Fund Managers Searching for Recovery Plays

The stock market’s sputter this week is reminding portfolio managers of the challenge they face this year in picking winning stocks.

Buoyed by recent data, many fund managers are optimistic about an economic recovery and have been hunting for the best sectors, and individual stocks, to play the rebound.

But they caution that although stock valuations in general appear to be reasonable based on estimated 2002 earnings, true bargains are tough to find--which is why some investors have been quick to take profits on recently hot issues.

The Dow industrial average, which surged 8.5% in the four weeks ended March 8, has pulled back 0.5% this week. The Nasdaq composite index, up 6.1% in the four weeks ended March 8, has slumped 3.9% this week.

On Thursday, the market ended little changed. The Dow added 15.29 points to 10,517.14 while the technology-heavy Nasdaq fell 7.89 points to 1,854.14.

“The rally [this year] is recognition that we’re in recovery mode,” said Carl Domino, manager of the Northern Large Cap Value Fund in West Palm Beach, Fla. “The real issue is, how much upside does the economy have?”

“I think the market has ‘priced in’ a lot of the early phase of the recovery,” said Brian Barish, Denver-based manager of the Alpha Analytics Value Fund.

That is particularly true of the tech and telecom sectors, fund managers say. That explains why many big investors still are shying away from those sectors.

But fund managers have been eager buyers in other stock sectors, including transportation, energy, home building, finance and aerospace.

Domino said he recently added General Electric Co. (ticker symbol: GE) to his portfolio, snapping up the conglomerate’s shares for the first time in more than a decade, when the price fell earlier this year as “Enronitis” accounting concerns spread to other companies.

Domino, whose fund is up 5.2% this year, also has added to energy holdings such as Marathon Oil Corp. (MRO), Conoco Inc. (COC) and El Paso Corp. (EP). Stronger energy demand, and the threat of a U.S. conflict with Iraq, have helped send oil prices higher this year.

Domino noted that although heavy-industry and other classic cyclical stocks such as Caterpillar Inc. (CAT) and International Paper Co. (IP) boosted his portfolio earlier in the year as investors anticipated an economic turnaround, in the last few weeks financial holdings “have started kicking in.”

Although interest rates may have bottomed--some experts believe the Federal Reserve might hint at future rate increases at its meeting next week--some financial stocks still are too attractively priced to pass up, Barish said. He recently added to stakes in FleetBoston Financial Corp. (FBF) and Bank of America Corp. (BAC).

And in the insurance sector, hard-hit after Sept. 11, Barish has added to stakes in Allstate Corp. (ALL) and Germany’s Allianz (U.S. ticker: AZ), he said.

Barish, whose fund is off 0.8% this year, also said he recently bought shares of Circuit City Stores (CC) when the stock tumbled because of disappointing earnings. Consumer electronics sales may benefit from an economic pickup, Barish said, and in the longer term as newer products such as DVDs, new video game consoles, high-definition TVs and digital cameras rise in popularity.

Ron Muhlenkamp, manager of the Muhlenkamp Fund in Wexford, Pa., said his fund has gotten a big lift in the last year from consumer cyclical stocks such as mobile-home maker Winnebago Industries Inc. (WGO) and home furnishings maker American Woodmark Corp. (AMWD).

But “now that they are no longer dirt cheap, I might have to look elsewhere for bargains,” said Muhlenkamp, whose fund is up 5.5% this year.

Housing stocks such as Beazer Homes USA Inc. (BZH), Centex Corp. (CTX) and Pulte Homes Inc. (PHM) also have had a strong run over the last year, but Muhlenkamp said that sector still might have steam.

“People always want more of what’s been working, so there’s a good chance they will put more money into their houses and less into their tech stocks,” he said.

In a precarious “stock picker’s market,” however, Muhlenkamp said individual security selection is probably more important than identifying the right sectors.

“You could have picked discount retail awhile ago, for example, and gone with either Wal-Mart or Kmart,” he said. “That’s a big difference.”

Art Bonnel, manager of the Bonnel Growth Fund in San Antonio, up 1.2% this year, said he remains in the anti-tech camp for now, instead spreading bets among other sectors, including retail, defense, dining and health care.

In recent weeks, Bonnel said, he has added to his stakes in Linens ‘n Things Inc. (LIN), which sells housewares; General Dynamics Corp. (GD), a major defense contractor; and IHOP Corp. (IHP), which operates the International House of Pancakes chain.

Longtime holdings Bonnel still likes in the health-care area include biotech giant Amgen Inc. (AMGN), drug distributor AmerisourceBergen Corp. (ABC) and medical products maker ICU Medical Inc. (ICUI), he said.

But some growth-fund managers, who focus on companies expected to show rapid earnings growth (rather than hunting for shares priced cheaply relative to earnings), say they are shopping selectively in the tech sector.

Jim Oberweis, manager of the Oberweis Mid-Cap, Micro-Cap and Emerging Growth funds in North Aurora, Ill., said smaller “niche” tech firms whose products detect flaws or improve speed in the manufacturing process continue to generate rising earnings.

Such holdings he likes, or has added to recently, include Versity Ltd. (VRST), HPL Technologies Inc. (HPLA), PDF Solutions Inc. (PDFS) and Cabot Microelectronics Corp. (CCMP), he said.

“There is a theme here: If companies don’t want to make [new] capital investments, they are willing to spend money on efficiency,” said Oberweis, whose funds have fallen 8% to 9% year to date.

In the medical area, he said he likes specialty product companies considered resistant to economic cycles, such as Cytyc Corp. (CYTC), whose cervical cancer screening products continue to gain acceptance, and Possis Medical Inc. (POSS), whose devices remove blood clots.

One problem facing all investors is that stocks in general never got deeply undervalued in last year’s downturn, Oberweis said.

Typically, when a bull market crumbles, as the last one did beginning in spring 2000, stocks sink “to an undervalued stage, sometimes extremely undervalued,” Oberweis said.

That hasn’t happened this time, because corporate earnings fell drastically last year even as share prices declined, he said. So share prices relative to earnings remain historically high in many sectors.