Mutual Funds Quarterly: Time to set sail for growth?

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.

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