includes many smaller-company shares.

By contrast, the Fidelity Blue Chip Growth fund, which focuses on big-name issues, was up a modest 6.3% in 2004.

Blue-chip stocks had led the market in the late 1990s while many smaller names were ignored. In this decade, the performance of the sectors has reversed.

Many analysts expected big-name stocks to take back the lead in 2004, but it didn’t happen. The conventional wisdom on Wall Street is that a shift is long overdue.

Since 1999, “My companies have been doing fine, but not their stocks,” said Robert Smith, co-manager of the T. Rowe Price Growth Stock fund in Baltimore. The result, he said, is that the average price-to-earnings ratio of his fund’s blue-chip stocks has been cut in half since 1999, to about 16.

Fans of smaller companies say those firms generally have better growth prospects than bigger companies, and so could continue to lead the market.

But Smith, whose fund owns such names as Citigroup Inc. and General Electric Co., said he expected his companies to post double-digit annual earnings growth in the long run. Investors, he said, eventually are going to notice that big-name stocks offer good growth as well as relatively low price-to-earnings ratios.

American Century’s Moore said his fund was focused in part on large-company issues that are facing what Moore considers “transitory” problems. He cites insurance giant American International Group Inc., which has been beaten down on concerns about regulators’ investigations of certain insurance industry practices; and paper- products maker Kimberly-Clark Corp., which is facing greater competitive pressure from rival Procter & Gamble Co.

Morningstar’s Kinnel said it might be true that many smaller companies have healthy growth prospects. Even so, he said, from the viewpoint of basic portfolio diversification, investors who have profited handsomely in smaller stocks since 1999 ought to be thinking about moving some of that money into market sectors that now may be bigger bargains -- particularly blue-chip shares, he said.

The same applies in judging the appeal of value-oriented funds versus growth-oriented funds, Kinnel said.

Value stocks typically sell for lower-than-average price-to-earnings ratios and often offer higher dividend yields. Growth stocks, by comparison, often sell for higher prices relative to earnings, underlying asset values and other measures, but also often boast better long-term growth prospects.

The plunge of the classic growth sector -- technology -- from 2000 to 2002 has soured many investors on growth. Value funds have far outperformed growth funds since 2000.

But Kinnel and other analysts say growth funds deserve a closer look by investors who figure that the sector’s time is bound to come again.