Now The Real Value Is In Growth

With profits strong, growth stocks are leaving their value cousins behind

After more than five years of sitting on the sidelines watching value investors bask in the market's glory, growth-stock aficionados can smell vindication in the air. In the past three months the Russell 1000 Growth Index has nosed past the Russell 1000 Value Index by a little more than a percentage point.

That may seem like small potatoes, but the shift is huge considering that growth stocks, and the mutual funds that invest in them, have been lagging their value cousins since 2000. "It's the first time we've had any kind of outperformance on a sustained basis for several years," says Larry Puglia, manager of the $8.6 billion T. Rowe Price Blue Chip Growth Fund (TRBCX ). Adds Peggy Adams, an associate manager of the $8 billion MFS Massachusetts Investors Growth Stock Fund (MIGFX ): "We are in the process of a rebound."

Growth mutual funds -- which focus on companies with significant earnings growth -- are a core holding in many portfolios, so a major switch from value to growth styles could offer a seismic boost for fund shareholders. (Value funds, by contrast, tend to invest in companies that are out of favor and undervalued.) But don't expect to see big gains in your midyear fund statements. While growth funds have closed in on value funds since March, the typical growth fund is still down 1.7%, while the average value fund fund lost 0.1% through the year ended June 10. Fund returns are calculated by Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ).

Fund managers have a long list of reasons why growth stocks should outperform in the coming years. First, there's the valuation argument. "The top 25 companies in the S&P 500 are as cheap as they've been in several decades," says Puglia. Stocks in the T. Rowe Price manager's fund are trading at 17 times next year's earnings. In January, 2001, the typical stock in the Standard & Poor's 500-stock index was trading with a forward price-earnings ratio of 30.

One other good sign is that in the midst of an acquisition boomlet, the stocks of acquiring companies haven't tanked. They often do when a major deal is announced because shareholders think the price tag is too expensive. Since Procter & Gamble Co. (PG ) unveiled plans in January to buy Gillette Co. (G ), P&G's stock has risen slightly. In addition, stock buybacks are soaring among companies. T. Rowe Price's Puglia says most of the companies in his portfolio have announced share repurchases. That is a clear signal big companies, including Citigroup (C ), Home Depot, and Nokia (NOK ), think that their stocks are a good deal. Flush with cash, more companies also are raising their dividends. And while earnings growth, which has been on a strong upward trajectory for the past year, is expected to slow down a bit, profits should continue to be strong. "[The stocks of] high-quality companies tend to perform much better when you have slowing earnings growth in the S&P 500," Puglia says.

Leading the blue-chip pack is General Electric Co. (GE ) "Management has executed extraordinarily well," Puglia says, noting that GE recently posted the best quarterly results in a decade. Puglia likes the fact that GE has sold businesses that earned skimpy returns while making major acquisitions in the lucrative entertainment and health-care fields. He's also bullish on Harrah's Entertainment (HET ) in the gaming sector and Nokia (NOK ) in the telecommunications group.

MFS's Adams, meanwhile, is betting on storage-device maker EMC Corp. (EMC ) "Ask a chief technology officer what really matters, and they'll say it's storage and security," Adams says. Her fund, which is down 2%, is also nibbling selectively on large-cap drug companies such as Eli Lilly (LLY ), Johnson & Johnson (JNJ ), and Wyeth (WYE ).

Surprisingly, a similar list of drugmakers appears in the $30 million Live Oak Health Sciences (LOGSX ) fund. A standout in the health-care group with a 7.3% gain in 2005, the fund usually focuses on biotech names. But pharmaceutical giants offer a backdoor biotech play. Aside from the reasonable price tag, co-manager Brandi Allen likes Pfizer Inc. (PFE ) because it's deftly partnering with biotech companies like Neurocrine Biosciences (WBIX ), which offers Indiplon, an insomnia drug. "If I were a biotech company, it's the first door I'd knock on," she says. "Pfizer has marketing muscle and scale."

RIDING OIL'S CLIMB

With oil prices soaring, the hot natural-resources group is the best-performing mutual-fund sector, with a 13.3% gain. Some investors are clearly chasing performance: A record $2.2 billion has poured into natural-resources funds through early June, according to fund tracker AMG Data Services. Even the normally staid Vanguard Group, which shuns market-timing shareholders, is letting investors back into its chart-topping $6.1 billion Vanguard Energy Fund. Closed to new investors at the end of last year, the fund has gained 18.8% in 2005. To curb short-term opportunists, Vanguard is imposing a minimum initial investment of $25,000.

With a mere $8 million in its coffers, Guinness Atkinson Global Energy Fund (GAGEX ) is one of the top-performing funds overall so far in 2005, with a gain of 25%. Some 20% of the portfolio is focused on established Canadian companies, including OPTI Canada, Canadian Natural Resources (CNQ ), and Canadian Oil Sands Trust, which are mainly in the business of extracting oil from Canadian oil sands. That usually is an unprofitable venture because it typically costs about $24 a barrel to extract oil from frozen bitumen. "But when oil is above $40 a barrel, it's a perfectly reasonable proposition," says manager Tim Guinness.

There's another nice surprise coming in the midyear statements. Bond funds remain in positive territory despite moves by the Federal Reserve to boost interest rates. The average bond fund has had a total return of 1.2% so far this year, and some fixed-income portfolios are posting even better results. High-yield municipal funds rose 3.7% while long government bonds are up 3.6%. Those certainly aren't blockbuster gains, but considering that analysts were projecting Armageddon, they look pretty good. Many pros say that the U.S. bond rally is nearing its end, though.

With rising commodity prices, emerging-markets bonds have been on a hot streak, too. Emerging-markets bonds are up 3.7%. A decade ago, investors in the U.S. had few fixed-income options abroad -- they could buy only sovereign debt as well as a smattering of corporate offerings in Latin America. In the past year, it has become easier to buy debt denominated in local currencies. "There's a lot of value in local currency markets," says Kristin Ceva, co-manager of the $61 million Payden Emerging Markets Bond Fund (PYEMX ). Ceva has been a buyer of local currency bonds in Brazil, Mexico, Peru, and Colombia.

Fund investors also have done well in Latin American stock funds (up 7.1%), since they are chock-full of raw materials companies. Plenty of Latin American names are popping up in more diversified portfolios, including the $1.2 billion UMB Scout WorldWide Fund (UMBWX ), which holds Cemex (CX ), a Mexican cement maker, Petrobras (PBR ), a Brazilian oil company, and Aracruz Celulose (ARA ), a Brazilian pulp manufacturer. Manager James Moffett expects these commodities to lose momentum eventually as economies cool down worldwide, but so far he's sticking with his investments. "The horse is still running," he says.

Investors who ventured south earlier this year have been duly rewarded. But with large-cap growth stocks perking up, the best returns of the second half may be earned at home.

By Lauren Young

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