Observers predict continuing opportunities in growth funds this year.

After wandering through the desert for three years, growth investors found an oasis in the huge market rally of 2003. And this oasis was no mirage-the S&P 500 jumped 28.67%, while the S&P Midcap 400 index zoomed 35.59% and the Russell 2000 small-cap barometer soared 47.25%. Solid earnings (helped by easy comparisons and a weak dollar) and strong GDP numbers heralded an economic recovery that bolstered equities across the board.

After getting skunked during the prior three years, growth funds roared back from negative territory with a vengeance. Small-cap growth funds led the way with collective gains of 44.77%, followed by mid-cap growth (36.05%) and large-cap growth (28.44%). Such explosive returns beg the question of how much room does growth investing have to run, let alone whether the small-cap universe can maintain its scorching pace.

Of course, if we knew the answers we'd all be rich and heading off into early retirement. But the general consensus is that barring any terrorist attacks or other geopolitical events, the markets are in for a year of steady-if more subdued-growth, thanks to stimulative fiscal and monetary policies, improving corporate earnings and piddling returns for fixed-income vehicles. "A lot of the trends that started last year are continuing this year," says Reuben Gregg Brewer, Value Line's manager of mutual fund research. "The best part is that the economy is broadening a bit; it's not just the consumer who's spending."

Aided in part by rising corporate spending, Value Line analysts expect the economy to grow about 4% this year, with a long-range forecast of 3.5% to 4% over the next few years. But Brewer cautions that this won't necessarily translate into a repeat of 2003 for equities. "We think the market is fairly valued now," he says. "We think momentum will lead to an up year, but most likely it'll be near the historic norm."

After a fast start in January, the market's pause in February slowed the growth train a bit, and by month's end the growth categories trailed the value and blend categories in each of Morningstar's overall large-, mid- and small-cap groupings.

For many people, growth means having a heavy bent toward tech or other high-flying areas such as cutting-edge health care. To Richard Drake, senior managing director at the ABN Amro Growth fund, growth investing means going with companies in any sector as long as they're growing faster than the S&P 500. "We try to pick the best companies and not try to manage to what we think the market will do," he says. "That's market timing, and we're not good at that."

By relying on steady companies with consistent earnings, the fund missed out on trends and trailed its peers in such boom years as 1999 and 2003, where its 21.6% gain trailed the large-cap growth category by seven percentage points. Still, its 10-year annualized return of 12.40% puts it in the top 4% in its category.

Drake is overweight in tech, including heavyweights Cisco and Dell. He's also overweight in consumer discretionary names such as Kohl's, Harley-Davidson and Starbucks. "These have strong business models with room to grow," he says.

Fidelity Capital Appreciation fund portfolio manager Harry Lange foresees good days ahead for the large-cap growth sector. "This fund can go anywhere in capitalization range, and it now has the biggest large-cap orientation it has ever had," says Lange.

Lange's heavy bet on tech in 2003 produced a whopping year-end return of 51.7%, placing it in the top 2% among all large-cap growth funds. Compared with its best-fit index (Pacific Stock Exchange Tech 100), the fund sported a low beta of 0.65 and a high alpha of 5.37.

Near the end of 2002 Lange increased his fund's tech weighting to its highest level ever. "Tech stocks were so washed out I figured we'd see a recovery in their fundamentals and that investor psychology toward them would improve," he says.

But in recent months the froth has given Lange second thoughts, and he has cut back his tech holdings to market weight. He's also concerned that the rise in interest rates that most people expect to occur by year-end will hurt high-multiple tech stocks. Nonetheless, he's still sticking with his overweight in the cellular phones business, including both handset manufacturers and suppliers. He expects people will replace their handsets faster than anticipated as new phones come out with high-tech features like cameras and GPS.

The fund also scored big last year with homebuilders such as Lennar, but Lange has cut back on them in part because of interest rate concerns. He's shoveled some of that money into medical devices and pharmaceuticals, two sectors he says have outstanding growth prospects. Drug companies and other large-cap companies with significant international exposure should benefit from the weak dollar, says Lange.

Jack Laporte, manager of the small-cap T. Rowe Price New Horizons fund, shares that view. As currencies rise against the dollar, those foreign profits are converted into more dollars. "It's a very good tailwind for large-cap earnings," he says. Because small-cap companies tend to have less overseas exposure, he adds, "It's a very tough call whether large- or small-cap earnings are going to do better this year."

The New Horizons fund has a sizable mid-cap bent because Laporte likes to let his winners run, contributing to a 49.3% return last year that reversed three years of losses. Among the big winners were two names in post-secondary education-Apollo Group and University of Phoenix.

Laporte points out that the Russell 2000 index's 47% gain in 2003 was the best calendar year return in its 25-year history. Small caps tend to lead the way in economic recoveries, but small caps have been the market pacesetters for five years. "After these five years of outperformance, the small-cap valuations are actually very similar to large-cap valuations on a P/E basis," says Laporte. "In order for small caps to continue to perform well, they are going to have to have compelling earnings gains." Small-cap earnings produced year-over-year earnings gains every quarter in 2003, and Laporte believes the trend will lead to double-digit earnings growth for small caps this year.

Perhaps, but some observers make the case that large-cap stocks are primed to catch up to their small-cap brethren. In Lipper's equity mutual fund outlook report for 2004, company analysts expect large caps to overtake small and mid caps by year-end. "With the economy now clearly into its upswing, the early-phase thesis for smaller companies is already well played out; valuations of larger companies will become relative bargains if they remain laggards," reads the report. It adds that as the swing to larger-cap names begins, momentum followers will pile into the sector. And as the bull market continues, it'll be easier to accommodate significant inflows of investor money in large rather than small stocks.

Michael Hershey, lead manager of the small-cap growth Henlopen fund, isn't averse to putting his money to work in large-cap plays. Recently, more than 9% of this self-described "go anywhere" fund invested in large- and giant-cap companies. "Consultants don't particularly care for us because we don't easily fit into one of the nine style boxes all of the time," says Hershey. "But people are beginning to realize that you can't always find your best investments in one place."

For Hershey, the best place has been, and will probably remain, the small-cap (68% of his fund) and mid-cap sectors (23%). "We wind up in these sectors because that's where we find the best ideas through various cycles over time," he says. The fund's ten-year annualized return of 15.29% placed it the top 3% in its category, according to Morningstar. Last year it gained 65%.

Taking an extremely long-term view, Hershey believes the recent multi-year market downturn closed out the multi-decade, post-World War II expansionary era. He reckons that we're beginning a secular-not cyclical-period marked by low inflation and a moderate interest rate environment. Given that, he expects small caps to do well for a longer period than many people forecast.

Playing to the small-cap theme in tech, Hershey likes so-called enablers from across the hardware, software and chip spectrum, which allow various technologies to integrate more efficiently with each other. One such company is Research In Motion, a maker of products for wireless communications. The fund is also high on internet security names such as Internet Security Systems, Cyberguard and Checkpoint Software.

Gaming companies are another favorite group. "These can be a good long-term play given the strength of lotteries, the demand for casinos to alleviate the public debt crisis in various states, and the proliferation of Indian gaming," says Hershey.

Value still matters to many growth managers, and for those folks the market run-up makes it harder to find good deals. "We look for companies we think have sustainable growth, and we try to buy them at reasonable valuations," says Rick Aster, manager of the Meridian Growth fund. "Valuations clearly aren't as good as a year ago."

This mid-cap growth stalwart has been one of the category's best performers during the past three- and five-year periods, helped by a healthy 47.9% return in 2003.

The quest for value has led some mid-cap managers to sell some of their winners in smaller, speculative companies and pick up larger, steadier names with more perceived upside potential, says Morningstar analyst Dan Culloton. "The lesson we should've learned earlier this decade is that valuations can get extended," he says, "and that valuations still do matter."