Investing for growth has been a losing battle for the past two years. Since the tech bubble burst in March, 2000, the stocks of companies expected to increase sales and earnings the fastest have been some of the worst performers.
Former high-fliers in technology and telecom have disappointed investors repeatedly by turning in worse-than-expected results quarter after quarter. That's why the BusinessWeek 50 -- which lists the top companies in the Standard & Poor's 500-stock index in terms of sales, profits, and share-price growth -- this year includes very few true growth stocks.
With an economic recovery beginning to percolate and investors gaining confidence, though, this could change -- and growth stocks could soon return to favor. "Now it looks like the markets are starting to turn back toward growth," says Andy Engel, a senior research analyst with Leuthold Group, an investment research firm. Since individual investors are still enamored of the former stars of growth, he thinks that once earnings improve, they'll rush back into their old favorites. "We think there is some true underlying strength. Plus, the public is conditioned to be in growth stocks," he says.
CORE VALUE. Nonetheless, a far better strategy since early 2000 has been for portfolio managers to search out stocks that represent good value. These tend to be older companies with solid core businesses, real assets, and steady profits. (While there are exceptions, think heavy industry for value. For growth, think tech.) Value investors may not even care if the company is showing earnings growth, as long as the value of its assets adds up to more than the stock's market capitalization.
Just as stock market leadership rotates between different industries and at times favors small-cap vs. large-cap stocks, it also alternates between growth and value investing strategies. Such swings have been more pronounced than usual the past four years. "Growth just did incredible in 1998 and 1999 and the first two-and-a-half months of 2000," says Brad Lawson, a senior research analyst with investment research firm Frank Russell Co. "Then value just destroyed growth."
In 2000, the growth portion of the Russell 3000 Index (a broad market index made up of the 3,000 largest stocks by market cap) lost 22%, while the value side gained 8%. In 2001, the growth index lost 20%, and the value side also fell, but by just 4%. The disparity is especially pronounced in small-cap stocks. In the past year, small-cap value mutual funds gained 12%, and small-cap growth funds lost an average of 12%. "It's uncommon for a trend this strong to last more than a couple of years," says Russel Kinnel, director of fund analysis at Morningstar.
GROWTH IN GROWTH. Some signs already point to growth making a comeback. Lawson notes that in the past year during several short periods, growth dramatically outperformed value. "The magnitude of the runs are pretty deep," he says. "The duration is not." For example, in the fourth quarter of 2001, when the market bounced back from the sharp losses following the September 11 terrorist attacks, Russell's broad-market growth index climbed 16%, while the value index gained 8%.
It looked like the growth trend would continue this year, says Engel. Then fear spread that the kind of accounting shenanigans that contributed to Enron's collapse might be common among growth stocks, sending investors back to safer value stocks. In March, growth stocks seem to be dominating again.
To Engel, these flip-flops signal that the market may be changing course and be ready for a longer stretch of time when growth outperforms value. Still, he cautions that since the market by most historical measures is already high-priced, it won't be too long before investors get spooked again and retreat to value.
EQUILIBRIUM? An improving economic backdrop will drive investors to growth stocks, but investing styles have as much to do with psychology as with the economic fundamentals. When the economy is growing, people tend to be willing to take more risk. "The more aggressive and speculative the market, [the more] growth is going to win," says Lawson. "In a more defensive, cautious market, value is going to win." At this point, he thinks, "The playing field between growth and value is probably more level than it has been in the past few years."
To investment strategists, none of this is a case for switching out of value and into growth. Rather, it's an argument for diversifying your stock portfolio -- not just among different size companies and sectors but also among investment styles. Kinnel says investors who dumped their poorly performing growth-stock mutual funds should get back in or they might miss out on good future returns.
Stock-pickers should take a close look at the BW50 to see which companies have really grown the most in the past year. We offer several Street Wise columns on BW Online to show what Wall Street thinks of some of the top performers -- not just in the large-cap BW50, but also among small- and mid-cap lists. "If there's a lesson out of this last five years, it's that you should be exposed to both large-cap and small-cap and value and growth," says Lawson.
Investing for growth may have been a dubious proposition in the past two years, but if Engel is right and investors are "antsy to move into growth stocks," you don't want to be left behind.
MARCH 25, 2002
By Amey Stone
Edited by Beth Belton
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