Courage now, bold returns later

Brave investors can profit from out-of-favor stocks

July 07, 2002|By William Patalon III | William Patalon III,SUN STAFF

With fear and distrust ruling the stock market, investors who have the courage now to buy out-of-favor growth shares should reap a substantial profit later when reason returns and these stocks inevitably rebound, professional money managers say.

For growth stocks, "it's been a trying time," said Morry A. Zolet, first vice president of investments for Salomon Smith Barney in Lutherville. "But [for investors], it's time to step up to the plate. The old investment adage says ... `Buy when there's blood in the streets.' Well, there's blood in the streets right now, and it's a great opportunity."

That is hardly the prevailing sentiment in the market, where growth stocks are about as popular as Typhoid Mary on a Caribbean cruise.

But in the late 1990s, growth shares were the backbone of a 17-month surge that nearly quadrupled the growth-dominated Nasdaq composite index. The higher the most popular of the growth shares rose, the more it seemed investors wanted to own them.

Traditionally, investors have divided stocks into two camps: "value" and "growth."

Value firms are usually companies whose shares have been beaten down because of current - but fixable - problems that will allow for a recovery in price. Growth stocks were shares of established companies such as Pfizer Inc., Cisco Systems Inc., Microsoft Corp. and General Electric Corp., whose profits grew at consistent, double-digit annual rates. But as the bull market turned into a market frenzy, experts say, investors broadened that definition to include any stock whose price was appreciating quickly. That's how Internet companies with no profits or even sales attained market values in the tens of billions of dollars - and it's why the bubble burst.

Grim watchword

The collapse of the market mania, and the country's first recession in a decade, caused virtually all stocks to nose-dive. But while some value shares have rebounded, devastation continues to be the watchword in the growth category, market indexes show.

The Russell 1000 Growth Stock Index has dropped 54 percent from the record peak it set March 23, 2000. The Nasdaq, a proxy for such high-growth categories as health care, biotechnology and computer technology, has been hit even harder. From its March 10, 2000, record, the Nasdaq has dropped more than 70 percent. While these declines erased billions of dollars from consumers' retirement accounts and brokerage statements, it was the one-two punch of accounting scandals at Enron Corp. and WorldCom Inc. - both former investor favorites - that drained away the last vestige of investor trust in growth stocks, experts say.

The result: Instead of growth stocks rallying with the economy's rebound, they have continued to decline.

"There's been a `disconnect' between the stock market and the economy," said David M. Citron, a partner with Wealth Management Services in Towson.

When that will change is anybody's guess. Many analysts see nothing on the horizon to stop the market's overall slide or to restore investor confidence in growth stocks. Some even foresee the Standard & Poor's 500 index - down 38 percent from its March 24, 2000, all-time high - falling another 40 percent to 50 percent.

While not quite that bearish, mutual fund manager John Hussman said U.S. stocks as a group remain substantially overvalued because of troubling trends: Capital spending remains low, federal-spending and U.S. trade deficits are widening, and the U.S. economy is getting weaker instead of stronger as most investors believe.

`Further declines'?

"Investors should allow for the possibility - should not rule out the potential of - substantial further declines" in share prices, said Hussman, portfolio manager of the Ellicott City-based Hussman Strategic Growth Fund. "That's not a forecast ... but no matter how you slice it, stocks are not a great value here."

But the catalysts that spawn bull markets are rarely foreseen, said John H. Laporte, who has managed the T. Rowe Price New Horizons small-stock growth fund since 1987. So, investors have to look at the current low valuations of proven growth firms, and at the history of market recoveries, to understand that now is the time to invest in growth stocks, Laporte said.

Laporte said that coming out of a recession, the shares of smaller growth firms (those with maximum market values of about $1.5 billion) outperform small-company value stocks 80 percent of the time. That hasn't happened yet, he said, but very likely will. Small-cap value stocks are up 50 percent from their lows. As those shares advance until they are no longer bargains, investors will begin to see just how cheap that the growth stocks have become, according to Laporte.

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