While value has ruled the roost in the recent past, growth funds may be poised to break out this year. Keep an eye on large caps, too
Investors hoping to cash in on some hot new trend last year might have ended up feeling a bit like fashion victims. Despite forecasts to the contrary, value stocks continued to outperform their growth counterparts in 2006, as they typically have done since the bursting of the tech bubble six years earlier. Stocks of small companies also extended their reign over large-cap stocks.
However 2007 may tell a different story, as other investing styles may come back into vogue. Growth could be poised to rebound this year, some analysts say, citing valuation, while large caps may gain on small caps (see BusinessWeek.com, 12/25/06, "Mutual Funds: It's the Large Caps' Turn to Shine"). International stocks, which fared best of all in 2006, might lead the pack again during the year ahead, according to market pros.
Domestic value mutual funds posted a 17.2% average total return in 2006, according to data as of Dec. 27 from fund tracker Lipper. Domestic growth funds trailed far behind, with an average total return of 8.5%. International small/mid-cap proved to be the best-performing fund category overall, with a 25.3% average return.
Giving Growth a Boost
The current U.S. value-led cycle may be getting long in the tooth, according to Joe Battipaglia, chief investment officer at Ryan Beck. "The average length of a value cycle is only two-and-a-half years," Battipaglia says. "Now that you've had this six-year value cycle, it may well shift in the other direction."
But timing isn't everything. Overvalued growth stocks, rising oil prices, and declining interest rates have contributed to value's recent dominance, Battipaglia notes. More recently, though, price-earnings multiples for growth stocks have been falling while multiples for value stocks have risen, which he suggests could give growth stocks a boost going forward.
Others recommend taking a neutral tack on the question of growth and value this year. The past two years have been tricky for style-based investors, and 2007 might prove no different, these analysts say. The wild card has been the energy sector, the second-biggest component of the value side.
Cooling Energy Market?
"Whether value outperforms or not is dependent on where the oil prices are going," says Brian Gendreau, investment strategist at ING Investment Management (ING). "Energy did very well in the early part of the year, then it did lousy in the summer, and all of a sudden it's outperforming again. Right now the arguments for being in growth vs. value just aren't compelling one way or another to us."
Some market watchers expect the energy sector to cool off this year after a torrid 2006. Ashwani Kaul, senior research analyst at Reuters Estimates, forecasts earnings growth of 5% for this sector in 2007, down from 21% in 2006. Despite high demand from China and India, OPEC's informal crude-price target of $60 a barrel should trim the oil refining industry's bottom line, Kaul says in a report.
Either way, any impending growth resurgence isn't likely to hold on as long as value's current run. "After the huge recent outperformance of value, we think growth is again likely to play catchup in the near term," says Morgan Stanley (MS) quantitative analyst Parin Gandhi in a note to clients. "However, we do not expect to see a major sustained period of growth over value."
Foreign Opportunities Ahead
In terms of market capitalization, bigger may be better in 2007. Last year, domestic small-cap funds led the way with a 13.4% average total return, according to Lipper, compared to 11.6% for large-cap funds. Mid-cap funds averaged a total return of 11.2%. In the new year, analysts expect a weaker dollar and slowing U.S. growth to give an edge to companies with significant international presence—and those companies tend to be large-caps.
Looking abroad, whether at international stocks or U.S.-based multinationals, could be a savvy strategy in 2007. Goldman Sachs projects world gross domestic product, or GDP, growth to stay above trend at 4.1% this year, as U.S. GDP growth slows to 2.1% from 3.3% in 2006. "We believe exposure to stronger growth in foreign markets may fuel outperformance," Goldman Sachs (GS) strategist David Kostin says in a note to clients.
Companies with sizable non-U.S. businesses might also benefit from a dollar that is expected to face continued weakness (see BusinessWeek.com, 11/30/06, "Ways to Weather a Weaker Dollar"). "A few years ago, almost half the earnings from the S&P 500 came from a currency move," says Chris Orndorff, head of equity strategy at Payden & Rygel. "Even though you might think if the economy's going to slow down it's going to be a lousy year for stocks, it could actually be a decent year simply because of the positive earnings momentum."
Large caps have looked more attractive on a valuation basis for a couple of years now, according to Jack Ablin, chief investment officer at Harris Private Bank. Ablin says small caps have continued to outperform, thanks to an abundance of liquidity. "Now that the Fed has ratcheted up short-term rates, the liquidity argument will dry up," he projects. "Expect to see small caps underperform large caps in 2007."
In the end, it's best for most investors to keep a well-diversified portfolio and limit speculative plays to a small portion of their assets, financial planners say. "Don't get too cute out there, trying to figure out which is the best style box to be in based on last year's performance," says Elizabeth Ruch, a senior financial adviser at Waddell & Reed (WDR). Trends come and go, but a savvy, well-balanced long-term investment strategy shouldn't go out of style anytime soon.