All Aboard The Growth Train

Mutual funds play up emerging markets, natural resources, and tech

Mutual fund managers have been calling for a rebound in growth stocks for more than a year. With growth funds beating value -- finally -- in 2005, fund managers say the streak should continue well into 2006. "Our bet right now is on growth stocks," says Gina Sanchez, who oversees American Century Investments' Strategic Asset Allocation funds.

Growth funds, which focus on companies with strong earnings momentum, still have a long way to go to make up for years of losses. But investors who hold a good mix of funds -- growth, value, small-cap, large-cap -- have nothing to complain about. The average U.S. diversified fund rose 7.7% in 2005, beating the total return of 5.7% for the Standard & Poor's 500-stock index through Dec. 9.

Thanks to high oil prices, natural resources funds continued to soar, rising 43%, while more diversified emerging-markets stock funds gained 29.2%. Because so many commodities come from Latin America, funds investing there soared 54%. That makes Latin American equities the best-performing category of funds. Overall, it was a winning year: The only losses came from world bond funds, which fell 3%.

Among growth funds, managers expect larger companies to shine in 2006 after a six-year streak of small-company outperformance. "It's time for large caps," says Robert Stimpson, co-manager of the Rock Oak Core Growth Fund (RCKSX ). That's because plenty of big companies have gotten their finances in order in recent years. Many are paying down debt, repurchasing stock, and building up hefty cash cushions. After climbing toward the stratosphere in 2000, large-company stock prices are back to reasonable levels.

Yet smaller companies, which tend to lead the way out of an economic recovery, should lose some momentum, especially if interest rates continue to climb. "At some point, higher interest rates will hurt smaller firms that are more prone to higher funding costs," Stimpson says.

Many growth fund managers are putting technology stocks at the top of their shopping lists. That's quite a turnaround, considering that most tech companies looked like toxic waste after the stock market crashed in 2000. "For the first time in quite a while, we are on the verge of a decent cycle in [information technology] spending," says Scott Schoelzel, manager of the Janus Twenty and Janus Forty funds. After ignoring technology for the past four years, he is giving the sector, particularly software companies, a serious look.

Other growth fund managers are moving in with a vengeance. Robert Smith, manager of the T. Rowe Price Growth Stock Fund (PRGFX ), has been loading up on blue-chip tech names like EMC (EMC ), Dell (DELL ), and Intel (INTC ). Smith's rationale: Cash-rich companies need to upgrade their computer systems and software. "In the next year, capital spending will be better than consumer spending," he predicts.

A WIRELESS BET

As a result, Microsoft (MSFT ) Corp. is one of the fund's top holdings because it has new products in the pipeline, including an update of its Office software and the launch of its next PC operating system, Vista, scheduled for 2006. "Software releases are very profitable," Smith says.

John Wallace, portfolio manager of the RS MidCap Opportunities Fund (RSMOX ), takes a different spin on the tech spending bet. He likes semiconductor companies, including Advanced Micro Devices (AMD ), Cypress Semiconductor, Marvell Technology Group, and Broadcom, which are poised to capture the explosion in demand for wireless communications. "When you look at all of the hot new products, including iPods and cell phones, all of them are using applications that require chips," Wallace says.

It also helps that tech companies are in better financial shape. Dell, Intel, and Microsoft are repurchasing stock, which should boost stock performance. "In the tech space, there's a lot of interesting activity going on," says Legg Mason Value Trust manager Bill Miller, who recently upped his tech holdings.

The good news for investors is that it's probably not too late to get in: The typical tech fund rose a modest 6.9% in 2005, with most of those gains occurring in the second half of the year.

Drilling down to other sectors, fund managers say high energy prices are creating some buying opportunities. Beneficiaries of higher energy prices can be found in some unusual places, too. For example, Don Hodges, manager of the multi-cap Hodges Fund, likes train operator Burlington Northern Santa Fe Corp. "The coal business is booming," Hodges says. Coal production is up because natural gas is so expensive, and this bodes well for railroads, since they are the primary transporters of coal. Railroads are also benefiting from global consumption trends since shipping containers laden with goods from China and other exporting nations need to be dispersed across the U.S., Hodges says.

BANKING ON JAPAN

Such increased demand for products from Asia helped push diversified Pacific/Asia funds up 23.4% in 2005. Fueling the gains in the region is Japan: Japan funds rose 24.2% for the year. "Japan has come a long way," says William Kennedy, manager of the Fidelity International Discovery Fund. Kennedy says the Japanese market has plenty of catalysts to continue to climb in 2006, including banking reforms, high domestic consumption, and a strong export base.

One Japanese export play is heavy-equipment maker Komatsu. Roughly 40% of the company's sales come from the emerging markets. "It's the Caterpillar of Japan," says Paul Blankenhagen, co-manager of Principal Investors Diversified International Fund. New products should help boost Komatsu's operating margins from 7% to 11% this year, he says.

Because the Japanese banking system is undergoing serious reform, Blankenhagen also likes Sumitomo Mitsui Financial Group. "Loan growth is going from negative territory to positive," he says. When the Bank of Japan starts raising interest rates -- which could happen in 2006 -- banks will make more money lending, he notes.

The outlook is a lot less rosy for fixed-income as interest rates continue to climb: "There's far less room for a bond market rally," says Mary Miller, director of fixed income at T. Rowe Price Group. Bonds treaded water for the year, with the typical fixed-income fund gaining 1.6%.

There are a few select opportunities, however. Steven Lear, manager of Schroders U.S. Core Fixed Income Fund, favors cash. "We think the surprise one year from now could be that cash is the best investment," Lear says. "Yields on alternative investments don't necessarily reward for the risk." The average money market fund yields 2.7%, up from 1.5% a year ago, according to Bankrate.com.

Bond fund managers are also sniffing around the muni-bond market. "In a higher-rate environment, intermediate-term municipals will outperform taxable bonds," says Steven Permut, head of the municipal-bond team at American Century. Credit quality from municipalities remains strong, thanks to rising home valuations and higher tax revenues.

Even if home prices come down, money managers aren't worried because high consumption and the tight labor market are boosting sales and personal income tax revenues, too. As a result, managers at both T. Rowe Price and American Century have been putting municipal bonds into taxable bond funds. While those funds do not need the tax break that municipal bonds offer, it's a sign that tax-free bonds are a pretty good deal.

By Lauren Young

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