Growth stocks may be down, but they're looking up to many money managers.

Over the past one and a half years, growth stocks have outperformed value stocks for the first time since 2000. This, say some money managers, could be a harbinger of things to come.

Will growth beat value in 2008? "It sure looks that way," says Edward Yardeni, president and chief investment strategist of Yardeni Research in Great Neck, N.Y. "Growth beat value for the first time in eight years in 2007 and is ahead so far in 2008 by an average of 383 basis points for the S&P and 107 basis points for the Russell."

All six S&P growth style indexes beat their value counterparts, but Russell style indexes are mixed. And growth earnings gains are expected to outperform value earnings because of write-offs in the financial sector in 2007 and 2008.

Yardeni also says that growth companies' forward earnings increased for the fifth straight month in July, while value forward earnings fell for the tenth straight month. The forward price-to-earnings ratio for growth, 12.5, was at a record low in July, but value's 12.2 price-to-earnings ratio is at about its mid-2006 low.

Ironically, growth stocks' price-to-earnings ratio in relation to their earnings growth rates, known as the "PEG ratio," is more attractive than value stocks' PEG. The PEG ratio for growth (0.94) is at record low and still below value's 1.14.

Financial research shows that Yardeni and others who like growth stocks selling at reasonable prices may be on the right track. Growth stocks tend to perform better than value stocks in a slow economic environment.

A working paper by Yuhang Xing, a finance professor at Rice University in Houston, found that value firms were more hurt by negative business cycle shocks than growth firms, which performed better in slow economic conditions. Xing comprehensively studied the cyclical movements in economic fundamentals for value and growth stocks in his working paper, "Value Versus Growth: Movement in Economic Fundamentals."

Robert Doll, chief investment officer at BlackRock in New York, agrees. "A focus on larger capitalizations, higher quality stocks and growth styles will continue to make sense in an environment of weaker economic growth and earnings," he says. "We would point to U.S. multinationals-companies that derive a significant amount of their revenues from overseas operations."

Doll favors information technology, health care and the energy sectors. He sees the U.S. stock market outperforming other developed markets.

"The U.S. equity market may continue to perform better than most other developed markets," Doll says. "Thus far, the U.S. market has weathered the downturn relatively well. We expect U.S. stocks to continue to outperform in the current environment since the U.S. is more generally a defensive market."
While growth stock performance has held up better than value stocks', many growth companies still face a lot of financial pressure.

Stephen Lurito, a chief investment officer of American Century, does not expect stellar returns from growth stocks over the next year. He was expecting several months of negative earnings reports. As a result, he is trying to invest in growth companies that have maintained earnings and have outperformed value stocks and the overall market.

The average holding in the American Century Growth Investment Fund is growing earnings at more than 22% annually. Plus, the sales growth and cash-flow growth of the average holding are in the double digits. The fund has outperformed the S&P 500 over the past three months to five years. Over the past year, the fund outpaced the S&P 500 by ten percentage points in total return. Through mid-August, the fund's average top ten holdings were up 7.6%.

About one-fourth of the stocks in the portfolio are midcap growth. The rest are large caps. The fund increased the purchase of stocks such as Qualcomm, Wal-Mart Stores, Emerson Electric and Honeywell International. It recently purchased Helmerich & Payne Inc., a U.S. oil and gas driller with more than 200 drilling rigs. The company is selling at just 10.3 times next year's earnings, while 2009 earnings were expected to grow about 26%.

"We see real challenges for U.S. consumers and the need to repair balance sheets through increased savings," Lurito says. "But we believe that cyclical variations in the U.S. economy can only slow, not stop, the long-term secular trend toward rising global living standards and development."

Over the long term, value stocks could outperform growth. But Grant Rawdin, president of Wescott Financial Advisory Group LLC in Philadelphia, says investors must have a lot of patience. In the long term, the investment will pay off. But in the near term, value stocks should underperform.

"It is important to remember that our value managers seize opportunities to make investments in out-of-favor companies," he says. "During 2008, this has meant investments in financial companies that have experienced sharp price declines. In the short term, the investments made in financials during the past year have significantly detracted from [our] results, year to date."

There are a lot of mispriced growth-oriented stocks in industries such as chemicals, fertilizer and agricultural equipment; in tankers and shipping containers; in infrastructure for airports and seaports; and in materials for roads, bridges and communities in Asia and the developing economies. As a result, companies such as Alcoa, Boeing, Caterpillar, DuPont and United Technologies benefit most from these trends.

"2008 has been an interesting year," Rawdin says. "We expect the mood of the market to improve once the murkiness of the financial sector clears and the election is over. During the interim, we will take advantage of bear market conditions for as long as they last to deploy new investments in our rebalancing of portfolios."

Ron Sweet, an equity investment strategist with USAA Investment Management Company in San Antonio, is not overly optimistic about growth stocks. He cites the sell-off in financials as the primary reason growth has outperformed value. As a result, USAA is taking a slightly neutral stance toward growth stocks, which he says are fairly priced.

The largest holdings in the USAA Growth Fund, which has been outperforming the market over the past year, include Apple, Gilead Sciences, IBM, Oracle and Monsanto. The average fund holding's price-to-earnings ratio is 17.5, while earnings have historically grown at 26% annually. In addition, the return on equity and the return on assets of the fund's holdings are higher than their category averages.

"We expect growth stocks to continue to outperform value stock in 2008 in a slower economy," Sweet says. "We also expect certain sectors within value stocks to become oversold in 2008, creating an opportunity to shift back into value stocks. We expect large-cap stocks to continue to outperform small-cap stocks in 2008, as large-cap stocks will do in a slowing economy, and benefit from global sales with a weak dollar."

Sweet says that, outside the charge-offs in the banking and auto industries, corporate earnings continue to be very strong, driven by a healthy expansion in margins. He is also encouraged by the growing consumer class in the emerging markets, the potential recovery of the financial sector and low-cost labor as a result of globalization. But the key to stock performance will be how corporate earnings play out over the next four to six quarters.

Among the factors that could dampen corporate profits are the weak consumer, the potential for shrinking corporate profit margins, a continued strong dollar, concerns about higher taxes and protectionism and the overall impact of the credit crisis on corporate earnings.

Mike Martin, president and chief financial officer with Financial Advantage Inc. in Columbia, Md., has only 6% of his overall portfolio in a few growth stocks that benefit from some inherent competitive advantages. Needless to say, he is not enamored with growth stocks right now. The economy and corporate earnings are poor.

He cites Cerner Corp., a dominant player in hospital information technology that is growing earnings at more than 20% annually. He also likes Mosys Inc., which licenses semiconductor designs and chips used in such items as Nintendo's popular game console Wii. Mosys, which also has a licensing arrangement with LG household durable goods, trades at just $4.50 a share and has $3 per share in cash. He expects earnings to grow at 50% in the future. There also is a chance the company could be taken over.

He is finding better investments on the value side. He sticks with funds such as Third Avenue Value, which has recently purchased distressed bonds that could gain 20% in value when the economy improves. The fund's average holding is selling at just 1.2 times book value. Its largest holdings include
Henderson Land Development, Cheung Kong Holdings, Toyota Industries, Posco and Nabors Industries.

"We need to see growth stock prices knocked down before we buy," he says. "There is a consumer retrenchment, and investors are just starting to realize that earnings may be in trouble."