Mutual Funds Quarterly: Time to set sail for growth?

Smiling, perhaps, but hardly jumping for joy. That depicts the mood of most mutual-fund investors as year-end performance statements begin to fill millions of US mailboxes. Fund portfolios liberally laced with stocks in foreign and small companies, or specialized sectors produced solid returns in 2005. Investors who owned funds packed with large blue-chip companies, on the other hand, experienced lackluster results.

Still, the vast majority of US equity funds beat the Standard & Poor's 500 index, which rose 3 percent for the year, well below its long-term trend. The average US diversified equity fund grew 6.7 percent in 2005, the third upside year in a row, according to fund-tracker Lipper Inc. Almost half of the gain came during a spirited market rally in November, when Wall Street shook off fears of soaring energy prices and a hurricane-induced economic slump.

"It was definitely a year for stock pickers rather than passive indexers," says Don Cassidy, Lipper Inc.'s director of fund analysis. Most of the more sprightly funds skirted the large companies that dominate the S&P 500 index, a favorite benchmark for passive investment strategies. While S&P index objective funds rose 4.4 percent for the year, large- and mid-cap growth funds posted gains of 6.2 percent and 9.8 percent, respectively. Many growth funds benefited from forays into non-US stocks and flexible charters that allowed portfolio managers to snap up stocks of midsize companies in sectors such as energy, healthcare, and technology.

International markets were a great place to be in 2005, especially in Latin America and Asia. Smaller Latin American funds rose 53 percent, while Pacific-region funds advanced more than 27 percent on average. International multi-cap growth funds, the most popular choice of investors venturing abroad for the first time, grew 15 percent, almost double the gain of their domestic counterparts.

Sector funds specializing in natural resources, real estate, and utilities cooled off during the fourth quarter, but retained their outsize gains for the year. Though easing oil prices sapped some strength from natural-resource funds, they soared 40 percent for the year. Utility funds, popular for their dividend yields, increased 14 percent for the year.

After trailing their small-cap rivals for six years, large-cap offerings were widely expected to edge out small- company stock funds in 2005. While that didn't happen, small-cap leadership appears to have faded, according to Leuthold Group, a Minneapolis-based investment advisory firm. "Small-cap stocks traditionally sell at a discount to large- cap stocks," says Leuthold senior analyst Andrew Engel, "But that's not the case anymore, and they look to be overvalued going forward."

If some investors pout over 2005's slim gains, the reason may lie in the disparity between the top-performing segments of the market and where investors' assets are actually lodged. Some 30 percent of stock-fund assets reside in large-cap stocks found in the S&P 500. That represents the core holdings of most small investors, says Mr. Cassidy. Less than 5 percent of these assets are where most of the sizzle has been, namely, natural resources, real estate, and international funds focused on smaller companies, the Pacific region, and other emerging markets.

Since the Internet bubble burst more than five years ago, value-oriented strategies, especially those focused on small- and mid-cap stocks, have led the performance derby. In 2005, however, returns on growth funds edged out value funds by a narrow margin. Value funds have enjoyed a prolonged wave of inflows, while monies for growth funds have dwindled. Many Wall Street strategists now believe that the tide is turning in favor of growth stocks and are advising investors to realign their portfolios toward large-cap stocks with superior earnings growth potential.

Small- and mid-size companies have had a sustained run, says Michael Mauboussin, chief strategist for Legg Mason Capital Management in Baltimore: "With the economy decelerating and corporate profits growth weakening, large company stocks should play catch-up in 2006."

"At this stage of the economic cycle, we lean toward large-company stocks where the gain in profits is perceived to be higher than the 7 to 8 percent increase we forecast for the S&P 500 index operating profits this year," adds Stanley Nabi, vice-chairman of Silvercrest Asset Management in New York. After five years of sub-par performance, large-cap growth companies, especially those making productivity-enhancing products for global markets, are relatively inexpensive, he says.

Valuation disparities between growth and value camps are converging and "have rarely been thinner," says Mr. Nabi. Typically, stocks with superior growth potential sell at a premium. Although corporate earnings have soared since 2002, key valuation methods such as price-earnings multiples - the ratio of a stock price to its earnings - have been falling and are now not far from historic norms. A shift to growth investing should benefit shares of US multinational companies in information technology, transportation, industrial equipment, and healthcare, Nabi adds. These sectors, he notes, are less vulnerable to rising interest rates than are financial services or utilities, sectors where value stocks are prominent.

Large-company stocks with little debt on their balance sheets, excess cash flow, and a pattern of steady dividend hikes are likely to be winners, Mr. Mauboussin says. Many cash-rich companies have launched stock buyback programs, which reached record levels in 2005. By shrinking the available supply of company stock at a time when many companies are also trimming stock-option grants, buybacks are viewed as a bullish market indicator.

Market strategists are guardedly optimistic about prospects for 2006. They cite rising business investment spending, strong productivity growth, and healthy job and personal income gains as props for growth. Consumer spending, while likely to be less robust than last year, isn't expected to fall off a cliff. "If short-term [interest] rates stop rising, and price-earnings multiples stay about where they are, the S&P 500 could be 7 to 10 percent higher by year-end," says Nabi.

One major caveat to the upbeat scenario relates to Federal Reserve monetary policy. Although forces of global competition should keep inflation under control, the Fed is still in a tightening mode. Wall Street is counting on the Fed to stop boosting short-term interest rates by spring, once its benchmark funds rate nears 4.5 to 5 percent. Any Fed moves to tighten beyond that range, a possibility if the economy expands too rapidly, could spell trouble for stocks.

Income-oriented investors, meanwhile, should sit tight, bond-market experts say. Don't go out on a limb and buy longer-maturity bonds quite yet, they warn. Yields of money-market funds have doubled over the past 12 months, and are likely to trend higher before the Federal Reserve stops pushing up rates. Absent a signal that the central bank is ending its campaign of interest-rate increases, shorter-term yields may keep rising relative to longer-term yields, analysts say.