Maybe it's time to buy large-cap growth funds

High-quality companies, from Pfizer to Citigroup, are selling at relatively cheap prices after five-year downward slide

Your Money

July 24, 2005|By Michael Oneal

You know a consensus is building in the stock market when the pros start parroting the same slogans. This summer's mantra: "Quality is on sale."

From Cisco Systems Inc. to Pfizer Inc. to Citigroup Inc. to General Electric Co., large, brand-name growth companies are considered priced to move.

Investors are starting to wake to this happy circumstance, having already driven the prices of many of these high-quality companies off their rock-bottom lows. But several market watchers believe there's still time to get in.

They predict this may be one of those fundamental market shifts that can last for several years.

"The train may be getting ready to leave the station," said Larry Puglia, manager of the T. Rowe Price Blue Chip Growth Fund. But, he added, "if everyone's on board already it's not evidenced in the stock prices."

Puglia could easily be accused of bias, given that he runs a mutual fund that specializes in these large-capitalization growth stocks. But many value managers - the kind who make their living ferreting out undervalued, beaten down stocks - are also crowing about growth stocks.

"It's an upside-down world today," William Nygren, the co-manager of Chicago's value-oriented Oakmark Fund, told investors recently. "Momentum investors have moved from large-cap growth to the mundane businesses value managers often own. ... It's not often that the best businesses are also the best values, but when it happens, we want to take advantage of it."

In the years building up to the market bubble's pop in 2000, fast-growing large caps like Cisco, Dell Inc. and Wal-Mart Stores Inc. propelled growth managers like Puglia to huge gains. Since then, however, the highest fliers have fallen the furthest in a classic market reversal. Nygren explained that cyclical companies and small caps have shown more earnings growth than the big, steady blue chips as the economy has improved over the past few years. Momentum has built behind those stocks, leaving the big companies in the dust.

According to Chicago-based fund analyst Morningstar Inc., large-cap growth funds have lost an average 8.43 percent a year for the last five years while funds that focus on the small, value-type companies that languished in the late 1990s have gained more than 14.74 percent on average.

What's left among the big companies are many bargains - value-priced market leaders with strong brands, powerful earnings momentum, piles of cash and strong dividend yields.

"You don't have to pay up much for growth these days," said Russell Kinnel, Morningstar's director of mutual fund research.

Wal-Mart is a good example. In the late 1990s, momentum investors piled into the world's largest retailer, driving its price to 50 times expected earnings -- almost double the market average. At the time, it seemed as if the stock might never be affordable again.

But now Wal-Mart trades at about 18 times projected earnings for the next 12 months, just a few points above the benchmark Standard & Poor's 500 average, despite the fact that the retailer remains one of the dominant companies in the world and its earnings have about doubled over the last five years.

If Wal-Mart were an average company, this would make sense. But Nygren points out that there is nothing average about Wal-Mart and no reason to believe its dominance of the retail industry is going to wane anytime soon.

"We think buying above-average businesses at average prices is just as much value investing as is buying average businesses at below-average prices," Nygren said.

Wal-Mart, he added, "sounds like a value stock to me."

Puglia at T. Rowe Price said that good large-cap growth companies are always desirable to own. They tend to have predictable earnings growth and high returns on equity. They dominate their markets and generate lots of cash. They tend to use that cash to benefit shareholders - either by dividends, stock buybacks or acquisitions. All of this is especially true today. Puglia said the companies of the S&P 500 have more free cash as a percentage of revenue than they've had since 1954.

Consider General Electric and Dell. Puglia likes both because each generates more free-cash flow per share than net earnings, a sign of the underlying power of its business. GE also has a dividend yield of 2.5 percent, well above the broader market's yield. Yet despite characteristics that make it much more attractive than the average S&P company, GE trades at around 18.2 times the next 12 months' projected earnings, close to the market multiple.

As for Dell, the stock has moved up nicely since late April. But it still trades at just 16 times its free cash flow per share, versus an average of about 20 for the broader S&P 500, Puglia said. Dell is priced higher than the market as a multiple of its earnings, but the spread is relatively narrow given its enviable earnings record, hoard of cash and perennial ability to outclass its rivals in a bitterly competitive industry.

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