Investors Shouldn’t Always Be Cool to an Already Hot Stock Sector

“Don’t chase performance!� investors often are admonished, and usually at the start of each year.

That means don’t indiscriminately shovel money into the investments that performed best in the previous year. The warning is predicated on the belief that what’s hot in financial markets often goes cold just as the public is catching on.

As a generalization it sounds logical enough. But in practice, “don’t chase performance� is way too simplistic an investment rule. It ignores that hot streaks -- by market sectors and by individual money managers -- can go on for very long periods.

For example, the Russell 2,000 index of smaller-company stocks has outperformed the blue-chip Standard & Poor’s 500 index every year since 1999. And substantially so.

An investor who opted against buying into a Russell index portfolio in 2000, 2001 or 2002, figuring that the game had to be over, would have left a lot of money on the table.

This year, it might look like the small-stock train finally has run out of gas: The Russell index tumbled 5.9% last week, nearly three times the loss of the S&P; 500 index, which fell 2.1%.

But there are 51 weeks left in 2005. A lot can happen, and usually does.

Another case in point: In 2000, Bill Miller, manager of the Legg Mason Value Trust stock mutual fund in Baltimore, beat the S&P; 500 index for a 10th consecutive year.

At that point, a bet that he would do the same for the next four years seemed a lot like keeping one’s money on the black space at the roulette table for an entire evening. Surely, red was going to come up, and soon.

Yet Miller indeed topped the S&P;’s performance from 2001 through last year. He lost less than the index in 2001 and 2002 and earned more in 2003 and 2004.

Granted, Miller is a rarity in the fund business. In any case, his performance has been worth chasing for the last 14 years.

The same can be said of Robert Rodriguez, who has overseen the FPA New Income bond mutual fund for two decades. The Los Angeles-based fund has made money for its shareholders every year since 1984. Twenty years without red ink is an amazing feat in money management.

Before simply ruling out an investment in a fund or market sector that had a good year or several good years, the question to ask is whether there are solid fundamental reasons that the trend should go on.

Their shareholders probably would argue that Miller and Rodriguez themselves are the best reasons to continue investing in those funds.

In the case of smaller- company stocks, their relative strength in 2000, 2001 and 2002 compared with blue-chip shares in part reflected that smaller issues had become dirt-cheap by 1999, because the market of the late 1990s had been dominated by big-name stocks.

As the bear market began in 2000, investors who still wanted to put money into stocks found that many smaller names were terrific bargains.

It’s difficult to find a small-stock fund manager who will say that today. The Russell 2,000 index soared 45.4% in 2003 and 17% last year. Even though earnings of smaller companies have been growing, in many cases the stock prices have been rising at a faster pace than earnings.

But investors could have other reasons for continuing to favor smaller shares over blue chips, last week’s profit taking notwithstanding.

After the so-called Nifty Fifty group of blue-chip stocks crashed in 1973 and ‘74, Wall Street remained suspicious of big-name stocks for nearly a decade. That made it easier for smaller companies to attract investors’ attention.

Measured by annual price change, the Nasdaq composite index -- the best overall proxy for the small-stock universe in the late 1970s and early 1980s (before the index became dominated by big technology companies) -- outperformed the S&P; 500 for eight straight years, from 1976 through 1983.

To be fair to the S&P; index, it appears to have had the edge in 1982 and 1983 if dividends were included.

Whether you give smaller stocks a six-year run or an eight-year run in that period, the current six-year winning streak is looking long in the tooth, if history is a guide.

So, too, is the streak of the “value� stock sector beating the “growth� sector.

The value sector mostly includes stocks that sell for lower-than-average price-to-earnings ratios and that pay relatively high dividends (think energy, utilities, banks, etc.). The growth sector is dominated by stocks of companies that typically are faster growing than value companies (think technology, healthcare, etc.) and for that reason tend to have higher price-to-earnings ratios.

By some yardsticks, value has beaten growth every year since 2000. The 2000-2002 crash in the tech sector has had a lot to do with that.

Will this be the year that blue-chip stocks take over from smaller shares, and that growth stocks take over from value issues?

For most investors, that question should take a back seat to two others: What is your time horizon, and is your portfolio properly diversified so that its overall risk level is reduced?

If you’re making a bet for the next 12 months, then you will care a great deal which fund sectors lead this year. But if you’re investing for the next five or 10 years, it’s more important to focus on having some money invested in all four principal U.S. equity market sectors (small stocks, large stocks, value and growth), so that whenever the cycles turn, you’re there.

If you are fortunate enough to have cash to invest now, or you are considering reshuffling your portfolio with the new year, start with an evaluation of those four major market sectors, along with foreign stocks and bonds. If you judge that you have too little in a particular sector but you’re wary of buying now, then make a plan to go in gradually -- say, with a small amount every month. But once you make the plan, it’s crucial to stay with it.

Investors who are hungry to catch the next long-lasting cycle of strong performance by a particular market sector ought to look at it this way: Once it starts, if it truly is a long-lasting cycle, you’ll have plenty of time to jump aboard along the way.

Tom Petruno can be reached at [email protected]. For recent columns on the Web, visit latimes.com/petruno.