The Case for Growth Funds Now
Funds that invest in high-P/E stocks were the rage in the '90s, only to be shunned in the bust that followed. Are they poised for a comeback?
(MONEY Magazine) – Remember growth stocks? Through the late 1980s and for all of the 1990s, one of the easiest ways to make money in the stock market was to buy the blue-chip companies with the fastest earnings growth and simply not worry about how high share prices were relative to those earnings. That all ended when the market began its big slide in 2000, and more than four years later the stocks of big, fast-growing companies—and many of the funds that buy them—are still in the performance doghouse. Result: Growth stocks are cheaper than they have been in years. According to data from the Leuthold Group, the median growth stock now trades for 20 times earnings, compared with 70 in 2000.
And growth looks even more attractive now when you compare the group with value stocks. Those stocks, which have lower P/E ratios, have held up pretty well since the bubble burst. So the valuation gap between growth and value stocks, according to Leuthold's numbers, is narrower than it has been in a decade.
In "Build the Goofproof Portfolio" on page 105, Michael Sivy explains how investors in individual stocks should take advantage of this shift by seeking out undervalued stocks that will fill gaps in their portfolio. There's no reason fund owners can't make this same contrarian move.
Right now the market is skeptical of growth companies for a lot of good reasons—a sluggish economy, underwhelming earnings growth from big names like Intel and Wal-Mart Stores, and high-priced oil, just to name a few. But you're buying growth funds now to get high-quality stocks at historically cheap prices, not for a quick pop in returns. No one can know when a shift back to growth stocks will occur. You're buying for the long term here.
That said, it's worth noting that growth stocks are starting to attract more attention from Wall Street. Harry Lange, manager of the Fidelity Capital Appreciation fund, says that when he's visiting a company that he's interested in investing in nowadays, it's not unusual to see the manager of a value fund there too.
One sensible way to get in on growth now would be to simply do a little year-end rebalancing of your portfolio. If you have a value fund that's done well in recent years, or if your fixed-income allocation during the recent bull market for bonds has grown beyond what you intended, take some of those profits and invest them on the growth side. We found four funds—three actively managed and one indexed—with strong track records and low expenses. Each comes at growth investing from a different angle, but they're all in a position to do well once higher-P/E stocks come back into vogue.
This is a go-anywhere fund that can invest in pretty much anything, from small companies to blue chips. But manager Lange says these days he's placing his bets on the biggest companies. He made the shift in August, and now the stocks he holds have a mean market capitalization—the value of all a company's shares—of $20 billion. "That's very large for me. I've historically had 30% to 40% in small and lower-end midcap stocks," says Lange. He cut his exposure to technology stocks at the end of 2003, but he now believes that big tech companies will benefit from a rebound in corporate spending. "People are too pessimistic," Lange maintains. "Companies have a record level of cash available to spend, and they've delayed that spending for longer than they normally would have." Lange's top holdings include Seagate Technology (STX), SBC Communications (SBC) and Genentech (DNA).
Manager Ron Canakaris isn't as sanguine about the economy's prospects as Lange, and because of that his stock picking goes in a different direction. Rather than owning stocks that will benefit from a boost in business spending, Canakaris owns big household names that he thinks can do well in a period of modest economic and earnings growth. Plenty of those kinds of stocks, he says, are to be had today at cheap prices. Among his top holdings are Gillette (G), Johnson & Johnson (JNJ), McDonald's (MCD) and Procter & Gamble (PG). "We're paying very little premium for quality now," says Canakaris. "These companies will have solid earnings growth over the next few years in an environment where profit growth is moderating." He thinks that the next phase in the stock market could be similar to the late 1960s, when corporate earnings growth averaged less than 1%, leaving a relatively small number of big companies with steady earnings, such as Polaroid and Xerox, to dominate the market. Because Canakaris has been light on tech stocks over the past few years, this fund's returns have tended to jump up and down less than those of other large growth funds, according to fund tracker Morningstar.
Manager Tom Marsico has returned about 5%, annualized, to his investors over the past three years, a time when most large-cap growth managers lost money. But Marsico to some extent defies categorization. He's a longtime growth investor who is often willing to stray from the fold to buy value stocks. He holds financial services giant Citigroup (C) and construction-equipment maker Caterpillar (CAT), both traditional favorites of value investors. So investing with Marsico isn't the purest way to play a rebound in growth stocks.
Despite the economy's lackluster performance in 2004, Marsico sees such compelling valuations among large-company stocks that he's cut his cash position to just 1% of fund assets. Marsico generally owns just 20 to 30 stocks, and that concentration, it's worth noting, could make the fund more risky than peers. Marsico's other top picks recently included General Electric (GE) and UnitedHealth Group (UTHC).
The no-brainer. This fund gets you into growth stocks efficiently and cheaply. Its portfolio of about 400 stocks simply replicates the MSCI U.S. Prime Market Growth index. Over the past decade, the fund's 10.6% annualized return has topped 85% of large growth funds, according to Morningstar. A caveat: The fund followed a different growth index prior to 2003, so that stellar track record doesn't exactly reflect the basket of stocks that you would be buying today. But the fund's most important feature has remained constant: Its 0.23% in annual expenses severely undercuts the average of its competitors by nearly 1.3 percentage points. That gives it a huge head start in performance, year in and year out.
Growth Gets Whacked
After more than a decade of heady returns, large-cap growth funds hit the wall in 2000. They're in the red over the past five years, even as the average large-cap value fund has scratched out a profit.
Growth funds generally own companies that increase their earnings at a faster than average rate. Because of that, investors value these shares more dearly. The biggest growth companies had a median P/E ratio of 70 in 2000, but that's recently fallen to 20.
Value funds usually buy stocks that sport low price-to-earnings ratios. Typically these businesses are in slow-growing industries, or they've run into difficulties that raise doubts about their future prospects.
NOTES: As of Oct. 29.  Annualized. SOURCE: Morningstar.