Experience says growth will outperform.
(But it doesn't say when.)

    They say that, over time, one of the basic facts of investing life is that value will outperform growth. It's just sometimes hard to get investors to notice.
    "I don't think people like to invest in value stocks normally," says Jim Averill, manager of the Hartford Value Opportunities Fund, a multicap value fund. "You say value, and they'll say, 'That's boring.' Growth is where the excitement is."
    While investors may be waiting for some exciting developments in the growth arena, it hasn't happened yet. And as equities continue down their boring single-digit-return path, value managers continue to largely outperform their growth counterparts.
    So far in 2006, this trend doesn't seem on course to change. As of April 4, the Russell 3000 Value Index was up 7.57%, compared with 4.47% for the Russell 3000 Growth Index. In the large-cap sector, the Russell 1000 Value was up 7.04%, compared with 3.57% for the Russell 1000 Growth index. Only in the mid- and small-cap sectors did growth hold a slight lead over value.
    Coming after five years of outperformance by value, it seems like value managers are bidding for an extended run of dominance. Yet value managers say they've been doing what they always do: looking for bargains in unexpected places. "Historically, we just go where the value is and make money on it," says Averill.
    Making today's market somewhat unique, he says, are the stocks that are now appearing on the typical value manager's radar: a mishmash of companies, including former stars of the growth arena.
    Averill attributes this to the bidding-up of value stocks that has taken place the last several years and the backlash to the technology collapse.
    Averill, for example, has been spying potential holdings in the pharmaceutical and technology sectors, where he believes negative outlooks have made for some attractive prices. "We've seen a convergence of multiples between what are basically thought of as growth and value stocks," he says.
    The appearance of what were once thought to be growth tech stocks in value funds shouldn't be surprising, says Michael Pytosh, senior technology analyst with ING Investment Management. On average, he says, technology stocks are more in tune with value than growth.
    During the ten-year period spanning 1994 to 2004, Pytosh says, the only time growth outperformed value in the technology sector was in 1999. "It just so happens that you had a very unique set of circumstances that happened in 1999, mainly Y2K, and the growth of the Internet and the cell phone market," he says.
    Tech stocks are more typically cyclical, with short product cycles and extended periods of slow growth. In other words, technology provides some of the volatility that value managers thrive on.

    At Federated Stock Value Fund, manager Kevin McCloskey is looking closely at the technology sector for companies that are turning themselves around and adapting their operations to a leaner economic environment. "A lot of them have completely restructured their operations since coming out of the bubble, particularly a lot of the software companies," he says. "We're more confident in their ability to change themselves going forward."
    The technology sector also figures into one of the hanging questions on Wall Street: Is growth poised to outperform growth? With technology companies on the rebound, and value stocks getting pricier after a five-year run of outperformance, many believe that growth is due for a rally. Yet not everyone is convinced that the market is ripe for a cyclical change between value and growth.
    Eileen Rominger, chief investment officer and portfolio manager on the Goldman Sachs U.S. Value team, notes that the trailing price-to-earnings discount of the Russell 1000 Value index to the Russell 1000 Growth index was about 33% as of the end of 2005-which represents the historical average. That compares to the last bull market, when value's discount was as deep as 70%, and the early 1990s, when value was actually selling at a 10% premium to growth.
    "To me, the odds are pretty even that value or growth are going to outperform in the next year," she says. "If you're just looking at valuation, it's really a toss of the coin."
    She feels megacaps-particularly in the technology sector-are poised for a rally on the strength of healthy earnings. "Many of these companies have, in a quiet and boring way, put up very good earnings numbers," she says.
    Rominger also feels mid-caps will continue to be a strong value play, as they benefit from merger and acquisition activity in several industries, including energy. For stock pickers in either school, she says, market conditions are not ideal. Rominger notes that the market's low volatility, while beneficial from a safety standpoint, has forced investors to work hard in finding bargains.
    "We don't have the extremes of under- and overvaluation that kind of make for a stock pickers paradise," she says. "I would say you really have to do a lot of digging these days to unearth truly mispriced securities."
    The U.S. value market is so flat that some managers are embracing the overseas markets. David Winters, former value manager with Franklin Mutual Advisors, launched a new fund last year-the Wintergreen Fund-that has the option of allocating all of its assets in foreign holdings.
    That provision, in addition to the fund's ability to invest in companies of any capitalized value and to utilize debt and convertible securities, was designed to provide the fund with maximum flexibility, according to Winters. So far this year, the fund is taking advantage of that freedom, with more than 40% of its assets allocated to international holdings, Winters says.
    "It's different from the year 2000, when you had the bubble and any real companies were basically being given away," he says. "If you had the courage and any money, it was a great time to be a value investor."
    The end of irrational exuberance has made for a more stable and sane market, which in the end is exactly the type of environment a value manager wants to avoid. "Over the past five to six years you've had a big rally in U.S., Europe and Asia, and it has made those obvious scratch-your-head situations kind of rare," he says. "I think you may have to dig a little deeper and turn over a few more stones. So we've decided to cast our net a little more globally."
    Among the catches at the Wintergreen Fund has been The Hongkong and Shanghai Banking Corp., which Winters feels has slumped in value because of less-than-stellar earnings in recent years.
    Yet he likes the banking company's fundamentals, its yield of just under 5% and capital appreciation that normally runs in the high single- and low double-digits.
    "It's kind of like buying an A+ bond that over time will return in the double digits," he says. "It's a comfortable, sleep-well-at-night type of investment to own." It's the type of stock Winters looks for as a value manager-one with little downside, holding the promise of either a big discount today or a free premium tomorrow.
    Two sectors where Winters is looking for companies that fit that description are old media and energy. In the former sector, Winters feels the concerns about the death of television and newspapers to new media such as the Internet are over played. In energy, Winters is cautious about investing in companies that have already spiraled upwards, but still sees companies trading at big discounts to their asset value.
    Mergers and acquisitions in the sector have also intrigued Winters.
    "You want to look at sectors where there is tremendous consolidation going on," he says. "You want to find the girl at the dance who's going to get tapped on the shoulder."
    Some value managers take the thematic approach. At the Victory Special Value Fund, energy and commodities such as metals and coal are considered top value, partly because the demand for raw materials is exceeding supply throughout the world.
    The fund is also investing in health care because demand is expected to sharply increase with the aging of the baby boom generation.
    "We look for supply and demand imbalances on a global basis," says Patrick Dunkerley, the fund's chief investment officer.
    Bruce Berkowitz, lead manager of The Fairholme Fund, a multicap value fund, says that while value fund holdings may change, the core principles of the investment style do not. "What we do for all companies is we count the cash," he says. "The analogy I use is sort of the corner grocery store. We watch the money that goes in and out of the register. At the end of the day, what's left-the free cash and owner's earnings-we count it."
    Such a bottom-line approach can lead to the appearance of surprising company names on the fund's holding list. The Fairholme Fund, for instance, was a big investor in MCI after it went into bankruptcy as Worldcom in 2002.
    One of the darlings of the bull market in the late 1990s, the company landed on Berkowitz's buy list after analyzing the company's cash flow.
    "In bankruptcy, with Worldcom's debt basically being cancelled, we saw hundreds of millions of cash being generated every month, and their bank accounts filling up," he says. "You can get fancy with accounts, but you can't lie about how much cash you have in the bank."
    The cash flow, coupled with the fact that Worldcom was just one of a couple of companies with a network sophisticated enough to service the U.S. government and Fortune 500 companies, is what turned MCI into a value stock in the eyes of Berkowitz.
    Ironically, he says, the fund lost about 20% of its assets shortly after launching in 1999 because it refused to buy Worldcom, Lucent and other technology blue chips. "We did not own a technology stock and clients left us because we told them that we did not want to be part of them losing money."
    Since reaping gains from the telecom wreckage and the technology collapse, Berkowitz has turned his attention to energy, where he feels valuations in some sectors have not yet caught up to current oil and gas prices. Among the fund's plays is Canadian Natural Resources, which Berkowitz says is sitting on top of billions of barrels of oil in the form of untapped oil sands. He also is an investor in EchoStar, a satellite television company that he feels is undervalued because of concerns about competition from cable television.
    In the final analysis, Berkowitz says, value investing is not for everyone. Growth funds, he notes, will outshine everyone in an aggressive bull market. An investor in The Fairholme Fund, meanwhile, will have to be content with a focused approach with about 20% to 30% devoted to cash.
    "Our number one rule is, don't lose," he says. "We assume our shareholders worked hard for their money."