Analysts spot opportunity as growth stocks outperform value stocks

~ The performance could signal a shift in the longer-term investment cycle.

Here's something to think about as you rebalance your mutual fund portfolio at the end of the year: Growth stocks, largely out of favor for the last several years, outperformed value stocks in November and may be positioned for a comeback in 2006.

Professional investors and fund managers have been finding attractive opportunities in growth for months now; in fact, growth has been performing well relative to value since May, said Stephen Wood, portfolio strategist with Russell Investment Group. This could signal a shift in the longer-term investment cycle.

"In the past five years, value has done OK, but the real story is that growth has been getting clobbered," Wood said. Now that it's started to take off, he added, "We don't think growth will roll over and go belly up. Once a style comes into favor, it tends to stay there for years. You just had the fifth year of a value cycle. Do you get a sixth year? You could. But I'm not convinced we'll see it."

When financial professionals speak of growth investing, they usually refer to stocks with strong earnings and revenue growth, or growth potential. This strategy differs from value investing, which seeks profits by accumulating shares of companies that are underpriced by fundamental measures. The theory behind value investing is that stocks like this won't stay unloved forever.

During the tech boom, value investing was a tough strategy to follow; growth was king. But in the aftermath of the bubble, the perceived safety and lower volatility of value investing held wide appeal once again. With traditional value sectors, such as energy and real estate, dominating market returns in recent years, many portfolios have taken on a value tilt, whether investors realized it or not.

In November, good performance among tech stocks helped the broad-market Russell 3000 Growth Index post a 4.4 percent gain, compared to a 3.4 percent advance for the corresponding Value Index. The Value Index still holds the lead for the year, but its advantage has narrowed to less than a percentage point: It was up 6.34 percent for the first 11 months of 2005, compared to a 5.49 percent rise for the Growth Index.

This doesn't mean you should dramatically realign your holdings. But if your portfolio is overweight in value funds and stocks, it is probably a good time to reassess your exposure to growth. Fund flows suggest our tolerance for risk is already on the rise. According to TrimTabs Investment Research, of the $2 billion that poured into domestic equity funds the week ended Dec. 7, more than a third went into aggressive growth.

Another potential influence on the outlook for growth is monetary policy. The Federal Reserve appears likely to continue to raise interest rates into the new year, which could have a dampening effect on the economy in 2006. That doesn't necessarily signal a bad year for value, but it could mean the characteristics of growth stocks will be more prized.

What is certain is that at some point, the tide will turn, said Richard Buck, managing editor of FundAdvice.com, a publication of Merriman Capital Management in Seattle. Market cycles go on for several years, and when the pendulum has been moving in one direction for a long time, at some point it will swing back, he said. For this reason, it makes sense to maintain good exposure at both ends of the spectrum.

"Will growth be the new hero in '06? We don't know, it's impossible to know and anyone who says they do know is lying and doesn't know what they're talking about," Buck said. "Is a shift going to happen? No question. Is it statistically overdue? Perhaps. Should people be investing in growth as well as value? Absolutely. People should not be ignoring those growth funds."

Over the very long term, value investing appears to have an advantage over growth, Buck noted. But market history shows that there have been long periods where value underperforms and growth is the leader. For this reason, going 100 percent one way or the other will likely lead to disappointment.

The key for small investors is to rebalance every year in a disciplined manner. For example, over the last five years you might have sold the shares of value funds that did well and bought shares of underperforming growth funds. In the short term, this might seem counterintuitive. Why buy a loser? But over the long term, you'd have the advantage of accumulating shares of growth funds cheaply. You'd automatically buy low and sell high.

You don't have to take on a lot of risk to get exposure to growth. You can have a footprint in it through a blend fund that invests in both types of stocks. The main thing is to not let your emotions dictate your allocation, or your rebalancing decisions, said Wood, of Russell.

"The human mind likes to stick with things that have done well recently, it's less painful," he said. "It's human nature to have short-term memory dominate your analysis. The biggest battle for investors to screen out how they're feeling."

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On the Net:

www.russell.com

www.fundadvice.com