Energy, international funds brighten dim landscape

By Jonathan Burton

SAN FRANCISCO (MarketWatch) - Investors relied on energy and international stocks to brighten a dim landscape for mutual funds, as interest-rate and inflation concerns pressured quarterly results.

Every diversified U.S. stock-fund category finished in negative territory for the first three months of the year, based on preliminary data from research firm Lipper. Investors were locked in a tug of war that pit a generally healthy economy and cash-rich, well-positioned companies against a headwind of rate hikes, soaring commodity prices and slower corporate earnings growth.

U.S. stocks hit three-year highs in early March, but by month end, pessimism gained the upper hand. Diversified U.S. stock funds lost 2.5% on average, a sharp reversal from a powerful 11% rally in the final quarter of 2004. Meanwhile, the Standard & Poor's 500 Index (SPX) shed 2.6%.

"It's not a great environment -- no question about it," said Bob Doll, chief investment officer at Merrill Lynch Investment Managers. Listen to interview with Bob Doll

"It's one that is going to cause folks to struggle to make money," he added. "It's not going to be easy to say, 'Give me your favorite stocks,' put them in a portfolio, and then wake up at the end of the year and hope you've done well. We're using the term 'muddle through.'"

Signs of a narrower, maturing U.S. stock market were evident, particularly in the unchallenged superiority of energy-stock funds. Watch related interview

The natural resources sector's 12.5% average gain on the back of surging oil prices dominated all others. Utility funds finished a distant second, rising 2.7%.

Other industry sectors sagged. Healthcare funds ended down 6.1%, technology funds lost 9%, and real-estate funds fell 6.7%. The average value-oriented fund also ended with a loss, but -- unlike their growth fund counterparts -- avoided the brunt of the downturn.

"It's a cyclical market," said John Brynjolfsson, manager of the Pimco Commodity Real Return fund (PCRAX), which rose 11.2% in the quarter. "The market is more concerned with inflation now. That's not surprising, because inflation has been above 3% recently and the Federal Reserve remains relatively accommodative."

More of the same

In many respects, the quarterly results continued established investment trends. Enthusiasm for energy stocks grew, mid-sized company stock funds stayed robust and investors demonstrated a clear preference for value strategies over growth.

"Energy has been the story in terms of performance, and the main driver of the market," said Don Cassidy, a Lipper senior research analyst.

Given the heavy global demand for energy and the scarce supply of oil, momentum for this sector is unlikely to subside anytime soon, Cassidy added. "A lot of money is going to natural resources funds," he said. "Money has been flowing into what has been working and what has been comfortably cautious - value, real estate, world equity funds."

One notable difference this quarter: Results for large-company stock funds, though negative, edged small-company rivals. After several years of small-cap supremacy, the change suggested that a long-anticipated shift of market leadership in favor of large-caps might be underway.

Shares of companies with larger market valuations tend to outperform smaller-cap counterparts when the profits cycle decelerates. Large-cap value funds in the first quarter performed accordingly, for example. The category lost just 0.8% in the period vs. a 2.1% decline for small-cap value, Lipper reported.

The most popular large-cap funds gave ground. American Funds Growth Fund of America (AGTHX) -- the largest actively managed U.S. stock fund -- saw its Class A shares fall 1.8%; sibling Investment Company of America (AIVSX) lost 0.9%.

Meanwhile, the Vanguard 500 Index fund (VFINX) lost 2.1%, and Fidelity Magellan (FMAGX) shed 2.7%.

Many core small-cap funds suffered worse. For example, the T. Rowe Price Small-Cap Stock fund (OTCFX) lost 3.4% in the quarter, while the Vanguard Small Cap Index fund (NAESX) shed 3.8%.

"We're pushing six years for value versus growth, but we don't see that changing," Cassidy said. "It's much more likely that size will change than style. Value gives you current income, makes you feel better about sleeping at night. In order to get growth really going, you have to have a pretty strong market where people throw caution to the wind. We just don't see the taste to jump on whatever is the next hot thing."

Faraway profits

Investors were far less conflicted about international-fund holdings, which benefited from continued U.S. dollar weakness and a perception that shares in both developed and emerging world markets are more attractively priced.

Of the estimated $19.4 billion flowing to stock funds in January and February, about $16.7 billion went to international funds, according to TrimTabs Investment Research. Stock funds are on track to collect $10.2 billion in March, TrimTabs reports, of which about $4.9 billion reflects international-fund investment.

While small-caps lost steam in the U.S., they forged ahead overseas. The three international small/mid-cap categories that Lipper tracks -- growth-, value- and core -- each topped their large-cap rivals in the first quarter.

International small/mid-cap value funds added 4%, while their growth counterparts gained 3%. Still, large-cap international funds trounced their U.S. peers. International large-cap growth portfolios, for example, lost 1.3% vs. a 4.6% slide for U.S. large-cap growth funds.

Emerging markets lost some of their luster. The average diversified stock fund in the category rose 1.3 percent. Among regions, Pacific ex-Japan funds rose 2.2%; Latin America added 1.9%, and European funds rose 1.1%. But China-focused funds lost 1.4 percent.

Still, investment strategists who've encouraged U.S. investors to "go global" found little reason to alter that stance.

"Our preference has been and remains for weighting non-U.S. markets higher than the U.S. market," said Merrill's Doll. "There are generally cheaper markets outside of the U.S., and generally accelerating economies with the notable exception of [developed] Europe."

Reason for optimism

Yet for some professional investors, the first quarter's poor showing was just a blemish on an otherwise appealing picture. They point to U.S. companies that are leaner, more competitive, and are returning surplus cash to stockholders in the form of dividends and share buybacks. In fact, the market's rising wall of worry only strengthens their bullish sentiment.

If analysts at Standard & Poor's are accurate, most U.S. stock investors will have much to cheer. The investment research firm sees the S&P 500 Index rallying 15.5% over the next 12 months.

"Breadth is very good; it's broad," said Howard Silverblatt, equity market analyst at S&P. "You have no great stars out there, but everyone is doing a bit better."

Large-cap stocks are poised for a rebound, added Bill Nygren, manager of the Oakmark fund (OAKMX), which lost 2.2% in the quarter. High-quality businesses are selling at only modest premiums to average businesses, he noted, providing attractive buying opportunities.

"It's going to be harder to add value as a stockpicker," Nygren said, "but the combination of a market that does OK, companies that are showing better-than-average growth, and the probability that relative P/Es expand, should be enough to show returns that investors are satisfied with."