Searching for Stability in Risky Sectors

There is nothing like a bear market to spook clients. Disciplined, patient investors, who used to know the value of putting money in different sectors and asset classes, have grown overcautious. After witnessing so many high-flying stock funds implode, the last thing clients want to discuss is a downtrodden technology fund on the theory that the time is right to buy low.

They are probably just as reluctant to consider small-cap growth funds, too, although on average they declined in the single digits over the trailing 12 months ended in April. Other aggressive categories of funds, such as those specializing in emerging markets — whose returns were in the double digits over the last 12 months — may also scare even the hardiest client.

In short, these categories tend to post volatile returns even during bull markets — an especially unappealing attribute at a time when investors crave security. But technology and other traditionally risky asset classes deserve a place in most portfolios. For starters, they provide diversification. What's more, some unloved sectors could present unusual buying opportunities.

“I like to look at asset classes that have been out of favor for a long time,” says Steve Shrier, a broker with LPL Financial in Beverly Hills, Calif., who has been recommending emerging market funds for the past year. “If clients trust you, they are willing to try things that seem due to rebound.”

One way to make risky sectors more palatable is by focusing on the relatively tame choices in each group. To be sure, all funds in the high-risk categories can be hazardous. But there are a few choices that have been consistently mild-mannered. In the big downturns, they lost much less than their average peer. The portfolio managers dampen volatility either by staying broadly diversified or maintaining careful price discipline, avoiding the high-priced issues that sometimes crash badly.

While such investments may not be appropriate for all investors, they make ideal choices for nervous clients who want to try small doses of risky holdings.

Taming the Technological Beast

Seligman Communications & Information A returned 3.6 percent in 2001. That's not particularly notable until you consider that the fund's average competitor lost 38.4 percent. Portfolio manager Paul Wick survived the downturn by focusing on moderately priced stocks with strong cash flows. That cautious approach enabled Wick to achieve low risk scores while delivering strong long-term returns (see chart).

Concerned that big stocks remain overpriced, Wick has lately been buying small- and mid-cap stocks. The fund is focusing on companies that can report steadily growing earnings this year. A top holding is Lexmark International, which supplies replacement ink cartridges, something customers must buy even in a sluggish economy.

Another fund that has outperformed competitors during downturns is North Track PSE Technology 100 A. An index fund, North Track buys and holds shares of the 100 members of the Pacific Stock Exchange's technology group. “We provide a vehicle for investors who want broadly diversified exposure to technology,” says Don Nesbitt, a North Track portfolio manager.

While the S&P 500 and other benchmarks give greater weighting to stocks with large market caps, the PSE index is price-weighted. This means that companies with a share price of $50 receive twice the weighting in the index as those priced at $25. This results in a portfolio where no one stock accounts for much more than 3 percent of total assets. In contrast, many technology funds have put more than 8 percent of assets into their top holdings. When the overweighted holdings collapsed in 2000, they took the funds down hard.

Steady Small Caps

In the best of times, small-cap growth stocks can be hazardous. Fast-growing companies that depend on a few products can often disappoint. Some small-cap growth funds have suffered particularly hard times because of a concentration — in some cases more than 30 percent — of their assets in technology.

One fund that avoided the carnage is Liberty Acorn, which outperformed during the past decade while being much less volatile than most competitors. A dedicated bargain hunter, portfolio manager Ralph Wanger buys cheap stocks with strong growth potential. Concerned about high prices, he has held few technology stocks. “The profit margins have been terrible in technology, and the prices are still ridiculous,” he says.

Wanger seeks to avoid mistakes by holding a diversified portfolio that includes more than 200 stocks. Wanger holds stocks for years, hoping that his small stocks will grow into giants. “If you buy a lot of promising small stocks, some of them will eventually be big winners,” he says. “When a stock increases twentyfold, that more than makes up for several losers.”

Baron Small Cap has a foolproof method for avoiding the volatility of technology: The fund has no assets in the sector at all. “We only want companies with predictable earnings,” explains Morty Schaja, president of Baron Funds. “It's hard to know what kind of earnings a technology company will produce three years down the road.”

The fund focuses on industries that seem likely to grow steadily for years. The aim is to find companies that can double their profits in the next three years. Many stocks in the portfolio sell for moderate multiples and have been reporting double-digit earnings gains.

Emerging Profits

Investors who plunged into emerging markets in the middle 1990s faced a series of disappointments. In 1997, Asian currencies fell, taking down emerging stocks around the world. Then, Russia faced a financial crisis. And when emerging economies seemed on the mend, technology stocks collapsed in 2000, hurting markets from Singapore to Sao Paolo. This year emerging market funds have been recovering. Stocks in Korea and Mexico have delivered strong performances. With stocks in emerging markets still selling for modest valuations, the rally could continue.

A solid way to play the sector is with Oppenheimer Developing Markets, the top performer in the category. Portfolio manager Rajeev Bhaman avoids pricey stocks and companies with shaky earnings. “We will only take the highest-quality companies that have very secure niches,” he says.

A favorite holding is Embraer, a Brazilian aircraft maker that is a leading producer of jets used by airlines for short hauls. Bhaman stays away from countries that have uncertain political outlooks (Colombia and Venezuela). He stays broadly diversified, holding stocks from a variety of countries and industries.

Investors with a taste for deep-value investing may prefer Bernstein Emerging Markets. The fund buys solid companies in relatively large markets such as South Africa and Korea. Such stocks have held up particularly well in downturns and helped the fund achieve risk profiles that may soothe nervous investors.