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What's the Best Way to Play a Large-Growth Rally?

You'll be surprised at which funds are poised for a large-growth rebound.

John Coumarianos, 04/04/2006

Morningstar analysts have been wondering when the tide will turn--that is, when the large-growth category will come back into favor.

Small caps turned into the darlings after the tech meltdown beginning in 2000, and they haven't suffered for investor affection ever since. In fact, the first quarter of 2006 shows a continuation of this trend, with small- and mid-caps leading the way and larger caps bringing up the rear. One change that we've noticed over the past six months or so is that small growth and mid-growth are beginning to outstrip their value counterparts. This hasn't happened in large-cap land yet, where value still rules the roost.

Nevertheless, we don't think large-growth stocks can remain neglected forever, and we've been hearing many fine managers say that large-growth stocks haven't been this cheap in a long time.

But is owning a large-growth fund the best way to play a rotation back to large-growth stocks? The fact is that many of our favorite value-oriented and blend funds have been picking up fallen growth angels lately. Many high-quality growth businesses with stagnating stock prices are appearing attractive to investors who ordinarily look for precipitous price drops or companies with temporary problems.

In other words, the combination of steady earnings growth and stock-price stagnation has caused some growth stocks to "grow" their way onto value and blend investors' initial screens. In this week's column, we'll discuss some of the most compelling nongrowth funds that have begun to trawl large-cap-growth waters. Their holdings may surprise you.

We should note, however, that none of these funds, with the possible exception of the Vanguard offering, has much technology exposure. This means they would lag in a tech-led rally, similar to the kind we saw in the late 1990s. However, barring an outright return to the tech-led frenzy of that time, these value and blend funds could capture a rebound of slower growth large- and mega-cap stocks quite well.

American Funds Washington Mutual AWSHX

This steady Eddie value fund owns growth-oriented names such as Microsoft; pharmaceuticals Abbott Laboratories ABT, Bristol-Myers Squibb BMY, and Merck MRK; retailer Wal-Mart; and global package delivery service United Parcel Service UPS.

Despite the fund's girth and recent sluggishness, analyst Paul Herbert notes that its positions in high-quality, profitable stocks make it easy to argue for a rebound. Herbert also reminds us that the fund fared well in the large-cap rallies of 1997 and 1998. The late 1990s, of course, were heady times for growth stocks.

T. Rowe Price Equity-Income PRFDX

This value stalwart's veteran manager, Brian Rogers (who was also recently named T. Rowe Price's chairman), has jammed Microsoft MSFT, Wal-Mart WMT, Coca-Cola KO, Anheuser-Busch BUD, and Time Warner TWX into his fund. This isn't extreme growth fare, but these highly profitable businesses don't exactly sport single-digit P/Es either.

Morningstar analyst Christopher Davis remarks that Rogers hasn't abandoned his value approach by owning these names; rather, Rogers is continuing his pattern of "[gravitating] to out-of-favor stocks trading cheaply relative to their historical price multiples." Right now, it's growthier names that fit that bill.PAGEBREAK

Vanguard Primecap Core VPCCX

This large-blend fund has had a long-standing interest in the health-care and biotech arenas and right now it's loaded up with pharmaceuticals such as Eli Lilly LLY, Novartis NVS, Pfizer PFE, and GlaxoSmithKline GSK. It also owns medical-device-maker Medtronic MDT and biotechs Biogen Idec BIIB and Chiron CHIR. Finally, it owns optical-equipment-makers Corning GLW and Agilent Technologies A, semiconductor manufacturer Texas Instruments TXN, and software-maker Microsoft.

Although analyst Christopher Traulsen characterizes the veteran team that runs this fund as favoring unit sales growth (a frequent tack of growth-leaning managers) and as being more aggressive than most blend managers, the team's previous and unsuccessful foray into airline stocks shows that it will go dumpster-diving to find value. This gives its current holdings even more significance; clearly, it thinks high-quality growth companies are on sale.

Oakmark OAKMX and Oakmark Select OAKLX

Next on our list of value-conscious funds whose managers are finding opportunities in growth stocks is Bill Nygren. Some of the stocks populating the portfolio of Oakmark Fund are Home Depot HD, Liberty Media L, Wal-Mart, and Abbott Laboratories. Although Nygren began accumulating these stocks early, some of the names that Nygren owns, such as Wal-Mart, generate the kinds of steady profits that investors cannot ignore forever.

Nygren is also media-heavy in his other, more concentrated charge, Oakmark Select, and owns pharmaceutical Bristol-Myers Squibb there as well.

Fidelity Dividend Growth FDGFX

This fund has fallen on hard times. It is in the bottom quintile of the large-blend category for performance over the trailing three years through mid-March 2006. Nevertheless, despite some bad moves by veteran manager Charles Mangum, Morningstar analyst Greg Carlson argues that investors might be leaving the fund at exactly the wrong time. Among Mangum's growthier picks that might leave the fund positioned to bounce back are Cardinal Health CAH, Microsoft, Cisco Systems CSCO, Wal-Mart, Intel INTC, Symantec SYMC, and Dell DELL.

Additionally, at $16 billion in assets, this chunky fund appears rather svelte compared with its bloated counterpart, Fidelity Contrafund FCNTX.

John Coumarianos is an analyst with Morningstar.

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