John Wallace thinks 2006 could be the year for growth stocks to rebound.

    Will the long-awaited market shift from value to growth stocks finally materialize in 2006? "This could be the year the worm turns," predicts John Wallace, manager of the RS Midcap Opportunities Fund. "We think that mid-cap growth companies may begin to reestablish leadership away from perceived value stocks."
    Obviously, someone who manages a fund that specializes in fast-growing mid-sized companies may not be the most impartial judge of whether a brand of investing that has lagged for several years will finally forge ahead, Still, Wallace's arguments might sway even some impartial observers. He believes that a number of factors, including reasonable valuations and a strong economy, bode well for companies whose earnings are predicted to grow at a healthier clip than the rest of the market.
    "The fund's portfolio is trading at 18 times 2006 estimated earnings per share, and we're looking for growth rates from our stocks to be at least in the mid-20s," he says. "So what you're getting is much higher-than-average growth at a multiple that's just a little higher than the overall market." He expects corporate earnings overall to grow from 5% to 8% over the next twelve months.
    While high energy prices, natural disasters, inflation and rising interest rates have raised concerns among many investors about prospects for 2006, Wallace believes both the market and the economy are more resilient than most people realize. "The economy and earnings have so far not encountered the much-predicted soft spot. If inflation fears subside enough for the Fed to stop raising rates, I think that the stock market will respond positively." He says a 2% to 2.5% rate of economic growth would be low enough to dissuade the Fed from raising rates but still signal a healthy economy and help kick the stock market into gear.
    Wallace says the current economic and market environment bears a resemblance to conditions that prevailed in the mid-1990s, when he took over the fund after managing the Oppenheimer Main Street Income and Growth Fund for seven years and the Oppenheimer Total Return Fund for five years.
    "At the end of 1994, the Fed had finished a series of interest rate hikes and the stock market took off in 1995," he recalls. "Then, between 1995 and 1997, things slowed down and valuations became more reasonable. That's about where we are today."

Small-Cap "Graduates"
    With a focus on stocks with market capitalizations of between $1.5 billion and $20 billion, RS MidCap Opportunities includes a number of "graduates" from the firm's small company funds, including flagship fund RS Emerging Growth. Wallace tends to emphasize the smaller end of the mid-cap spectrum, and the stocks in the portfolio have a median market capitalization of $5 billion
    To find candidates for purchase, Wallace uses quantitative screens to sift through a universe of about 1,200 companies. The screen identifies characteristics such as rising revenue and earnings, and consistency of earnings, and then winnows the list down to 300 names. From there, he moves to fundamental analysis to identify a catalyst that can add zip to earnings growth and qualify a company for inclusion in the portfolio, which usually holds between 90 and 110 names.
    He sets upside price targets on his buys and will start pruning them when they get within 10% of those targets. If a stock falls more than 15% below the fund's cost, Wallace will automatically trim the position. "We don't try to rationalize our mistakes," he says.
    Recent "mistakes" include department store chain Kohl's, which the fund sold out of the portfolio in the third quarter after concerns about energy prices and two hurricanes hit stocks in the retail sector. Wallace, who sold the stock because he "found no compelling reason to stick with it," shifted most of the proceeds from the sale into upscale merchant Abercrombie & Fitch.
    Even though Abercrombie stock had lost nearly 40% of its value in the third quarter over concerns about excess inventory, price competition and a change in management, Wallace views the pessimism as overblown. "The negative news has already been priced into the stock," he says. "The company is growing at a rate of 20% and the stock trades at just 18 times earnings."
    The no-excuses sell discipline helps produce a portfolio turnover rate of close to 200%, although Wallace says much of the activity comes from trading around core positions. "I want to profit from market volatility by taking advantage of moves on the upside and the downside," he says.
    His decisive, aggressive style "has delivered the goods in environments hospitable to the fund's style while avoiding severe losses in down markets," writes Morningstar analyst Christopher Davis. While he points out that its expense ratio is higher than average, he notes that "the fund's long-term record trumps most of its peers."
    Over the three years ending in mid-November, the fund's performance put it among the top 21% of mid-cap growth funds, according to Morningstar. It ranked among the top 25% over five years, and among the top 15% over the ten-year period ending October 31.
    The strong performance of the fund's energy and utility holdings, such as gas distribution and exploration company Southwestern Energy Co., helped boost returns in 2005. Wallace believes higher natural gas prices, along with an accelerated drilling program, will help push the stock to higher levels in 2006. Another energy holding, BJ Services, provides pressure pumping for oil and gas wells in the U.S. and Canada. Higher-than-expected demand for its rig-oriented well servicing operations should help the company realize annual earnings growth of at least 30% over the next two years, he says. In mid-November, the stock traded at 17 times estimated 2006 earnings.
    "Going forward, the key with energy stocks is to take advantage of market corrections," says Wallace. "In October, we saw some stocks in the sector fall 20%, and used the drop as a buying opportunity. In the investment world everyone's a weatherman, so fears about a warmer than usual winter could bring the stocks down again."
    The fund's eclectic basket of stocks includes Advanced Medical Optics, which develops and sells contact lens care products and optical surgical devices. The company should benefit from new product launches, and the integration of new acquisitions should lead to better earnings in the years ahead, he says.
    Mid-sized biotechnology companies, such as fund holding Covance Inc., recently have caught his eye Pharmaceutical companies have ample stockpiles of cash and may look to acquire smaller biotechs to help expand their drug pipelines, he believes. Stock of another holding, Harrah's Entertainment, fell after investors became concerned about the hit to the gaming company's Gulf Coast operations after the hurricane. Wallace points out that the region accounts for a small part of the company's revenue, and felt the sell-off was "overdone."
    Although technology stocks underperformed during the first half of 2005, the group picked up steam later in the year. The biggest tech winner for the fund has been SanDisk Corp., which more than doubled in the third quarter on very strong earnings and increased estimates for 2006. The company, a leading supplier of flash memory data storage cards used in digital cameras and other electronic devices, should profit from the introduction of several new products over the next year. However, he notes, "We are monitoring the stock as it is nearing our intermediate-term price target."
    Results for long-time tech holding McAfee have been more disappointing, with the anti-virus software maker's stock falling recently over concerns about competition from Microsoft. "I think it's premature to worry about competition," says Wallace. "Microsoft has been talking about entering this business for a long time. A company with a market capitalization of over $4 billion and sales of more than $1 billion a year isn't going to go away."
    He wasn't as sanguine about prospects for InfoSpace when he decided to cut the fund's losses and sell stock of the online search and directory service in the third quarter. At the time, management had dramatically reduced second-half 2005 earnings and cash flow estimates due to customer defections, lower pricing power and increased costs.
    Despite some disappointments, Wallace contends that technology stocks have a good shot at bouncing back after several disappointing years. "It's hard to believe that we would have a solid market in 2006 without some technology stock participation," he says.