Publish date:

The New Fundamentals for Fund Managers

Now that momentum's out, what works for investors?

As mutual fund investors are painfully aware, it's quite a different market these days from this time last year.

While just being in technology funds at the beginning of last year would get investors triple or high double-digit returns, those same holdings were responsible for jaw-dropping losses later in the year. The situation isn't much better now, as earnings disappointments and a slowing economy make the returns of early 1999 seem like a fairy-tale world of easy money. Although the

Federal Reserve's

move to lower rates has some market watchers suspecting better days may be ahead, others aren't so sure.

While there's no consensus among fund managers about where this market is heading, they do agree that it differs from recent years, and there's a different way to play it. So, where should investors be putting their money to work in this market?

"If you were to ask me this question a year ago, I would have said momentum works," says Dave Nadig, co-founder and portfolio manager of

MetaMarkets.com

, a fund company that shows its holdings in real time on its Web site. "We would make trading plays based purely on technical momentum moves. What people are looking at now are value metrics."

Nadig is not alone in his sea change. Many managers who capitalized on the upward momentum of the technology sector last year are now carefully choosing stocks based on the company's fundamentals. Whereas investors got excited about a company's potential for profitability alone last year, now fund managers want to see actual results in the form of earnings growth, high-quality management and product superiority.

Nadig, who co-manages the aggressive growth

MetaMarkets.com OpenFund

says he's paying more attention this year to factors such as a company's

PEG ratio, the amount of cash and debt on the books of nonprofitable companies and a company's investment portfolio than he did last year.

These fundamentals are important simply because they point to the financial health of a company. A PEG ratio, which is the company's price to earnings ratio divided by its expected earnings growth rate, can shed some light on how fairly valued a company's stock price is (a PEG ratio of more than 1 implies that the stock is overvalued). The amount of cash on hand can be crucial to determining how long a company can survive if it is not yet earning profits. In the same vein, a heavy debt load can be problematic for unprofitable companies. And this past year's dot-com blowup has served as a reminder to take a look at what kind investments companies are making.

That's not to say that Nadig is turning into a value investor; he's just taking a closer look at valuations. As an example, Nadig says his fund holds

Genzyme

(GENZ)

, a biotechnology company that trades around $84 1/8 and has a price-to-earnings ratio near 29 times trailing earnings, rather than a stock like

IDEC Pharmaceuticals

(IDPH)

, which trades around $169 1/2 and has a hefty P/E ratio of 216 times earnings.

"This doesn't mean we're not going to invest in unprofitable companies," says Nadig. "We're just taking valuations and giving them a higher weight."

Some managers say that the key difference between the market then and now is perception. Rob Zidar, co-manager of the

(MANTX)

Merrill Lynch Internet Strategies fund and senior analyst on the

(MAGTX)

Merrill Lynch Global Technology fund, says the market was far too optimistic about the prospects of unprofitable companies at this time last year.

"What we're doing now isn't necessarily terribly different than what we were doing 12 months ago; it's just the market is a lot less optimistic," says Zidar.

Zidar says his team primarily looks at a stock's price to next year's earnings and will occasionally pay a higher P/E multiple for a company they think will have a higher sustainable earnings growth than its competitors. Other factors Zidar eyes include technological advantages that give a company a dominant position in the marketplace (he cites

Microsoft

(MSFT) - Get Microsoft Corporation (MSFT) Report

TheStreet Recommends

as an example), or the presence of "unhealthy" competitors in the marketplace which could lead to price wars and drain a company's earnings (the personal-computer market illustrates this point, he says).

But just as the irrational exuberance of early 2000 warped investors' sense of what they should be paying for stocks, Zidar says he's not letting the current pessimism distort his opinions of what he thinks are good, solid, long-term plays. Among the top holdings in his Internet fund, for example, are

AOL-Time Warner

(AOL)

,

Checkpoint Systems

(CKP)

and

Oracle

(ORCL) - Get Oracle Corporation Report

.

"In a slowdown, most companies will have downward earnings revisions, but you need to decide which ones are reflected in the stock price," says Zidar.

Jay Tracey, chief investment officer of

Berger Funds

, agrees that the current market favors individual stock-picking rather than sector weightings, adding that the market's dismal environment might even make it easier for managers to separate out leading companies from the rest of their sector.

"Look at whose businesses are holding up the best during the decline, and try to judge what's happening to market share during the decline," he says.

Tracey, who manages the

undefined

Berger Growth fund and co-manages the

(BESLX)

Berger Select fund, says predictability equals quality in a downward market, so he is favoring what he considers predictable companies like networking systems producer

Cisco

(CSCO) - Get Cisco Systems, Inc. Report

, which he holds in the Berger Growth fund.

Many value managers, who invest in fundamentally sound companies that are out of favor with the market, have been vindicated for sticking to their guns last year when so many investors who chased highflying tech stocks got burned. However, the new market tone presents opportunities for even these stalwarts.

Invesco Funds'

Charles Mayer, who manages many of the firm's value-oriented funds such as the

(FSEQX)

Invesco Value Equity fund, says he has slightly increased his tech weighting this year, buying companies like Cisco and Microsoft when many were selling them off late last year.

"Last year when these stocks were so high, everyone told you that you had to own them, and now that they're down, they're telling you it's too early to buy," Mayer quips.

Mayer says his key to picking leading companies during the slowdown is to look for solid management. A management team that is really in touch with its business will give the market fewer surprises, he says.

"People have to work this year," says Mayer. "It's not easy. It's not a deal market. It's not just buying the same names and writing them up."