Are Growth Funds Poised to Sprint?

Is it time for value to hand the baton to growth? The contrarian in us wants to say yes. Morningstar's large-cap growth category has lagged every domestic diversified stock fund group more often than not during the past six years. Based on performance and the idea that value won't trample on growth indefinitely, it seems reasonable to conclude that large-cap growth funds are ripe for their turn at the head of the pack.

Hold on, though, while we examine a few crucial facts. Large-cap growth funds may indeed be due for a comeback, but as a group they are not screaming buys, according to underlying fundamentals. In fact, large-cap growth funds don't look drastically different from large-cap value funds in some regards.

A Look at History
Let's rewind to March 2000, the peak of the bull market. That was the point in time when large-cap growth funds looked most different from their large-cap value counterparts. The table below shows just how different, and by how much things have changed:

Then and Now
Valuation and Growth Metrics	Large-Growth Category	Large-Value Category	Large-Growth Premium Over Large-Value
Price/Earnings, March 2000	40.13	17.82	125.20%
Price/Earnings, Sept. 2006	21.05	14.89	41.37%
Price/Book, March 2000	8.13	2.86	184.27%
Price/Book,  Sept. 2006	3.70	2.37	56.12%
Price/Cash Flow, March 2000	27.67	9.95	178.09%
Price/Cash Flow, Sept. 2006	14.43	9.63	49.84%
Price/Sales, March 2000	4.51	1.19	278.99%
Price/Sales, Sept. 2006	1.98	1.31	51.15%
Earnings growth, March 2000	24.74	10.94	126.14%
Earnings growth, Sept. 2006	29.66	20.98	41.37%
Morningstar Data

We've come a long way since March 2000. Growth stocks have had a painful trek back to reality, and value stocks have enjoyed the market's favor. Sure, growth funds still hold more expensive companies today, on average--and some premium is warranted as companies that are growing faster should logically cost more. Yet the premium managers have to pay for growth is far less than it was at the peak of the bull market. Overall, valuations, such as price/earnings and price/sales ratios, have compressed, and the earnings growth differences aren't as profound as they once were.

Fishing in Each Other's Ponds
The parallels between value and growth portfolios aren't limited to aggregates and averages. They have been noticeable at the individual fund level, too. We're seeing skippers from both sides of the value/growth spectrum crowd around many of the same stocks. Take technology, for example. Value-minded funds that we like such as  Dodge & Cox Stock (DODGX) and  Schneider Value  have been scooping up shares of former growth darlings such as  Dell . Growth investors haven't necessarily given up on those very same stocks;  Vanguard Primecap  (VPMCX) and  American Century Growth (TWCGX) have also purchased Dell shares recently. Other common tech picks include  Oracle (ORCL) and  Intel  (INTC).

Meanwhile, growth managers have increasingly tapped into traditional value sectors such as energy and targeted many of the companies that are popular with value managers. For example, oil-services firm  Schlumberger (SLB) has been the most common stock purchased in large-growth and large-value funds in recent months.

The overlap between growth and value managers isn't a complete anomaly. Value managers have to consider a company's future growth when assessing relative value measures or when modeling a firm's intrinsic worth. Likewise, growth managers have to figure out how much they are willing to pay for a company's future growth potential. But the fact that skilled fund managers are fishing in each other's ponds suggests some parity in the marketplace.

More Evidence of Parity
Morningstar's equity analysts generally concur with this idea. Based on Morningstar's price/fair value metric for ETFs, growth and value look equally attractive. This measure, which uses the fair value estimates set by Morningstar's 90 equity analysts for 1,800 stocks, indicates that both the iShares Russell 1000 Growth (IWF) and the iShares Russell 1000 Value (IWD) ETFs are trading at 97 cents on the dollar. What's more, the Growth and Value ETFs have 31% and 32% of their assets, respectively, in stocks rated 4 or 5 stars by Morningstar's stock analysts. There's thus not much of a resounding argument in favor of growth over value, or vice versa.

Fees, Diversification, and Fundamentally Sound Strategies
We're not arguing that large-cap growth stocks will never outpace value ones. In fact, they surely will at some point. But given the current basic underpinnings between growth and value funds, we wouldn't bet the farm that large-cap growth funds will come roaring back soon.

We would be willing to bet on other factors, though. As with any fund, low expenses are crucial, giving funds a lasting leg-up regardless of what style the market is favoring. In fact, Morningstar research shows that fund expenses are a meaningful predictor of future outperformance, relative to similar funds. And given how level the playing field looks today, we think that a fund's relative performance will depend more on execution and less on broad style-based themes. So in addition to focusing on cheap funds, investors should key in on skilled management teams with bold enough strategies to pull ahead. Our  Fund Analyst Picks are a good place to start.

That doesn't mean that investors shouldn't consider large-cap growth funds today. After all, growth and value funds don't look alike in all respects. Growth funds still lean more heavily on tech and health-care stocks and rely less on financials. These sector differences combined with the fact that it is nearly impossible to call a market inflection point strengthen the case for balancing growth and value stocks in a portfolio.

Morningstar.com's X-Ray tool provides a great way to see if rebalancing is necessary. The strong performance of value over growth has undoubtedly left some investors overexposed to value funds. You may find that now is indeed a good time to add to growth--not because it is about to take off, but because it's the smart long-term portfolio move to make.