The Growing Interest In Growth Stocks

Lately this sector is outrunning value funds

If you have any doubts that it's time to dump value stocks for growth issues, talk to Harry Lange. The manager of the $7 billion Fidelity Capital Appreciation Fund (FDCAX ) has the freedom to buy any kind of stock -- small, large, U.S., foreign, growth, or value -- and right now he is heavily into growth. "Growth stocks are as cheap as they've been relative to value in 30 years," he says. "Many stocks in the technology, medical devices, telecom, and biotech sectors have the same or lower price-earnings ratios as more defensive value stocks." About 38% of his portfolio is now in tech, up from 25% a year ago.

In recent years the market has often disappointed those who bet on growth stocks, but no more. In the third quarter, mutual funds investing in growth stocks -- no matter whether small-, mid- or large-cap -- trumped their value counterparts, with the average mid-cap growth fund delivering a 4.5% total return, the best of any diversified domestic equity fund category. That said, the perennially favorite small-cap value group nipped at its heels, with a 3.9% total return, while the Standard & Poor's 500-stock (MHP ) index delivered 2.4%. (Returns are through Sept. 27.)


The winning sorts of funds for the past three months include precious metals, natural resources, and emerging markets -- especially Latin America. Japanese funds, all but ignored by investors for years, are gaining some traction along with the Tokyo stock market. They're up 16.3%. The returns for bond funds look skimpy by comparison, no surprise given that the Federal Reserve continues to raise interest rates. All told, taxable funds eked out just a 0.2% return on average, and tax-free bond funds fell 0.2%. Long-term bond funds, which are the most sensitive to rate increases, suffered the most, falling 1.9% on average.

Value funds did manage to deliver decent performances, although after four years of strong returns, there's not a lot of opportunity in those stocks. Even Ben Inker, director of asset allocation at the $100 billion investment shop Grantham, Mayo, Van Otterloo, says high-quality growth stocks are more attractive. "For years companies with low profit margins and high debt loads have done well," says Inker. That has led to a situation in which high-quality companies in the beverage, food, health-care, and technology sectors have become relatively cheap, trading at p-e ratios that are lower than that of the market as a whole. "Normally, such issues trade at a premium," he says.

What concerns Inker is the momentum behind lower-quality companies. This is especially true of small-cap stocks, which look as if they're well on their way to a seventh straight year of beating large caps. "They're less profitable, more volatile, and have more debt on their balance sheets than large companies," says Inker. "They're also more expensive." Even veteran fund manager Charles Royce, who oversees $20 billion worth of small-cap funds at Royce & Associates, doubts that "we'll see any outperformance of small caps over the next five years."


There are always exceptions. Fidelity's Lange has found opportunities in smaller technology and medical-device stocks. Ajay Krishnan of the Wasatch Global Science & Technology Fund (WAGTX ) says many small chipmakers are attractive -- mainly niche companies that manufacture chips for cell phones and flat-panel TVs. One of his favorites is Leadis Technology (LDIS ), which designs and manufactures display driver chips for cell-phone screens. It currently trades at $6.69, a little more than the cash per share on its balance sheet.

Some deep-value hounds have even begun buying tech companies, finding better deals there than in the industrial and financial stocks they usually favor. Manager Bill Nygren of the $7 billion Oakmark Fund (OAKMX ) recently scooped up shares of Sun Microsystems (SUNW ) and Texas Instruments (TXN ). Over the past quarter, manager James Barrow of the $30 billion Vanguard Windsor II Fund (VWNFX ) has amassed enough shares in Hewlett-Packard (HPQ ) and Nokia (NOK ) that they now make up 5% of his holdings. "It has been seven or eight years since I owned tech stocks," Barrow says. He also likes blue-chip companies in the pharmaceutical sector. Such names as Pfizer (PFE ), Bristol-Myers Squibb (BMY ), and Wyeth (WYETH ) account for 13% of his portfolio. "They're pretty cheap right now, but when we see some new drugs coming through the pipeline, they'll move up," he says.

Co-manager Eric Bjorgen of the "go-anywhere" fund, Leuthold Core, which can buy stocks, bonds, or commodities, also favors health-care stocks, and they account for 28% of the equity side of his portfolio. A quant who uses computers to pick stocks, Bjorgen says that of the 150 industries he covers, a number in health-care fields are consistent leaders in his screens. "We've got a position in big pharmaceutical companies that's almost 10% and another 13% in a conceptual group we call health-care cost containment companies which offer products or services that help reduce costs," he says. "It's a play on or a hedge against health-care inflation and we think it's a group that will have a good fundamental story for the long term." One of his favorites is Cerner, a software maker that helps hospitals and clinics manage their inventories more efficiently.

The two sectors that continue to generate stellar returns -- oil and gold -- are also the most controversial. Some managers, such as Wasatch's Krishnan, who also heads up the $1.2 billion Wasatch Ultra Growth Fund (WAMCX ), think that energy stocks may be in a bubble similar to the dot-coms in 2000. "At the end of the day, oil is a commodity, subject to the whims of the economy," he says. "It shouldn't be reclassified as a high-powered growth sector, the way some funds I know have done." But manager Dan Rice of BlackRock Global Resources Fund(SSGRX ), up 29.7% this quarter, says that the market is valuing oil stocks as if their reserves were worth $40 a barrel instead of today's $65. "There is absolutely no evidence of a lower demand or an increased supply of oil on the horizon," he says. "How is that a bubble?" Manager Frank Holmes of U.S. Global Investors Gold Shares (USERX ), up 22%, sees similar supply constraints in his sector, noting that because of stringent new environmental regulations it now costs $1.4 billion on average to build a new gold mine. He argues that investor demand for the yellow metal is picking up -- because it's a hedge against inflation and a diversification tool.

Certainly, international markets in general, and emerging markets in particular, have benefited from the rise in commodity prices, as most production occurs outside the U.S. Brazilian oil giant Petrobrás (PBR ) is the largest holding in T. Rowe Price Latin America Fund (PRLAX ), up 27.8% this quarter, and with a forward p-e of 5, it is the cheapest oil company in the world, says manager Gonzalo Pangaro. Yet Pangaro says Latin America offers more than just commodities to investors. He has been buying into initial public offerings of Brazilian cosmetics company Natura and Mexican homebuilder Urbi. The demographics -- Brazilian women entering the workforce who need cosmetics and young Mexicans living with their parents who want to buy their own homes -- favor both companies, he says. What's more, the many IPOs are a sign of improving market conditions.

Latin American stocks have been on a tear for some time, but the big recovery story overseas this quarter is Japan. "We're finally getting close to the end of deflation in Japan," says manager Brent Lynn of the $2.4 billion Janus Overseas Fund. "Real estate prices and rents have finally started to move up." Moreover, consumer confidence is strong and Japanese banks, which have been troubled for years, have finally cleaned up the problem loans on their balance sheets, he says.

Emerging-market bond funds did well this quarter, up 3.6% on average, for the same reason as emerging-market stocks. As commodity prices rose, money from the developed world flooded such commodity-rich countries as Russia and Brazil, strengthening their fiscal balance sheets and the credit quality of their bonds. Consequently, investors became less fearful of owning them. "Many so-called emerging markets have long since emerged," says manager Bill Gross, who oversees some $500 billion as head of PIMCO Funds bond department. "Russia now has an investment-grade credit rating and with oil where it is right now, probably more money in the bank than the U.S."

Gross favors emerging-market debt but little else. Because yield spreads have narrowed substantially between corporate bonds and Treasuries, and because the U.S. economy is on shaky ground from oil shocks and hurricanes, he thinks investors are better off with funds that buy Treasury Inflation-Protected Securities (TIPS) and short-term bond funds that buy mortgage-backed securities. The one other category he favors is municipal-bond funds, where yields can be well above Treasuries once you adjust for taxes. Says Gross: "In this kind of an environment, that's a slam dunk."

Gross thinks high-yield bonds are too richly valued right now, but the extra yield they provide tends to make them less sensitive to interest rate increases. (In comparison to other bonds, when rates rise, junk yields still look attractive.) For this reason high-yield bond funds gained 1.2% on average this quarter, the best performers in the group being those which invested in the lowest quality bonds with the greatest payouts. Top performer SunAmerica High Yield Bond Fund, up 3.8%, has 35% of its assets in "distressed debt" on the verge of bankruptcy or in bankruptcy proceedings.

This may be a high-risk area, but the fund is sub-advised by insurance giant AIG, which has a 25-member managerial and analyst team that pores over the balance sheets of distressed companies to see if they can avoid or survive bankruptcy. Right now, co-manager Greg Braun says there are still some attractive opportunities in the airline sector, which has been suffering terribly from oil increases.

Surprisingly, hurricanes Katrina and Rita have yet to make an impact on the muni-bond market. In Louisiana and Mississippi, "insurance companies have been making the interest payments on most of the debt," says Thomas Fetter, who oversees $13 billion in muni-bond funds at Eaton Vance. "There hasn't been a lot of trading of the bonds in the region. People are just holding them to find out more information." In the long-term, Fetter thinks all of the aid flowing into the region will be a positive. "Congress has set aside everything on its agenda this fall to focus only on Louisiana and Mississippi," says Fetter.

Given that most funds would only have relatively small holdings in this region, muni fund investors don't need to worry about hurricane fallout. Diversification mitigates the financial damage from such events, and diversification is something mutual funds do best.

By Lewis Braham

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