Can Large-Growth Stocks Regain Their Luster?

After five great years, large U.S. growth stocks have seen the bloom come off the rose.

Many of these household names--from Gillette to Dell Computer to Pfizer to America Online--have slid 25% or more in recent months, though most also have rallied off their lows in recent weeks.

“The last few months have seen many of these mighty names humbled,” Edward Keon, director of quantitative research at Prudential Securities, noted in a recent report.

The stocks’ slump has been felt by the roughly 500 mutual funds that focus on large-growth companies. Those funds rose just 4% in the second quarter, versus the 14.2% gain for small-growth stock funds and a 9.8% gain for the average general U.S. fund.

For the last five years, it hasn’t been much of a contest: The average large-growth fund has gained 25.2% a year, versus 20.7% for all stock funds and 16.7% for small-growth funds, Morningstar says.

Likewise, growth stocks’ archrivals--”value” stocks--also had taken a back seat for a long time. Until the second quarter, that is. Funds that focus on large value stocks shot up 9.4% in the quarter, more than double growth funds’ gain.

How worried should large-growth investors be?

There’s no question that these companies, which include many of America’s premier consumer franchises, still are great businesses. But their stocks had climbed to levels that many analysts considered pricey, to say the least.

At the end of May, the typical stock held by a large-growth mutual fund was priced at about 40 times its most recent 12 months’ earnings per share, according to Morningstar. That was well above the 28 price-to-earnings ratio (P/E) of the market overall, and extremely high historically.

Sector May Have Been Due for Breather

Growth stock proponents said their stocks were worth those P/Es. The lure of these stocks is that they generally are posting annual earnings growth that’s faster than the average company, and more dependable. The growth camp includes many technology, drug and consumer products companies.

That contrasts with value stocks, which tend to be slower-growing or have less dependable earnings outlooks, lower P/Es and generally more of a “bargain” feel to them. Stock sectors often included in the value camp include heavy-industry shares, utilities and natural resources issues.

Analysts note that it’s always hazardous to draw stark distinctions between growth and value stocks, as individual companies can bounce between either camp, depending on how the market feels about their shares.

But classic growth stocks were obviously the market’s favorites over the last five years.

What fueled that rally was a combination of strong profits, a desire to be in very liquid stocks, and a mania for large-stock index funds that are dominated by growth names, said John Ballen, chief investment officer at the MFS mutual fund group in Boston.

“Many people concluded that if they could make 25% a year in the Standard & Poor’s 500, why bother with anything else?”

But no market trend lasts forever. Large-growth stocks were due for a breather, and investors got several excuses to take them down in the second quarter: slowing profit growth projections for key firms, such as Gillette; the strong dollar, which can hamper U.S. firms abroad (many large-growth firms are multinationals); and, most important, rising interest rates with the strong U.S. economy.

Higher rates historically have caused investors to reevaluate how much they’ll pay for growth stocks, and that’s exactly what happened in the second quarter.

At the same time, many value stocks often perform better when investors sense that the global economy is improving, even if interest rates are rising. Hence, heavy-industry shares attracted investors in the quarter. Likewise, a whiff of inflation this year has revived long-dormant stocks in energy, mining and other value sectors.

There also have been industry-specific problems for the growth sector. Demand for personal computers has softened, while some drug companies don’t have as many blockbuster drugs in the pipeline, said Andy Gallagher, manager of the Phoenix-based Pilgrim Large Cap Growth Fund.

Large-Growth Managers Confident

But if large-growth managers are worried about their sector, many aren’t letting on.

Gallagher, who navigated the Pilgrim fund to a sizzling 36% gain during the first half by dumping Internet stocks at their crest and making other shrewd moves, remains optimistic.

He focuses on firms undergoing positive fundamental changes, and he continues to find opportunities in growth areas such as cellular phones and cable TV, he said.

Philip Treick, co-manager of three Transamerica Premier Funds in San Francisco, said he still favors large-growth stocks over smaller stocks, citing strong cash flows and more stable operations.

In addition, Treick thinks the nascent Asian economic recovery will tend to boost large multinational companies. “This is a positive factor, especially for large technology companies,” he said.

And with the Federal Reserve’s decision last week to raise short-term interest rates just a quarter point--then shift to a “neutral” stance on rates--growth stocks’ current rebound might gather speed, some analysts say.

But growth stock critics warn that many of the shares still are highly valued, and thus vulnerable if market interest rates resurge.

Some also point to continuing weakness in some key names, such as Coca-Cola--whose shares have made no net progress in two years.

Finally, the shift to value could simply take on a life of its own.

In the period 1992-93, the last time value beat growth for an extended period, the S&P; value-stocks index rose 22%, while the S&P; growth stocks index added just 2% over that two-year span.

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Russ Wiles is a regular contributor to The Times and co-author of “How Mutual Funds Work,” published by Simon & Schuster. He can be reached at russ.wiles@pni.com.

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