A funny thing happened on the way to upbeat quarterly reports by the Chicago Tribune’s stock-pickers.
Call it irrational exuberance. Call it dumb luck. But the benchmarks used by many stock-pickers did better than fund managers who use the benchmarks to measure their investment performance.
They complained that investors chasing low-priced stocks issued by companies that don’t earn profits pushed small-capitalization stock indexes higher at a rate nearly double the gain of the Dow Jones industrial average.
“It was very hard to outperform the index this quarter,” said John Rogers of the Ariel Fund. Rogers tracks the Russell 2000 value index, which gained 22 percent in the last three months, compared with a total return of 13 percent for the Dow. The Ariel Fund posted a return of 17.6 percent.
“I’ve been fairly bullish,” Rogers said. “I think the market bottomed last October. I wasn’t surprised that we had a rally, but the strength of the rally was surprising.
“You’ve had a year’s worth of returns telescoped into one quarter, and that’s a concern if you’ve come too far too fast.”
Rogers says he’s turned cautious. “Now is not the time to take extra risks,” he said. “When everyone gets optimistic, it’s time to be concerned about a downturn.”
Kathryn Vorisek, whose small-cap fund also uses the Russell 2000 value index as a benchmark, agreed.
Markets not rational?
“Are market participants being rational? I would argue no,” she said. She said companies priced below $5 a share, with no profits, drove the Russell 2000 value index higher.
“We have lagged our small-cap benchmark this quarter because we run a higher-quality portfolio,” she said. “We don’t buy stocks under $5. We don’t buy stocks that earn no money.”
John Keeley’s small-cap value fund returned 20.2 percent in the quarter, nearly matching the Russell benchmark.
On the upside, “mutual fund cash flows have been positive, the interest rate scenario is about as good as it will ever get, [and] the market was buoyant because of the tax cuts,” Keeley said.
“We’re now in a bit of a waiting game to see if this big gain has been justified.”
Despite troubles in the European economy and continued recession in Japan, David Herro’s Oakmark International Fund beat the total return of 20 percent for the benchmark Europe Australia and Far East (EAFE) index compiled by Morgan Stanley Capital Markets.
“This has been one of our better quarters,” Herro said. The weaker dollar helped, he said, as non-U.S. gains translated into stronger dollar returns.
“But there is still a lot of umph left in foreign markets.”
For the first time in a while, Herro picked a Japanese stock, Daiwa Securities Group, though he remains unimpressed with the recent rally in Japanese stocks. The benchmark Nikkei 225 index gained 14 percent in the latest quarter.
“I would bet that the Japanese market is going to spike up, but as long-term investors we try to focus on a combination of price and quality in the businesses, and in the case of Japan it’s just not there.”
Daiwa has successfully restructured, he said, and “it’s trading at a burnt-out price.”
On the home front, the powerful second-quarter rally advanced several stocks our stock-pickers had selected as candidates to sell or avoid.
The popularity of home buying pushed home builder Lennar up by 47 percent, though Keeley is lightening his position in Lennar and rival KB Homes.
ManTech International, which provides technology services to the Defense Department, gained 29 percent. Vorisek had turned sour on the company after it issued additional shares last year without a clear strategy.
Rogers bet wrong on Sears, Roebuck and Co., believing Sears and other retailers would stumble competing against Wal-Mart Stores. He’s sticking to his Wal-Mart theme and kept Sears as a stock to sell or avoid.
Herro missed a 48 percent gain in carmaker Porsche, but continues to avoid the stock.
New approaches surface
For the third-quarter selections, several new ideas emerged.
Keeley noted the natural gas shortage in the U.S.
In an uncharacteristic comment beyond interest rates and big-picture economic themes, Federal Reserve Board Chairman Alan Greenspan recently called for the U.S. to import more natural gas.
Keeley likes Chicago Bridge & Iron, which is based in Texas and owned by the Dutch. The company makes containers for transporting and storing liquefied natural gas, he said.
Rogers has become bullish on Deerfield-based Baxter International. Shares of the health-care company fell hard in the last 15 months, from nearly $60 a share to about $19, though they rebounded in the second quarter.
“Their franchise is still intact,” he said. “There are real barriers to entry to come in and compete with them.”
Vorisek picked three new names, including securities-services provider Kroll. The company has diversified into corporate turnaround work–it is managing Enron–and electronic evidence retrieval.
She also likes industrial equipment manufacturer Gardner Denver, based in Quincy, Ill., and scientific instrument and test-supplies maker Varian.
The fund managers said the performance of their selections for the third quarter depend on the widely believed expectations of an economic rebound materializing.
“We’re going to have to see an acceleration in the economy overall and particularly in the manufacturing sector,” Vorisek said.
“We’re now poised to see how earnings are going to come out,” Keeley said.
For international investors, the question is whether stocks in major industrialized regions can duplicate the rally just witnessed at home, Herro said. There are still plenty of opportunities abroad, he said.
“We don’t have a uniform recovery taking place overseas yet, and as a result, I remain very optimistic,” Herro said.
He believes the gradual development of consumer buying in China will “be beneficial to the rest of the world, not just East Asia.”
He’s watching auto sales, which have begun to reach into the general Chinese population.
“It used to be just government bureaucrats and cab drivers. Now you see a market developing for consumers,” he said.
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Coming Monday: The 2nd-quarter mutual funds and stocks report.
