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Three Solid Funds Left Behind in Growth's Rally

Why are these large-growth funds still lagging?

Through mid-September, 2007 has been the year of growth stocks' rebirth. After seven consecutive calendar years in which value outperformed growth, the leading diversified domestic-stock fund categories this year are mid-growth, large-growth, and small-growth (in that order). Growth's rebound has been driven by the now-narrow gap in valuations between companies with highly cyclical businesses and leveraged balance sheets, and firms that generate substantial profit growth due to competitive advantages. (The latter group typically trades at a significant premium to the former.) And as interest rates have generally risen--despite the Federal Reserve's rate cut on Sept. 18--companies with shakier finances have found it more expensive to borrow. On a related note, rising rates helped bring on the cooling of the housing market, and issues with lower-quality mortgages have hit the financial sector (a favorite of value investors).

Yet despite the recent reversal, some of the large-growth funds that have fared worst in recent years--funds that prefer financially sound companies cranking out steady profit growth year after year--have continued to lag their rivals this year. That's because investors have instead turned to rapid growers with higher price multiples, often within technology and Internet-related areas. For example,  Research in Motion (RIMM), which makes the BlackBerry, and Internet retailer  Amazon.com (AMZN) have enjoyed huge gains this year. We wonder how long this trend will last. If the U.S. economy's recent hiccups are a harbinger of a prolonged slowdown, investors may become less willing to pay up for such high-octane fare (and the firms' rapid earnings growth could slow, too). That in turn could lead to a flight to the "quality" firms that the lagging growth funds below tend to favor.

Certainly, there are some aggressive-growth funds that are fine long-term choices, but we think the following funds are attractive contrarian plays. Each one lagged its typical large-growth rival in 2003 (the first year of the post-bear market rebound, and when speculative firms had their best year since 1999), and has lagged again for the year to date through Sept. 19, 2007. (Each also lagged for most of the intervening years.) But although they haven't been in the market's sweet spot lately, these funds stand to benefit when financially sturdy, growing franchises return to favor. Each boasts veteran managers with sensible, proven approaches and moderate costs. (For our take on several other funds that are lagging their rivals this year, check out senior analyst Gregg Wolper's recent column.) It's worth noting that two of the three funds below don't invest heavily in mega-cap firms, which often sport a steady profile due to their sheer size and dominant market share within their industries. These funds have simply found companies across the market-cap spectrum that have kept competitors at bay and managed their finances well.

 Jensen Fund (JENSX)
This offering is the poster child for the steady-eddie investing approach. Its management team employs a very stringent screen before it will even consider a stock for purchase: The company must have generated a return on equity of at least 15% for each of the past 10 years. That criterion narrows the fund's universe to less than 200 stocks. From there, management builds a portfolio of about 25 holdings that have solid long-term prospects and sell at substantial discounts to the team's estimates of their values. Management then holds on for the very long haul; portfolio turnover is often in the single digits. Its approach eliminates most companies subject to commodity-price swings (such as energy firms) or short product cycles (including most tech firms). Because the fund looks far different from most of its large-growth rivals, its relative returns are quite streaky, so only patient investors need apply. But the fund boasts fine risk-adjusted returns over the long term, and its aftertax returns are excellent, too.

 Calvert Social Investment Equity (CSIEX)
This fund boasts one of the most experienced managers in the socially conscious investing niche. Lead skipper Dan Boone has been at the helm of this fund for nine years and has worked for subadvisor Atlanta Capital Management since 1976. He and his team favor companies with many of the traits we discussed above: a history of solid earnings growth, healthy balance sheets, and well-established business franchises. (Their picks must also pass Calvert's social screens, which exclude alcohol, tobacco, gambling, and weapons companies, as well as those with poor environmental records.) This approach has caused the fund to lag through much of the post-bear market rally, and this year, steadier fare such as  Colgate-Palmolive  (CL) and former growth darling  Microsoft (MSFT) have held the fund back. However, investors were served quite well in the bear market here, and the fund's record over the whole of Boone's tenure is superb.

 DWS Capital Growth (SDGAX)
We wouldn't have recommended this or any other DWS fund a year ago. Its advisor, Deutsche Asset Management, was involved in the market-timing scandal and just settled with regulators in December 2006. However, the firm has taken enough positive steps to eliminate serious doubts about its commitment to shareholders. As for this particular fund, it's managed by an experienced team that put up fine returns in a six-year stint at the now-defunct Mason Street Growth before taking over this fund in late 2002. Lead manager Julie Van Cleave and company do own a slug of energy stocks, but they stick almost exclusively to huge, well-established firms across all sectors. Thus, the fund's top 10 holdings include both energy-services provider  Schlumberger (SLB) and more-typical growth fare such as  Pepsi (PEP) and  GE (GE). The team has posted subpar returns thus far on this fund (their tenure began about the same time as the post-bear market rally), but their previous charge held up quite well in the bear market, and we expect their current picks to look better when the economy slows.

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