Professional stock pickers faced tough tests in summer school this year, as third-quarter results of the Tribune’s mutual fund panel indicate. But it might be too early to assign grades.
A sudden freeze in the global credit market, a surprise cut in interest rates by the Federal Reserve and a steep run-up in commodity prices were among the top-down shocks that made life difficult for bottom-up equity fund managers.
Whereas the blue-chip Dow Jones industrial average posted a 3.6 percent gain for the period, the Russell 2000 index of small-company stocks, the benchmark for many equity fund managers, dropped 3.4 percent.
“I think you’ve seen during times of stress a turning away from small- and mid-cap companies to large-cap companies as a kind of flight to safety,” said John Keeley, manager of the Keeley Small Cap Value Fund. His fund slipped 1.9 percent for the quarter.
He avoided stocks related to the troubled housing and mortgage finance sectors. For 2007, the fund was up 11 percent through the end of September, easily beating his performance benchmark, the Russell 2000 value stock index, which was virtually unchanged.
The same instinct helped Kathryn Vorisek stay in the black for the third quarter at the FMA Small Company Fund. The fund was up 8 percent through September, compared with a 3.2 percent total return by the Russell 2000 index.
“There was a greater understanding that the housing situation was going to have a greater impact on economic growth,” she said.
Steady-as-you-go investing strategies faced some rough seas, said John Rogers of Ariel Fund.
“The volatility has been way abnormal,” he said.
The fund dropped 6 percent in the third quarter but was up 5.4 percent for the year through September.
David Herro of the Oakmark International Fund got caught on the wrong side of stock sector plays. The fund was off 3.5 percent in the quarter, compared with a 1.1 percent advance by the benchmark Morgan Stanley Capital International Europe Australia Far East index.
For the first nine months of the year, Oakmark International returned 4.5 percent, compared with a 13.7 percent gain for the EAFE index.
Herro owned stocks in the financial services and consumer sectors and shunned stocks linked to commodities and materials. That was the wrong tilt, as commodities and materials rallied, along with a weakening dollar and economic expansion abroad.
It was “a terrible quarter,” Herro said. “Anything ‘financial’ got tarred this summer. There was a mass of money moving out of the financial sector and pumping up resources and industrials in the belief that the cycle is going to go on forever, and I just don’t believe it.”
The same approach
Looking forward, none of the four fund managers saw a need to alter their approach much. Rogers said the marching orders for the third quarter were to buy depressed stocks in sectors they already own.
“We stay focused on a relatively narrow number of industries,” he said. “We should be able to make quick and effective decisions during these volatile periods. The vast majority of our decisions were to add to or build new positions in stocks that got pummeled in this period. The mistakes we made were being too conservative.”
In particular, Rogers, Keeley and Herro are bullish on financial-service stocks, the second-worst-performing sector in the market in the third quarter.
With long-term interest rates climbing, after the Federal Reserve cut short-term rates, “community banks and savings and loans are finally going to start to show some earnings momentum,” Keeley said. “This sector, while we have avoided it for three years, is going to start coming back into vogue.”
For one of his three fourth-quarter stock picks, Keeley chose First Niagara Financial Group, a New York-based bank holding company.
Herro stuck with Swiss banking giant UBS, which rallied strongly Monday and Tuesday despite the company’s forecast on Monday of a major third-quarter loss, including the write-down of $3.4 billion in mortgage-backed securities.
Rogers retained all of his third-quarter “buy” and “sell” selections, including a “buy” for California banking firm City National. The stock lost nearly 9 percent in the third quarter.
“Maybe the economy is going to slow down a bit but, at the end of the day, the subprime mess has been contained,” he said. “The worst is behind us.”
Naysayer on housing
Vorisek disagreed, saying the fallout from massive unsold house inventories and risky mortgage lending is not over.
“The market is becoming slowly convinced that the housing issues are going to get deeper,” she said. “We’re looking for a leadership shift to technology and health care.”
For the fourth quarter, she chose Skyworks Solutions, a developer of wireless software for hand-held communication devices. The company has supplier deals with Nokia, Samsung and Motorola. She also picked perfume-maker Inter Parfums, which in recent months began selling through Gap and Banana Republic stores.
Herro’s doubts about the recent commodity price boom led him to recommend avoiding the iShares MSCI Emerging Markets Index Fund and Australian mining operator BHP Billiton.
“I want people to get the message that this stuff is overpriced and to be careful,” he said. “When the resource bubble pops, a lot of this money will find its way into other sectors.”
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bbarnhart@tribune.com
