‘Growth’ was hot; ‘value’ was not
Never quite sure whether a stock fund you own is a “growth” or “value” fund? Just check its performance in the third quarter.
Growth funds rallied while value funds mostly lost ground in the three months ended Sept. 30, one of several significant shifts during a wild time in financial markets.
Another momentous shift: the resurgence of big-company stocks while smaller stocks struggled.
Overall, most stock funds made money in the quarter, despite extraordinary market turmoil triggered by a global credit crunch.
The average diversified U.S. stock fund was up 1% in the quarter and 9.9% for the first nine months of 2007, according to Morningstar Inc. The average foreign fund rose 4.6% in the quarter and 17.3% in the nine months, helped by robust economic growth abroad, and the tail wind of a weak dollar.
But if the trends underlying stock funds’ recent returns continue, investors’ portfolios could be facing a radical turnabout from what they’ve known for much of this decade.
Value-oriented stocks and funds have mostly ruled the market since 2000, as many investors sought relative safety in shares that appeared cheap based on their earnings or other measures. That’s the classic definition of value on Wall Street.
By contrast, many growth stocks -- shares of companies whose earnings are expected to grow at an above-average pace over time -- have been in the doghouse since 2000. That was the beginning of the crash in technology shares, which had long epitomized growth investing.
But look who’s back on top this year. In all three broad size categories of stocks (large-capitalization, mid-cap and small-cap), growth-focused mutual funds significantly outpaced value-focused funds in the third quarter and the nine months, according to Morningstar.
Mid-cap growth funds, for example, were up 3.7% in the quarter, on average. Mid-cap value funds lost 3.2% in the period. Fund returns include share price change plus any dividends earned.
Funds that focus specifically on tech issues rose 6.6%, on average, in the quarter and 17.8% in the nine months.
Growth-stock fund managers had been telling their shareholders for two years that a rebound was overdue. “This year it finally happened,” said John Calamos Sr., head of Calamos Asset Management in Naperville, Ill.
His $15-billion Calamos Growth fund surged 21.8% in the first nine months, boosted by hefty holdings of tech shares including Apple Inc., Google Inc. and Nokia.
Many market professionals say the gains in the growth sector, and the sell-off in value, reflected some simple math: As growth stocks lagged in recent years they began to look inexpensive relative to their underlying earnings.
The opposite was happening to value stocks. As the shares rose, they began to look pricey compared with earnings.
“Valuations have been compressing for years between value and growth stocks,” said Greg Carlson, an analyst at Morningstar in Chicago.
“Growth just got too cheap,” Calamos said.
Cases in point: At midyear, shares of cellphone giant Nokia were at about $28, or 16 times the $1.76 a share the company is expected to earn this year.
Railroad company Union Pacific Corp., traditionally a value stock, was more expensive than Nokia at midyear, with the stock’s price-to-earnings ratio at about 17.
Nokia shares jumped 35% in the third quarter while Union Pacific slipped about 2%.
Apart from valuations, the shift to growth and away from value was helped along by the midsummer market upheaval, money managers say.
The credit crunch fueled by the U.S. housing sector’s woes raised doubts about the domestic economy’s health. That boosted demand for shares of companies that seemed to have a good shot at outpacing a weak economy.
At the same time, bank and brokerage stocks were hammered by the credit squeeze and fears of rising defaults on high-risk mortgages and other dicey loans. Financial stocks have long been one of the mainstay sectors of value investing because of their typically low price-to-earnings ratios.
Funds that focus exclusively on financial stocks were among the biggest losers in the third quarter, falling 3.6% on average, according to Morningstar. They were down 3.1% for the nine months.
Another classic value sector that has struggled this year: real estate-oriented funds, which mainly own shares of real estate investment trusts. The group was down 3%, on average, in the nine months.
The rush to growth stocks was a global affair in the third quarter. Foreign large-cap growth funds were up 5.3% in the quarter, on average, compared with a 1% rise for foreign large-cap value funds, Morningstar said.
George Evans, manager of the MassMutual Premier International Equity fund in New York, said he expected growth stocks to outrun value issues for the next three to five years worldwide.
Many classic growth companies are plays on one of Evans’ favorite investing themes, he said: the rise of “mass affluence” worldwide, as the ranks of the middle class grow in China, India and other developing nations. He sees Swiss watchmaker Swatch Group and France’s Pernod Ricard, the world’s second-largest liquor company, among the beneficiaries.
Still, it isn’t certain that value funds will go into a long-term fade, many financial advisors say. Savvy value-fund managers may find bargains in places they wouldn’t ordinarily look.
Indeed, one manager’s growth stock can be another manager’s value stock. For example, shares of computer titan Hewlett-Packard Co. are in the Calamos Growth fund and also are a major holding of the Dodge & Cox Stock fund, one of the biggest large-cap value portfolios.
What’s more, if the economy should sink into recession, it isn’t clear which stock sectors would hold up best. That might depend on the nature of the recession -- whether it’s marked by a pullback in consumer spending or a decline in business outlays, for instance.
Nonetheless, among Wall Street pros there is strong evidence of growing bias against small- and mid-cap value stocks, in particular.
In a survey of 342 institutional investors conducted in late August and early September, Russell Investment Group found that just 13% were bullish on small-cap value stocks over the next 12 months, and 25% were bullish on mid-cap value issues.
By contrast, 69% were bullish on large-cap growth stocks.
It could make things tough for value-fund managers if they begin to face heavy redemptions by investors who are cashing in the healthy gains the sector produced in the last seven years.
The value-focused Diamond Hill Small Cap fund closed its doors to new investors in 2005, when the fund’s assets were approaching $500 million. The portfolio had gained 123% from the end of 2000 through 2004, three times the return of the Russell 2,000 small-stock index.
But this year money has been flowing out as some financial advisors have been shifting clients away from small-cap value in general, said Tom Schindler, the fund’s co-manager in Columbus, Ohio.
The fund eked out a 0.4% return in the first nine months.
“Assets can be leaving just as you’re finding things you want to be investing in,” Schindler said. He added that he was trying to maintain long-term bets on small oil and gas companies and industrial firms such as Kaydon Corp., which makes bearings and other components for the defense business and other industries.
Even if value is going out of favor for a while, shifting entirely away from value funds could be a mistake, many financial advisors say. That’s because there’s no telling when the sector might be back in style.
One way to avoid an all-or-nothing bet on growth or value: Choose a fund that owns both.
Funds that tend to own a mix of growth and value stocks are categorized as “blend” portfolios by Morningstar. Not surprisingly, their returns often fall somewhere in between the returns of pure growth and pure value.
