But despite expectations, growth funds have yet to break out.

By Raymond Fazzi

    After five years of disappointing performance, growth managers had reason to feel optimistic going into 2006. They had just concluded a year in which growth had rallied in the last half, outperforming value funds in the large- and mid-cap categories for the first time since 2000.
    Corporate earnings were still on a solid footing, job growth healthy and the overall economy was still in a growth mode, albeit with lingering uncertainties about the future of interest rates. Also pointing to a shift from value to growth was valuations-what analysts view as a good number of bargains in growth relative to the prices in value. "Value has become expensive, if that makes sense to anyone," explains Stephen Wood, portfolio strategist with Russell Investments.
    Not expensive enough, apparently, to significantly change the mindset of investors. As the first quarter of 2006 drew to a close, it was clear that growth failed to carry over the momentum into 2006 as large- and mid-cap growth trailed their value counterparts. Only in the small-cap category, where the Russell 2000 Growth Index was up 7.02% at the end of February, compared to 6.68% for the Russell 2000 Value Index, did growth assert itself.
    Investors, it seems, are still not ready to fully embrace growth equities-a wariness that some market watchers say may be due to a lingering backlash to the technology collapse of 2000, as well as continued uncertainties about the economy. "The market has been sideways for almost the exact duration the Fed has been tightening rates," Wood says. "I don't think that's a surprising relationship. Everyone is just sitting on their bets and waiting for some clear direction."
    Growth managers, however, say that regardless of the tepid first-quarter performance, a peek under the hood reveals a growth sector full of opportunity. Ironically, many growth managers are finding these opportunities in the very sector that sparked growth's slide five years ago: technology. That sector, along with health care and energy, appear to be the sectors growth managers are focusing on as they search for equities in a generally low-return market.
    At the ING Growth and ING Midcap Opportunities funds, technology-along with healthcare and energy-are the sectors that have been setting the pace since last year.  The large-cap and mid-cap funds scored gains last year of 8.7% and 10.2%, respectively.
    Managers of the fund view Internet-related sectors as a key area for growth, noting that the area has matured since the dot.com mania and overspeculation that was prevalent in the late 1990s. Unlike that period of time, Internet broadband services have taken root across the country and are still expanding, fund co-manager Richard Welsh says.
    Also, wireless Internet services, cell phones and laptops have allowed for mobile access to the network, expanding opportunities for companies to market and deliver services. Underlying the changes, Welsh says, is the fact that the Internet is much more of a consumer play than it was eight to ten years ago.
    A hot area lately has been the Internet advertising space, where companies such as Google, Yahoo!, Microsoft and AOL are expected to battle for market share in the coming years.
    Jitters over how that competition is going to play out and whether or not speculation has become too heated have contributed to volatility in the price of Google recently, but Welsh remains optimistic about the area. ING Growth, for example, began the year with most of the Internet advertising players, including Google, in its portfolio.
    One key trend that keeps the fund involved in the area is that in the second half of last year, spending on Internet advertising disrupted the money companies spent on television and radio advertising. "It's such a new and emerging area, it's difficult to credibly forecast how big the opportunities can be," he says.

    Richard Driehaus of Driehaus Capital Management LLC in Chicago feels the data indicate that growth investing has turned the corner and continues to gain momentum from its strong finish last year. "I think the cycle turned against value and is pro-growth," Driehaus says. "The extreme undervaluation of growth versus value hit an inflection point."
    From a historical perspective, he says, small- and mid-cap growth asset classes are historically cheap relative to value. In a white paper Driehaus issued last year, at about the time growth was starting to rally, he noted that as of April the relative price/earnings ratio of the Russell 2000 Growth Index versus the Russell 2000 Value Index had reached 1.18. The spread between the two indexes had not been that tight since April of 1988, he notes, adding that it was also near the all-time low of 1.17 that happened earlier in 1988.
    Given the significant outperformance by value the previous five years, Driehaus says, the evidence points to a cyclical shift in favor of growth.
    Looking more closely at the equity market, Driehaus sees another shift that works in favor of growth management: an improvement in the fundamentals of technology companies, and more opportunities in the health care sector.
    In technology, Driehaus is most optimistic about the growth of broadband services and the consumer services and products that dovetail with the expanded Internet services. "They've increased capital spending, have come up with new applications and are seeing more demand from consumers," he says. "These companies have restructured and, with new developments in broadband, the outlook is good."
    As for emerging themes within growth, Driehaus is keeping an eye on the energy sector, particularly companies related to production and facilities expansion. One energy stock that has been in the firm's portfolio for several months is OYO Geospace, a Houston-based company that develops monitoring systems used by the oil and gas industry to acquire geophysical data. "They make products for getting more oil or gas out of the reserves," Driehaus says.
    Driehaus is also excited about solar energy, saying that the energy source may be ready to produce solid sales. Among the companies he likes in this area are Suntech Power Holdings Co., a China-based manufacturer of solar energy systems, and SunPower, a Sunnyvale, Calif., maker of high-efficiency solar cells and panels.
    Jim Grefenstette, manager of the Federated Mid Cap Growth Strategies Fund, which finished with a gain of 12.8% last year and was up about 7% as of mid-March, 2006, says the opportunities are plentiful in the growth sector, as long as you carefully look for them. "I think people have gravitated to where you can find the growth," he says.
    For Federated, the search for growth has resulted in a shift over the past year from the consumer discretionary, home building, gaming, lodging and specialty retail sectors into what Grefenstette describes as the "back end of the economy"-industrial production and general, large-scale construction. That includes everything from builders of refineries to transportation networks, he adds.   
    "We have shifted the tenor from the consumer to the industrial side," he says. "We're looking to see where the bottlenecks are in the economy-where demand is outstripping supply."
    Grefenstette is also looking for strong top-line growth, stable-to-expanding profit margins and strong earnings growth. That has led the fund to the industrial, energy and telecommunications services sectors, areas that were considered value plays a decade ago. Energy, with tight capacities, is expected to experience a surge in capital spending in the coming years, he notes. In the telecom sector, the fund is following companies that give it a play in wireless services, particularly cell tower construction firms and rural cellular companies. "These are areas where the penetration isn't mature yet and you still have positive demand," he says.
    At the Victory Focused Growth Fund, which since launching in 2004 has racked up annual gains of more than 11% in each of its first two years, the key sectors in the portfolio are technology, health care, financials and a few consumer holdings. The large-cap growth fund, however, took a significant step recently by adding energy to the fund holdings-a move that had been discussed but never implemented during its first two years.
    "What dissuaded us in the past was that the cycles are too short-lived for our taste," says Erick Maronak, a member of the fund management team. "We are long-term investors who tend to have a horizon of three to five years."
    There were, however, two factors that led the fund to finally step into energy. One is the unprecedented energy demand represented by the growing economies of China and India, and the other is an oil and gas infrastructure that Maronak says is in dire need of expansion. "The sorely lacking infrastructure of the last 20 years has elongated the energy cycle," he says.
    Rather than the integrated oil companies, which have seen record earnings the past two years, the fund is interested in companies that facilitate infrastructure expansion. One such company owned by the fund, National Oilwell Varco, manufactures equipment and components used in oil and gas drilling and production, as well as supply chain integration products.
    The company has been a steady riser, going from $10 per share in 2003 to a high of $77 earlier this year. It was at about $57 per share in the second week of March.
The company, with a market cap nearly topping $10 billion, has had earnings growth exceeding 80% the past 12 months, but Maronak says the fund is projecting annualized growth of about 20% over the next three to five years.
    It's a projection that fits neatly into the profile that the fund looks for. Maronak adds that economic conditions are making the job of finding buy candidates a bit easier. "Cash flow is strong," he says. "Free cash flow will top a trillion dollars for companies this year, with half paid back in dividends, buybacks and other investments."
    It has added up to a sound environment for growth investing, he says. "I think one of the comforting facts is that our list of potential companies to add to the portfolio is longer than it was two years ago," he says.
    One manager with a different take on the economic conditions is Jay Rushin, manager of the SunAmerica Growth Opportunities Fund, a small-cap growth fund that has performed to a three-year annualized return of 16.77% and a five-year annualized loss of 5.45%. What bothers Rushin about the current environment are all the uncertainties, ranging from interest rates to the direction of the real estate market and the economy's rate of growth. Rushin thinks a slowdown in economic growth is a plausible possibility this year. That, however, doesn't automatically translate into a dearth of investing opportunities, he says.
    "If we do have a slowdown, and the market does roll over, typically small caps will underperform," he says. "But the beautiful thing is that there is always some little company somewhere doing fine no matter what the economic condition is."
    Growth, Rushin says, is short on thematic investment stories. "It comes down to picking individual stocks with good stories and management teams," Rushin says.
    While growth managers continue to make forays into the energy sector, Rushin is worried about the recent energy sell-off. He's also concerned about how technology would hold up if economic growth undergoes a slowdown. "That whole sector could get hit hard," he says. As a result, SunAmerica Growth Opportunities is slightly underweight in energy and technology and slightly overweight in industrials and health care, he says. Meanwhile, Rushin says he is doing a lot of cherry picking. One of the companies he has bought recently, Symbion of Nashville, Tenn., owns and operates a network of surgery centers. "They're growing at 20% a year and buying a lot of mom-and-pops, so to speak," Rushin says.
    Tony Weber, manager of the ABN Amro/Veredus Select Growth Fund, feels it's still too early to know which sectors are going to be the hot areas for growth investors. The fund, which focuses on a company's history of earnings surprises rather than real and projected growth rates, is dabbling in technology as a possible play. "I feel like a growth stock or a long-term growth record is built one quarter at a time," he says. Weber has steered clear of the energy sector, saying that the sector leaves investors with too many ways in which to be blindsided. "With energy, unlike other areas, you not only have earnings risk, but commodity risk as well," he says.
    One area that has been successful for the fund the past four to five years is the home building sector, where there has been a steady rise in the number of public companies consuming market share. Over the past five years the company's share price has grown from $5 to about $70. Of the home building market, Welsh says, "There is no foreign competition, no technology to supplant you with a better widget, and the inventory goes up in price, typically quarter to quarter."