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  1. Large -Growth Stocks Still Have Room to Run

    Fears of past market crises have investors selling the category despite its wide margins of safety and outperformance over its blend and value counterparts, says Morningstar's Shannon Zimmerman.

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Growth on a Roll

Growth stocks have paced this year's market, especially among large caps.

Shannon Zimmerman, 10/04/2012

So far in 2012, big has been beautiful, at least among U.S. stock funds. Indeed, although they've experienced significant outflows this year, the large-growth, large-blend, and large-value peer groups sit atop the category performance tables for the year to date through Sept. 30. Growth has been the clear winner. A gain of roughly 16% for the average large-growth fund surpasses the large-blend and large-value norms by 1.7 and 2.5 percentage points, respectively.

The picture is mixed among mid-cap offerings--the mid-growth and mid-value averages both hover near 13%--but growth has also led the way among small-cap funds. The margin of victory hasn't been as wide in that part of the market. Nonetheless, the typical small-growth fund has surpassed the average small-blend offering by roughly 80 basis points. It has bested the small-value norm by 1.5 points, too.

Large Growth on a Roll
For investors of a certain vintage, it may come as a surprise to learn that, in addition to booking a fine 2012 thus far, the large-growth category now holds sway over large-blend and large-value peers during the three-, five-, and 10-year trailing periods as well. In the aftermath of the market's meltdown in 2000, large-growth funds--highfliers during the tech and Internet-led rally of the late 1990s--became chronic underachievers, lagging typical large-blend and large-value funds by 17 and 43.5 cumulative percentage points in January 2000 and December 2008. In 2009, though, the category handily surpassed both peer groups in dramatic fashion. It sailed past the latter by 11.6 percentage points and bested the former by 7.5 points.

Unfortunately, investors may be working under the old mental model (that is, early 2000s). Large growth has been the most redeemed category during the past five years. One might view this as a sign of risk aversion following a disastrous 2008 for the peer group and broadly consistent with the trajectory of fund flows on an industrywide basis: The sums flowing into fixed-income vehicles have swamped those into equity funds for some time now.  

Yet a closer look complicates that picture. Much of the assets that have come into more-buttoned-down fixed-income peer groups appear to have been yanked from even-more-cautious money market funds. And investors' appetite for risk has been evident from the sums they've plunked down on emerging-markets stock funds and, in a mad scramble for yield, higher-risk fixed-income vehicles as well, including those that focus on high-yield bonds and emerging-markets debt.

Margin of Safety
For some money managers, though, large-growth has become fertile terrain for stock selection. After a protracted period of underperformance--recent results aside, the typical large-growth fund continues to lag the large-blend and large-value norms in the 15-year trailing period--the growth end of the market's valuation spectrum offers a relatively attractive fishing hole for managers who require wide margins of safety and who favor firms whose share prices reflect steep discounts to estimated intrinsic value.

Bill Nygren's concentrated, best-ideas vehicle, Oakmark Select OAKLX, provides an example. The fund has lately tilted toward the growth end of the market's valuation spectrum, with approximately 42% of assets invested in firms residing in the growth column of the Morningstar Style Box. Just 20%, meanwhile, is parked in stocks that mesh with the criteria that match our definition of value.

Make no mistake: As with each of Oakmark's funds, the composition of Oakmark Select's portfolio doesn't reflect any kind of top-down design. Nygren doesn't adhere to a particular area of the style box but rather to a bottom-up strategy focused tightly on company-specific fundamentals and valuations. Oakmark enjoys a strong reputation for value investing, but it is not a traditionalist about it. Any company can be a contender for an Oakmark portfolio as long as it meets the managers' financial health and business growth requirementswhile trading at a substantial discount to estimates of intrinsic value.

As of their latest portfolios, the fundamentalist value hounds at the helms of Sequoia SEQUX and Weitz Value WVALX share Nygren's growth tilt. Given those managers' bottom-up approach to stock selection, their funds offer good illustrations of what may be driving growth's outperformance this year. If bottom-up, cheapskate investors like Nygren and the teams at Weitz Value and Sequoia--all of whom can be particularly exacting when it comes to considering a company's share price relative to its prospects--have backed their way into a substantial stake in growth stocks, it's likely because that's where some of the market's biggest bargains, and widest margins of safety, are to be found.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.

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