Big Growth A-Go-Go

Since the 2000 tech crash, large-cap growth stocks have lagged their counterparts by historic proportions. Time to buy.

Big earnings boosts. Big market valuation increases. Big price/earnings multiples. Big futures. That's what large growth stocks are all about. But these issues also are big on volatility. They have this Icarus-like trait of flying high, then plunging. Lately, however, they are showing signs of heading up once again. If so, now is a good time to get back in, while large growth shares are still relatively cheap.

Of the 62 different stock fund categories that Lipper researchers track, large-capitalization growth is ranked sixtieth over the past five years, returning a paltry average annual 2.3%. Compare this with almost any other fund area over the same period--small-cap value (on the other end of the investing spectrum) at 15.3%, midcap value 14%, even small-cap growth 7.7%. More stunning still: Of the 35 different bond classes Lipper has, including munis, large-cap growth has lost out to all of them.

To John Jostrand, manager of William Blair Growth Fund, a smallish ($256 million assets) large-cap growth portfolio, this means the category has never been a better buy. "Everything in the market is cyclical, and big growth stocks again will have their day," says Jostrand, with no small self-interest but a lot of common sense.

He recalls a recent investment conference in Chicago, Illinois at which he was one of three panel speakers. "As a growth guy," he told the audience, "I have not been asked to speak on an investment panel in six years." He got a good laugh.

Jostrand, 52, is a longtime student of the market, and he is quick to give us a history lesson. Over the last 25 years return for large-cap growth funds is a solid annual 11%, within a percentage point or two of the five other broadest-ranging fund categories. So, he reasons, if you believe that returns regress to the mean, large growth must outperform hugely in the future to keep in line with historical averages.

Runs tend to go in five- to seven-year spurts. From 1995 to 2000, during the great tech mania, large growth funds with stocks like Cisco Systems and Dell raced ahead, averaging a 29.5% annual return. The usual pattern is that growth performs the best early in a new market cycle, hence four years into this uptrend it seems that opportunity has passed.

On the other hand, market behavior has been anything but typical over the past ten years. The violent end of the tech boom in 2000 meant that large-growth stocks were so badly mauled that they would take a long time to mend. That's why large-growth believers like Jostrand take heart that such a day may be at hand.

A further boost to large growth now is the waning of people's fears over terrorism. Investors may be living in a fool's paradise, yet as long as the fear level is down, the optimism necessary for large growth has a better chance of taking hold.

Another impediment to a bull run on large growth in the U.S., Jostrand contends, has been legal fear--namely concerning the Sarbanes-Oxley law, passed in the U.S. in 2002, which mandates strict accounting and executive liability for corporate decisions. Result: Many big U.S. companies have become overly cautious. Management has paid less attention to the task of expanding the business.

One indication of that is the huge amounts of cash piled up on balance sheets. Cash as a percentage of the largest 1,500 companies' assets is 9.7%, nearly double that of a decade ago, and stands at a generational high. This has depressed return on equity and comes hand in hand with a low level of new product introductions, the growth engine for big companies. "Cash is a nonearning asset, especially in this low-rate environment," says Jostrand. Cash earns something--maybe 3% aftertax--but that's not what growth investors are paying for.

Meanwhile, what large growth stocks make the most sense? Jostrand prefers companies with above-average ROEs (his portfolio's is 23%, to the S&P's 20%). He also likes to see low debt levels (his fund's long-term debt to capitalization is 27%; the S&P's 48%) and above-average revenue from new products, which indicates a company has been investing its cash in future expansion.

An example is Amgen, the big biotech firm (market cap: $85 billion), a font of new products. It gets 42% of its revenues from products introduced in the last five years. Among the promising ones are Vectibix, the colorectal cancer treatment, and denosumab, for postmenopausal osteoporosis. Further, the company, 29% debt-capitalized, returns 15.4% on equity.

Another company in Jostrand's portfolio is Taiwan Semiconductor, with half of its revenues now coming from new products. The chipmaker, headquartered in Hsinchu, Taiwan, has negligible debt and returns 32.4% on equity. At a recent $1.89, it is 13% off its 52-week high and a strong Jostrand buy.