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Why the Biggest Gains are in Growth Stocks, Not Value Stocks

Look for companies that grow earnings faster than the overall market

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Looking at a similar chart comparing large-cap stocks to small-cap stocks (with large-caps represented by the Russell Top 200 Index and small-caps represented by the Russell 2000 Index) we find a similar pattern of under-valuation (see below). According to the Russell data, investors are currently paying about 14.6 times earnings for the largest stocks, while they’re paying 26.2 times earnings for small stocks. On average, large stocks have typically sold for more than 22 times earnings when small stocks were this richly valued, as the chart below shows.


Source: Adviser Investments, Russell Investments. Note: Red line is the average relative price-to-earnings (P/E) ratio between the Russell Top 200 and the Russell 2000 Indexes, while the blue line shows the month-to-month relative P/E ratio. Relative P/E ratio is calculated by dividing the P/E ratio of the Russell Top 200 Index by the P/E ratio of the Russell 2000 Index. Chart data from 12/31/86 through 7/31/11.

Attractive Large-Cap Growth Funds

While profit growth really defines growth stocks, it’s a different story for growth funds. Growth fund managers (as defined by style-maps or their prospectus — objectives can vary widely under the “growth fund” label) may be looking for companies where profits are currently growing at breakneck pace, or for companies whose assets are so undervalued that market recognition of that value may generate strong price appreciation. Either way, above-average growth is what matters.

When we evaluate a growth fund, we look for the ability to power a portfolio by producing long-term gains that can be banked five, 10, 20, or even 40 years into the future. Often, those gains come with lower current income, which means greater tax efficiency for investors with taxable accounts.

Between Fidelity and Vanguard, as well as certain other fund families, we’ve identified and invested alongside some of the best large-cap growth managers running funds today.

Within Fidelity’s fund universe, we include Will Danoff’s Fidelity Contrafund (MUTF:FCNTX) or Matthew Fruhan’s Fidelity Mega Cap Stock (MUTF:FGRTX) in certain client portfolios. Danoff has run Contrafund since 1990 with a broad contrarian mandate–choosing companies that go against the grain or are underappreciated by investors. While he has the freedom to choose among growth and value stocks large and small, Danoff has historically stocked the portfolio with large-cap growth names. At Mega Cap Stock, Fruhan invests in the largest, best-known companies in the U.S., mainly picking companies found in either the S&P 100 or Russell Top 200 indexes.

Within the Vanguard family of funds, we’ve been long-time believers in the PRIMECAP Management team, which runs the PRIMECAP (MUTF:VPMCX) and PRIMECAP Core (MUTF:VPCCX) funds in the large-cap growth space. Unfortunately, if you don’t already own these funds, they are closed to new investors. However, PRIMECAP Odyssey Growth (MUTF:POGRX), a near clone of PRIMECAP, and PRIMECAP Odyssey Stock (MUTF:POSKX), launched around the same time as PRIMECAP Core and run in the same style, are still open. The PRIMECAP team follows a growth-at-a-reasonable-price philosophy, meaning that they are likely finding great values in growth stocks these days.

A Vanguard option that remains open to new investors is Don Kilbride’s Vanguard Dividend Growth (MUTF:VDIGX), which invests in companies that have shown a commitment to growing their dividends. Kilbride’s strict investment discipline has produced a concentrated, large-cap portfolio that’s generated market-beating returns since he took charge in 2006. Unlike the other growth funds we’ve spotlighted, Dividend Growth investors benefit from both the potential for capital appreciation as well as a steady stream of income (the fund pays out distributions semiannually).

The pendulum between growth and value, and small-cap and large-cap is constantly on the move. In today’s environment, we think conditions favor large-cap growth stocks, and have included them in our clients’ portfolios by investing in some of the funds mentioned above. While we believe in a diversified approach across multiple capitalization ranges and styles when it comes to portfolio construction, it’s gratifying to know that key components of our clients’ portfolios are in great position to achieve long-term growth, especially in light of the recent uncertainty in the markets.

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