Waddell & Reed Rides AOL to Sizzling Returns

How does a self-described small-cap fund wallop the S&P 500 in a year in which large-caps are the favorites by far?

The answer for (WRGRX Quote)Waddell & Reed Growth in 1998 was, in part, simple: Make your biggest holding a "little" company called America Online (AOL Quote).

Hold on a minute -- America Online? Yep, you heard right. You may argue with the way the fund posted the sizzling numbers it did last year, delivering a red-hot 45% return, beating the index by a good 16 percentage points (all data from Morningstar). But you get no apologies from Growth's managers, Mark Severovich and Grant Sarris.

Of course, AOL is hardly an undiscovered small company. But it once was. And that's exactly when the fund loaded up on the stock -- back at the end of 1993. Selling when it reached a "magic" market-cap number seemed silly to them, so the Internet powerhouse remains in their portfolio. "What we do here is buy small companies that have a chance to be big companies," Severovich says. "And if we're right about a small company becoming a big company, we don't chop it off at the ankle."

No question they were right about AOL. "It's up a hundred-fold since we bought it!" Sarris says with more than a bit of awe in his voice. But the stock hasn't traveled in a straight line. In 1996, when it was out of favor with many funds, Severovich and Sarris held on.

That style of buying and holding -- even during tough quarters -- sets the Kansas-based team apart from the Wall Street crowd. Often they'll even pick up more of a stock once it stumbles. "None of the really good stocks have been without controversy," says Severovich. "We buy stocks that miss a quarter so long as the business isn't impaired. Consensus earnings all too often rule the day on Wall Street, and I think they overrule common sense."

Adds Sarris: "Investing is about time horizon and patience. It's not 'make a quarter, we buy it; miss the quarter, we sell it.'"

They are selling some of their stake in AOL, trimming it from about 5% of the portfolio to 3%. "I like the company," says Severovich. "But in the next five years, it's not gonna do for this fund what it did in the last five years." You won't find any other Internet highfliers replacing it, either. Severovich says the fund is steering clear of the explosive moves many of the .coms are making. "I'm not interested in any of these stocks at these levels."

They Like Telecom Stocks

What do they like? Telecom is a favorite sector. In particular, the duo says that U.K.-based Colt Telecom (COLTY Quote) is poised to move higher. "It's the MFS of Europe," says Sarris, referring to the firm that was acquired in 1998 by MCI WorldCom (WCOM Quote). They also like Western Wireless (WWCA Quote) here at home, as well as RCN (RCNC Quote). "That's an exciting story. They're one of the only ones to go after the residential opportunity -- taking fiber into dense residential areas, offering video, Internet and voice over one connection," says Sarris.

Of course, avoiding the wrong sectors is as important as finding the right ones. It didn't hurt that the fund sidestepped two of the worst-performing small-cap sectors recently: energy and finance. Still, the portfolio of some 50 stocks is quite an eclectic group -- you'll find everything from AOL to H&R Block (HRB Quote) to American Italian Pasta (PLB Quote). You'll also find a sizable chunk of cash -- now about a fifth of the fund's assets.

Good Returns Come with Volatility

The cash hasn't proven to be much of a drag on performance. Waddell & Reed Growth can boast a strong long-term record. For the past five years, it beats all but 5% of its mid-cap growth peers with a 22% average annual return.

But those numbers come with a hefty dose of volatility. In 1994, the fund was near the top of the charts with a 13% return, besting the S&P by 11 points. The next year, however, it ranked in the bottom half of its category, and in 1996, a measly 2% gain left it behind the index by 21 points. In the past two years, it's been back on top again with 21% and 45% gains, respectively.

As for 1999? The plain-talking managers aren't predicting they'll repeat recent performance, in part because they can't see another AOL on the horizon. "I don't expect to ever have another stock in my career that's gone up as much as it has," admits Severovich, who says he has "significant" personal money at stake in the fund. But they do expect to continue using their tested strategy of picking small companies ready for the big time and holding on as they grow.