Wed, 10 Oct 2012
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.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. Large-cap growth stocks have been on a tear recently, but fund investors have been shunning the sector. Joining me to discuss that phenomenon is Shannon Zimmerman. He is associate director of fund analysis for Morningstar. Shannon, thank you so much for joining me.
Shannon Zimmerman: Good to be with you, Christine.
Benz: So, let's talk about large-cap growth stocks and funds they've really been leading the way.
Zimmerman: That's right.
Benz: What in your view has been driving that level of outperformance? And is that typical of what we would expect during a period of economic recovery like what we seem to be going through?
Zimmerman: To your first question, most of the fund managers who I cover are sort of value specialists, but they're also gravitating toward growth stocks, as well, which you can sort of back your way into what might be going on. If investors like Bill Nygren of Oakmark Funds, who is a very successful value investor over the long haul, has a preponderance of assets in one of his funds--Oakmark Select--in the large-growth square of the Morningstar Style Box, that probably suggests that he is seeing bigger gaps. And I should say from the outset that he doesn't do any top-down investing at all. But he is backing his way into a substantial stake in that part of the style box because that's where he is seeing the widest margins of safety. He's always looking for discounts there, and as at other value shops, as well, discounts between the market's price that's been assigned to a company, and then what [the fund managers] think that the company is actually worth.
So, why would that be? And if you look at the three-, five-, and 10-year trailing periods, right now large-cap growth actually holds sway over the large-blend and large-value stocks, which for investors of a certain age, who remember large growth being an underperforming category for so long, might come as a surprise. It's still an underperforming category over the 15-year period and that kind of go-to-the-value proposition. If you think the mean reversion is going to have impact at the level of fund style, there is a way that large-growth funds tend to catch up to the large-blend and large-value categories because still over that 15-year period, it's an underperforming category.
Benz: Let's discuss the point we are at in this economic recovery. Is this recent level of outperformance for growth stocks typical of what one would expect at a period like right now?
Zimmerman: Is anything typically anymore...
Benz: That's true.
Zimmerman: I don't know. I think that it sort of depends on the nature of the economic recovery and how confident people are in the long-run economic prospects. Typically when people are feeling confident about the future, they do tilt toward risk and toward growth and expect a higher risk premium. And that kind of comes with a territory for growth investors, as well. Then also you look at how low inflation has been for so long, again mean reversion will suggest that inflation is probably destined to tick higher, rather than lower in the foreseeable future, and that usually tilts people toward growth as well because they're looking for a better returns to kind of stave off the erosion of purchasing power. And growth stocks, at least in theory and sometimes in practice hold that promise, as well.
Benz: Even though performance has been relatively good in the large-cap growth space, investors have been selling the funds. Why do you think that is?
Zimmerman: Right. It's a good question because that's the opposite of what you typically see: When a category is doing well, investors are stampeding into it. I think that folks are still just feeling skittish about what happened in 2008, which was such a searing experience for so many investors that there is some relative caution. There is equity exposure, and then there is growth-equity exposure. And for the most part investors are leaving those funds in droves.
Benz: Even though large-cap growth stocks didn’t necessarily perform any worse than value during the downturn, that downturn coupled with the dot-com bust really soured investors?
Zimmerman: Exactly, and a distant memory of [the dot-com bust] that might be a bigger impact for investors of a certain age.
Benz: Shannon, you mentioned Bill Nygren actually having some concentration in the large-cap growth square of the style box. You've actually identified some other funds, well-known value-oriented funds that are liking this square of the style box, as well. Let's talk about some of the other ones.
Zimmerman: Well, Sequoia is one, and, like Oakmark and other value investors, they are always looking for the big gap between [price and] intrinsic value, which is just their estimate of what they think the company is actually worth. And there are various valuation metrics that they look at to do that. At Oakmark, one of the big ones is to look at what they call true business value. And I think that all of the value investors who are absolute value investors are making investments not based on whether or not a company looks cheap relative to industry averages, but whether or not it looks cheap relative to their estimate of its actual worth.
Neither [Sequoia or Oakmark] is doing anything on a top-down basis and trying to find the area of the market that's a sweet spot. But that they are backing their way into those positions, to me it's even more compelling evidence that in the large-growth square that's where you can find some of the most the widest margins of safety.
Benz: Shannon, what's your advice to people looking at large-cap growth now. This is a category that's had a tremendous run. How should they be viewing this category given its recent runup?
Zimmerman: They should be viewing it in a way that you view any area of the style box now. So you want to make sure that you have an understanding of what your current portfolio composition is before you buy the next fund or send the next round of investment dollars. But to the extent that you are perhaps underexposed to large-cap growth, I still think that there is plenty of room to run. You look at that 15-year track record, and even though large growth now, as I was saying, holds sway during the three-, five-, and 10-year periods versus value and blend, during that 15-year stretch of time, it does not. That implies that if mean reversion holds, that there is room for that category to continue to run.
Benz: But do investors necessarily need a dedicated large-cap growth fund, or could they perhaps obtain exposure in some other way?
Zimmerman: That's an excellent question. You look at just an S&P 500 Index tracker. Well, how does it get to be a blend fund? It chooses from growth and value, and then core, as well. So you may have ample exposure to growth as it stands now.
Benz: Well, Shannon, thank you so much for sharing your insights with us.
Zimmerman: Absolutely. Good to be with you, Christine.
Benz: Thanks for watching. I'm Christine Benz, for Morningstar.com.