The Rocky Road for the Stars of '99

Dispensing with the legal gobbledygook found in most mutual fund literature, IPS Advisory's Robert Loest laid out his own funds' risks with the kind of blunt language usually used to frighten teenagers away from sex, drugs and alcohol. "We buy scary stuff," he warned, alluding to the technology stocks that were a growing part of his Millennium and New Frontier funds in the late 1990s. He also admitted that it wouldn't take much for the stocks to drop 50% or more because "nobody else knows what they are worth either."

Loest, who was something of a Day-Glo-socks guy in the button-down world of fund managers, ended with a candid warning: "Don't come crying to us if we lose all your money and you wind up a Dumpster Dude or a Basket Lady rooting for aluminum cans in your old age."

Written in 1998, when his funds had just $25 million in assets, this plain-English disclaimer (still posted at www.ipsadvisory.com) turned out to be as scary as a Halloween witch costume. In the euphoria of the dot-com bubble, investors found the triple-digit returns of IPS's funds irresistible (New Frontier gained 187% in 1999, and Millennium rose 120%), and they didn't seem to care how Loest achieved them. By 2000, Knoxville-based IPS was managing more than $600 million in assets.

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Now, in the cold light of the post-dot-com bubble, Loest's bluntness sounds a lot like hubris. But in many ways he was prophetic. All the bad things he said could happen to his funds did, and for the reasons he warned about. New Frontier fell 75% from its peak value, and Millennium dropped 55%. Today, New Frontier is gone, and Millennium is almost unrecognizable after its sale to North Dakota-based Integrity funds and a change in strategy. Loest still manages the fund, now known as Integrity Growth Income. Its performance has improved, but assets are down to $53 million.

In a business in which managers rarely switch strategies (or at least admit to it), Loest knows he faces an uphill climb to persuade investors that his adoption of a conservative, value-oriented outlook is something other than an act of desperation. "This business is like politics," he says. "If you change your method, you're unpredictable, flaky and unreliable. That goes with the territory."

IPS's rise-and-fall story is hardly unique to the period. In 1999, 173 funds returned 100% or more. It was a strange and intoxicating year. The Nasdaq index rocketed 86%, and even the stodgy Dow industrials gained 25%. In that kind of environment, almost anyone, it seemed, could run a stock fund and make good money. Top performers in '99 included Berkshire Focus, run by a former software engineer, and Thurlow Growth, managed by an ex-lawyer.

But in the six years since, those funds and most other members of the 100% club have fallen on hard times. Roughly one-fourth of them have been shut down or merged into other funds. Among the surviving funds, only 25 delivered positive returns over the past six years.

What went wrong

The common failing of all the post-'99 losers was an infatuation with overpriced technology stocks. In fact, of those 25 that made money over the past six years, 18 specialize in overseas stocks and one is a biotech sector fund. Thus, they were mostly invested elsewhere when tech stocks imploded beginning in 2000. For the rest, the obsession with tech was often a symptom of other shortcomings that were all too easy to overlook when the bull was charging ahead.

Lack of experience. After Berkshire Focus posted returns of 104% in 1998 and 143% in 1999, it's doubtful many investors were looking closely at the reacute;sumeacute; of its manager, Malcolm Fobes III. The warning signs were in plain sight. The 1997 prospectus for his new fund stated that Fobes "does not have previous experience as an investment adviser." He founded Berkshire Capital in 1993 at the age of 29 while employed as a technical-support engineer at Adobe Systems, a Silicon Valley software firm. By 2000, Berkshire Focus had $150 million in assets, at which point Fobes began experiencing what was a first for him as a fund manager: a bear market. His fund dropped 16% that year, then suffered cataclysmic losses of 72% in '01 and 59% in '02. The fund has lost an annualized 24% over the past six years to December 1, or a cumulative decline of 81%. Fobes did not return a call seeking comment.

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Untested strategies. Thomas Thurlow, the former lawyer who launched Thurlow Growth in 1997, dubbed his approach "middle down" investing. It called for picking an undervalued sector or one that was gaining momentum, and then investing in the sector's most attractively priced stocks. In practice, it turned out to be a formula for buying hot stocks, many in the tech sector. After gaining 213% in 1999, the fund lost 56% the next year and suffered double-digit losses in 2001, 2002 and even 2004, an up year for the market. In December 2004, Thurlow announced he would shut the fund. At last check, it was still open with $80,000 in assets. Thurlow didn't return our calls.

Too much cash, too quickly. It's no secret that the best-performing funds lure the most money. When IPS Millennium was riding high in the late 1990s, discount brokerage Charles Schwab added it to its Select list of recommended funds, and Morningstar awarded the fund its top five-star rating. The fund's assets more than quadrupled in a year, to $635 million. The irony is that the big money often arrives after the bulk of the gains have been achieved. In fact, the flood of money often hastens the fall. "Managers who don't have the investing ideas to match the cash coming in wind up putting the money into second-rate ideas," says Max Rottersman, who runs Fundexpenses.com, a consulting business in Hanover, N.H.

The diversified U.S. stock funds that scored big in '99 and have held up since avoided those pitfalls. Turner Micro Cap Growth returned 144% in 1999 and suffered only one down year in the aftermath, a loss of 20% in 2002. Over the past six years to December 1, it returned 15% annualized.

Although 1999 was the fund's first full year, manager Frank Sustersic had been a health-care analyst and portfolio manager with Turner since 1994 and had run money at First Fidelity Bank before that. Sustersic says his experience investing in biotech stocks gave him an inkling of what was ahead for the tech stocks in his fund in 1999. Like biotech firms, tech companies were burning through their cash while trying to develop viable products. When the Federal Reserve began raising interest rates in 2000, helping to prick the bubble, Sustersic saw that tech firms would have trouble paying their bills. "Little firms had been able to raise capital easily every three or four months," he says. "Then all of a sudden they couldn't get a transaction done."

Sustersic aggressively moved his holdings out of tech just in time to catch a lot of other stocks on their way up. His fund gained 19% in 2000 and again in 2001. Sustersic, too, had to contend with a flood of cash -- assets went from $5 million at the end of 1998 to more than $150 million in 2000. But Turner closed Micro Cap Growth to new customers in March 2000. The fund remains closed today.

Another top-performing survivor, Bridgeway Aggressive Investors 1 (1999 return: 121%), is in many ways similar to Turner. It is a small-company fund run by an experienced manager, John Montgomery, who gracefully exited from tech stocks before the roof fell in. Like the Turner fund, Bridgeway earned a double-digit gain in 2000 and kept its 2000-01 losses tolerable. Also like Turner, it is closed to new investors. Over the past six years, Bridgeway returned 8% annualized. (Four other U.S.-focused triple-digit winners of 1999 produced positive six-year returns through November 2005: ABN AMRO Veredus Aggressive Growth, American Century Vista, MTB Small Cap Growth and First American Small Cap Growth Opportunities.)

Broadly defining tech

Other members of the 100% club adopted various survival strategies after spectacular losses during the 2000-02 bear market. For example, Kinetics Internet fund adopted an expansive view of its mandate as it was losing more than half its value in 2000 (following gains of 216% in 1999 and 196% in 1998). Manager Steven Tuen says an Internet stock is one that "uses the Internet as an enabling technology," or produces content that "generates interest in the use of the Internet." Thus, a famous "old media" company, the Washington Post, qualifies as Kinetics Internet's biggest holding.

In contrast, Kevin Landis, who heads Firsthand Funds, is sticking with an unambiguous tech portfolio, even in the face of crushing losses. "You don't want to cross the line to the point that you're rationalizing to get out of tech because you're scared of it at the moment," he says. Three Firsthand funds, Tech Leaders, Tech Value and Tech Innovators, had triple-digit returns in 1999. They have suffered mostly negative results since then.

IPS's Loest has taken another tack entirely. He has adopted an ultra-conservative strategy of buying only shares of companies that generate prodigious amounts of free cash flow (cash left after expenses and capital expenditures needed to maintain the business), and only if he can buy the stocks at steep discounts to what the companies might sell for in private transactions. The change in philosophy has provoked skepticism. "It's pretty unusual to see someone switching from aggressive growth to deep value," says Morningstar analyst Laura Lutton.

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In fact, when IPS Millennium was launched in 1995, it was a growth-and-income fund, a category typically associated with safe, dividend-paying stocks. But it was never a typical growth-and-income fund. Loest, a former biologist, "looked at the economy as a large ecosystem" of companies looking for ways to connect with each other, says his partner and president of IPS Advisory, Greg D'Amico. "So he started buying companies that were creating more connectivity." The fund took on a distinct tech flavor as Loest became convinced the economy was in the midst of a "fundamental technological revolution," as he exclaimed in the fund's 1999 annual report.

Loest tried to offset the volatility of his tech-heavy portfolio by buying dividend-paying utility stocks. But this so-called barbell strategy took hold just as once-safe utilities such as Enron and Calpine were morphing into high-flying merchant energy traders.

With the risky and low-risk sides of the portfolio providing supercharged returns, Millennium emerged in 1999 with one of the best performance records in its category. New Frontier, with a similar portfolio but without Millennium's utility allocation, was also a top performer. The iconoclastic Loest, who had at one point dropped out of society for a decade and worked as a blacksmith, was attracting attention in other ways as well. He kept a daily Internet diary of his buys and sells, a forerunner of today's blogs, and launched iFund, an experimental fund in which shareholders would vote to determine which stocks to buy and sell (it has since folded).

But the tech-stock bust and the bear market revealed large holes in Loest's scheme. "We didn't have a rigid, well-disciplined sell strategy," he admits today. "As long as a company was well managed and cash flow was growing, we were happy. We didn't look at valuation. That was our big mistake."

As tech stocks plummeted and assets dwindled, IPS moved into smaller offices and fired six staffers, leaving only Loest, D'Amico and a third partner, Rich James. Last year they sold Millennium and New Frontier in exchange for 750,000 shares of Integrity Mutual Funds. Shares of Integrity recently traded at 32 cents.

"Draconian" rules

Loest, now 62, also strove to lower his fund's risk. He began adding large, dividend-paying companies, and in 2002 adopted what he now calls draconian new criteria: A company must produce annual free cash flow equal to at least 8% of its market value and sell for a discount of at least 30% of its true worth, according to a valuing methodology that assumes conservative growth rates. Integrity Growth Income's top holdings are Federated Investors, a mutual fund company, and Aflac, an insurer; 25% of assets are in cash.

Jerry Szilagyi, senior vice-president of business development at Integrity, says he's comfortable with IPS's current direction. "They learned a lot in the bear market, and that seems to have paid off in the past three years," he says.

But given the fund's recent history, it may be awhile before risk-averse investors will consider it. Its annualized gain of 13% over the past three years exceeds the return of Standard Poor's 500-stock index by just one percentage point per year. And the fund, once marketed directly to investors without a commission, is now sold through brokers with a 5.75% sales charge.

Loest seems reconciled to the idea that he still is, in essence, on probation with investors. "We screwed up and we fixed it," he says. But, he adds, "it's going to be another two or three years before the market believes us again."

STARS OF '99

How a dozen funds fared after the bubble burst

Big returns mean big risks, as these former rockets -- the top diversified U.S. stock funds of 1999 -- demonstrated in the six years since the good times ended. We would not invest in any of them today.

*Data to December 1, 2005. **Merged into Morgan Stanley Instl Small Cap Growth on 8/1/01. sup1;Formerly: BlackRock Micro Cap Equity A. sup2;Formerly: Vanwagoner Micro Cap. sup3;Formerly: Strong Enterprise. #Formerly: PBHG Select Equity. laquo;Merged into Janus Enterprise on 4/17/03. -Not applicable.

Source: Copyright copy; 2005, Standard Poor's, a division of the McGraw-Hill Companies Inc. All rights reserved.