Will 1995 Be the Year Growth Stocks Take Off?

Against a generally favorable economic and political backdrop, growth stocks might actually start to grow again.

That would be a welcome change for several hundred mutual funds that seek out companies with promising sales and earnings potential. Most of these funds are showing modest losses so far in 1994.

Worse yet, they have been outperformed since 1991 by their archrivals--funds that invest in bargain or “value” stocks. These are companies characterized as cheap in terms of having a low price-earnings multiple, a low price-book value ratio, a hefty dividend yield or the like.

The two categories of stocks tend to alternate in and out of favor for years at a stretch, and many growth-fund managers are becoming hopeful that 1995 will be their year. This optimism can be boiled down to several key reasons:

* In a slowing economy, which many people are forecasting for 1995, growth companies are better able to maintain impressive financial results, at least compared to value stocks.

“The U.S. economy is in the mature stages of its current expansion,” says Michael Gerding, manager of the Founders Worldwide Growth Fund in Denver. “Such an environment favors growth stocks, and small growth stocks in particular,” he says.

* Higher interest rates, while bad for stocks generally, will put added pressure on firms in debt-laden industries such as the electric-utility business and energy production. Big borrowers, including many cyclical companies, often fall into the value camp.

* A lower capital-gains tax rate, if the new Republican Congress can push one through, would tend to favor investments that deliver appreciation rather than dividends. True growth companies pay little if anything in the way of dividends.

A cut in the capital-gains rate would also tend to shift investor enthusiasm toward stocks generally, notes Hans Ziegler, chief executive officer of Stein Roe & Farnham in Chicago.

* It’s about time for growth stocks to rotate into favor. Value companies have been winners most of the time from 1981 on, having logged much better performance in 1992 and 1993. “Growth shares currently are undervalued relative to the market on a historical basis,” says Ziegler.

This year, the growth is doing better, raising hopes in the growth camp that the momentum is shifting.

Mike Flynn, a manager at Stratford Advisory Group in Chicago, says his firm in recent months has been recommending that clients shift their holdings of domestic stock funds to 75% growth, 25% value from a 50-50 split this summer.

Margie Mullen of Mullen Advisory in Los Angeles recommends a 50-50 split between the two, but that represents her heftiest growth weighting in three years.

“After three years of under-performance, I think growth will do well,” she says.

As a caveat, it’s not always easy to identify one type of stock from the other--investment beauty often is in the eye of the portfolio manager.

Besides, classifications change. A few years ago, pharmaceutical companies were viewed as classic growth stocks because of their superb record of profit increases. But these issues got clobbered when the Clinton Administration raised the specter of health-care reform, and now many drug manufacturers have become value plays.

Perhaps more troubling for mutual fund shareholders, you can’t assume that a particular growth fund will be holding growth stocks.

The growth nomenclature is used to describe funds oriented toward capital-gain returns rather than dividends. Many fine growth funds actually follow a value investing approach. Some even have “value” in their names.

But you are more likely to find value portfolios in the growth and income and equity-income fund categories.

It’s worth noting that not everybody thinks growth stocks will necessarily outperform in 1995.

In a soft market, especially one marked by rising interest rates, stocks with high price-earnings ratios often get banged up the most, says Judy Vale, manager of the value-oriented Neuberger & Berman Genesis Fund in New York. Growth stocks trade at higher P-E ratios than value shares. Considering that interest rates still appear to be rising, that could be an important negative.

Vale combines the two approaches in that she looks for growing companies whose share prices have stumbled. There’s a perception that value firms often are “static,” she says, but in many cases the shares of quality companies have been beaten down simply because management reported a flat quarter.

“A number of companies continue to have strong fundamentals, but their stock prices are off,” she says.

Given the blurry lines between many growth and value stocks, not to mention the difficulty of predicting which category will fare better, it’s often wise to cover your bases. The easy solution is to buy at least two stock funds--one with a growth orientation and the other with a value slant.

*

John Neff, one of the most successful fund managers ever, will step down from the helm of Vanguard Windsor at the end of 1995.

Neff became manager in 1964, when the fund had $75 million in assets. Today, it counts $10.7 billion. Under his direction, Windsor beat the market through most of the 1980s, stumbled badly in 1989 and 1990, and has since resumed its relatively good performance. The fund is currently closed to new investors.

Neff will stay on in an advisory role. Charles Freeman will take over as lead manager of Windsor. He has worked for the fund since 1969.