Although large cap growth stocks have been out of favour for several years, the evidence suggests they are due an impressive re-rating by the markets
Growth stocks and growth-style investment funds have been underperforming their value equivalents since the bursting of the dotcom bubble in 2000. From 11 March 2000 (the day the technology-heavy Nasdaq began its decline from record highs) through to the end of 2005, US value funds posted a cumulative return of plus 8.98% (in US dollars), compared with minus 5.38% for growth funds, according to investment research company Morningstar. Large-cap growth funds performed even worse.
Growth funds invest in stocks - often in technology, healthcare or retail - that cost more relative to earnings, but are expected to see their earnings grow more rapidly than the market.
Value funds tend to be more conservative, focusing on undervalued shares of companies trading at levels below what the managers of these funds consider to be their true worth.
But growth stocks have been staging something of a comeback since mid-2005, prompting some to talk of a cyclical rotation return to favour growth investing, particularly large-cap growth, to the detriment of value.
First, the good news
Recent double-digit rises in earnings for growth stocks mean that the largest S&P-quoted companies (stocks with a market cap exceeding $100bn (or £57bn) were trading at 25-year lows at the end of 2005.
There may be parallels to be drawn between 2005 and 1984 and 1994. In both these latter years, large-cap growth stocks in the US faced strong headwinds because of a compression in valuations triggered by rising interest rates.
But stock markets in the following years - 1985 and 1995 - proved to be very strong, with a performance tilt in favour of growth stocks. It is conceivable we will see a similar trend in 2006 as the Fed comes to the end of its monetary tightening cycle, as expected.
The Russell 1000 Growth index outperformed the Russell 1000 Value index by 70 basis points in the fourth quarter of 2005, while the gap between price-to-earnings (P/E) ratios for growth stocks and value stocks narrowed considerably. Time will tell whether growth's recent outperformance will continue.
Low valuations and debt levels may well continue to renew the appeal of growth stocks. In addition, unlike the late 1990s, many large-cap growth stocks are now paying dividends and have spent considerable energy since the bursting of the dotcom bubble strengthening balance sheets and increasing pricing power. The macro-economic backdrop for growth stocks in the US is also good.
Despite a succession of short-term rate increases, longer-term interest rates remain relatively low and the American economy is strong. Although the housing sector and consumer spending may slow, unemployment remains low and inflation remains in check. Gross Domestic Product growth may slow somewhat this year, but this is to be expected in the fifth year of uninterrupted expansion.
Historically, large-cap growth stocks have outpaced their value equivalents as the economy moves out of the recovery phase after a downturn. True, the maturing of the economic cycle has implications for profit growth, but even a possible slowing in corporate earnings growth this year may not impede the upswing in the relative performance of growth stocks.
By their nature, large-caps are more financially robust than small-caps. Less cyclical large caps (for example, healthcare stocks) that pay dividends could still be expected to shine. And growth companies like Google and Amazon.com, even though they have recently disappointed analysts' expectations, are still forecast to post good earnings in the future even if the US economy softens.
Also, some analysts believe growth-oriented firms that have been building up cash on their balance sheets may finally begin to put their money to work this year, either by investing for growth or returning it to shareholders in the form of dividends. This would help boost their share price.
The economic news from mainland Europe has also been improving, prompting the European Central Bank to begin to tighten rates after a long pause, while business and investor confidence in countries like Germany has soared. The surge in M&A activity in recent months is a further sign of corporate confidence in Europe. Corporate profits have generally been strong and interest rate differentials have, for the moment at least, removed upward pressure on the euro relative to the US dollar.
Against this backdrop, investors focused on growth areas such as infrastructure, innovative services and selected technologies may well see healthy returns.
The end of the party
Yet, alongside this upbeat assessment of the prospects for growth stocks, there is room for some prudence.
With markets so rich in liquidity because of excess global savings and so many investors chasing yield, the case could be made that growth indices' recent outperformance in both Europe and the US is not actually due to any fundamental shift in the market cycle. At the very least, successive base rate increases in the US could finally be reflected in long-term yields and as a result increase volatility indices that have remained uncannily low throughout 2005.
How growth-style investments fare this year could also depend on the causes and consequences of monetary policy.
In the US, for example, the markets expect the cycle of successive rate hikes since 2004 to end sometime in 2006, as economic growth slows and the substantial appreciation in asset prices, such as houses, tails off. Some might also argue that an environment of slower economic activity, at least in the US, is hardly conducive to growth stocks in general.
a period of transition
Some questions of definition arise. High-quality growth-style stocks have become cheap relative to value-style equivalents. And many traditional value stocks linked to energy, utilities and basic materials have become expensive.
But this has simply led to a certain blurring of frontiers between these two investment styles. Increasingly, stocks that would have been considered prime growth stocks in the late 1990s can now be found in value funds. This is not really surprising, as value funds focus on finding out-of-favor and undervalued companies trading at low multiples of earnings, sales and book value.
There may be a period of transition caused by the continued compression of valuations between growth and value stocks. Some of the former may be at their cheapest level relative to value in 30 years, with many stocks in the IT, medical devices, telecom and biotech sectors offering the same or lower price-earnings ratios as more defensive value stocks.
This situation may prove challenging for managers focused on a top-down strategy. By contrast, even value-oriented stock pickers welcome the increase in the variety of stocks from which they can choose.
Value stocks continues to outperform growth-style investments
Large-caps are more financially robust than small-caps
Markets rich in liquidity
£300bn of liabilities
View from the front row
Transfer from occupational scheme
Appointed by FCA and PSR boards