Growth Stocks: Ready for a Comeback?

With the economy stagnant and many companies shrinking, is this the time to bet on growth stocks? Some professional investors say it is

By Ben Steverman

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Depending on who you ask, this is a great time for growth stocks or a terrible time to be buying those risky investments.

Many much-admired, fast-growing companies have seen their share prices plunge as the economy slowed. Tough times can squeeze the most innovative companies, as risk-averse investors refuse to pay extra for "hot"—but highly speculative—stocks.

Not that growth stocks need a bad economy to stumble. Often their appeal is based on one or two products: If a fad fades or a competitor wins out, sales and profits can start shrinking as fast as they were previously expanding.

A classic recent example is Crocs (CROX). The shoe company was hailed as the next Nike (NKE) for its ugly shoes made of an innovative material that makes them especially comfortable. Crocs shoes suddenly seemed to be everywhere. Then competitors emerged and many consumers lost interest. Crocs shares had rocketed to almost $70 by October 2007, but a year later they fell 97% to below $2, where they remain.

Long-Term Funk

Clearly, growth investors must choose carefully. But even if they pick smart firms with great prospects, much depends on the state of the economy.

Michael Alpert, managing director at J. & W. Seligman is a growth investor, but he worries the economy will remain in a funk for a while. Even if some growth companies continue to do well, "I'm not sure people come back into growth stocks in a big way," he says. In a tough economy, investors aren't willing to take extra risks—and pay expensive valuations—for growth. But whenever the economy does recover, Alpert expects a "huge move" for growth stocks.

A number of factors can help certain companies grow even if the broader economy is stagnant or shrinking. Technological change is a typical growth driver, as are medical advances in the health-care arena.

Many growth investors are also betting on a new growth driver: politics. President Barack Obama has proposed regulatory and spending changes that affect a wide swath of the economy, from health-care and energy companies to financial firms, automakers, and defense contractors.

"We have political risk in this country where we haven't had that before," says Jim Reed, a fund manager of the UMB Scout Stock Fund (UMBSX). He is trying to exploit that risk by, for example, investing in Cerner (CERN), a health-care information technology firm that should benefit from Obama's push for electronic medical records.

Another risk for growth stocks is the credit environment. Many fast-growing firms borrow money to fund expansion, but debt on a balance sheet has been stock market poison lately. Investors know that heavily indebted companies risk bankruptcy at a time when the economy is weak and banks are reluctant to lend.

Avoiding High-Debt Companies

Jeff Cardon, portfolio manager of the Wasatch Small Cap Growth fund (WAAEX) says he carefully screens out companies with lots of debt. "You don't have to take on huge balance-sheet risk to find interesting growth companies," he says.

The tough economy—and even a wave of bankruptcies—could pay off for the investor who is able to find the survivors, says Charlie Mercer, portfolio manager of the Aston/Veredus Select Growth Fund (AVSGX).

"There are going to be winners out there," he says. The tough economy and scarcity of credit will create "barriers to entry" for potential competitors. "That takes a significant threat off the table" when the economy finally recovers, Mercer says.

Growth stocks are rarely a quiet or predictable part of the market. As the economy struggles to recover, stocks valued for their growth potential could be especially volatile. But for investors who can endure a wild ride, the right growth stocks could be a lucrative, long-term bet.

See the accompanying slide show for professional investors' recommendations of growth stocks that could excel in the coming years.

Steverman is a reporter for BusinessWeek's Investing channel.