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Course 402
Shades of Growth

Introduction

Not everyone loves a sale. After all, sales can be messy and tiring and you can pick up some real duds along the way, whether it's a sale on shoes or refrigerators or an old house that has dry rot underneath the hardwood floors.

Value and growth are often considered opposites in investing, and for good reason. Most growth managers are more interested in a company's earnings or revenues and a stock's potential for price appreciation than they are in finding a bargain. Thus, growth funds will usually have much higher average price/earnings and price/book ratios than value funds, as the managers are willing to pay more for a company's future prospects. Value managers want to buy stocks that are cheap relative to the company's current worth or some other benchmark.

Of course, growth managers have different styles, just like value managers do. And not surprisingly, those styles have a big effect on how a fund performs and how risky it is.

Earnings-Driven

The majority of growth managers are earnings-driven, which means they use a company's earnings as their yardstick for growth. If a company isn't growing significantly faster than the market average or its industry peers, these managers aren't interested.

Within this earnings-driven bunch, momentum managers are by far the most daring. Momentum investors buy a rapidly growing company that they believe will deliver a quarterly earnings surprise or other favorable news that will drive the stock's price higher. Managers who follow this style try to buy a stock just prior to a positive earnings announcement (that is, when a company announces that its earnings are higher than Wall Street analysts predicted) and sell it before it misses an estimate (that is, when its earnings fall below what analysts thought they would be) or has other negative news. Momentum managers pay little heed to stock prices. Their funds, therefore, can feature ultra-high price multiples. They also tend to have high annual turnover rates, which can make for big capital-gains payouts and poor tax efficiency. Some prominent momentum funds include Turner Midcap Growth TMGFX, Brandywine BRWIX, and American Century Vista TWCVX.

Some managers seek earnings growth in a different way. Instead of searching for stocks with the potential to surprise during earnings season, these managers seek stocks that boast high or sustainable yearly growth rates. Although some funds will look for high growth rates higher than 20% (and will often pay up for such performance), other, more moderate earnings-growth-oriented managers look for stocks growing in a slow but steady fashion. The slow-and-steady group usually buys blue-chip stocks such as Wal-Mart WMT and Oracle ORCL. As long as these stocks continue to post decent earnings, slow-and-steady managers tend to hold on to them. Steady-growth funds often have more modest price ratios than their peers. But when reliable growers take the lead, these funds endure as much price risk as the more aggressive funds. Funds known for following this moderate-earnings-growth strategy include American Funds Growth Fund of America AGTHX and Fidelity Blue Chip Growth FBGRX.

Revenue-Driven

Of course, not all growth companies have earnings. In particular, younger companies may be unprofitable for years until their businesses reach critical mass. Some growth managers will buy companies without earnings if the companies generate strong revenues. (Revenues are simply a company's sales; earnings are profits after costs are covered.) Because there is no guarantee that firms without earnings will ever turn a profit, this approach can be risky.

Growth at a Reasonable Price

Managers who seek growth at a reasonable price (GARP) try to strike a balance between strong earnings and good value. Some managers in this group find moderately priced growth stocks by buying the rejects of momentum investors; often, these stocks have reported disappointing earnings or other bad news. GARP managers also look for companies that have been ignored or overlooked by market analysts and that are therefore still selling cheaply. Like value investors, GARP investors try to find companies that are only temporarily down and out and that have some sort of catalyst for growth in the works. Because many GARP managers are sensitive to high price tags, this group of growth funds often features lower-than-average price multiples than the flat-out growth funds we discussed in the preceding section. As a result, these funds can land in the blend column of the Morningstar Style Box. GARP funds also tend to have lower turnover rates than pure-growth funds and are therefore generally more tax-efficient than more aggressive growth offerings. Prominent GARP funds include Fidelity Contrafund FCNTX and American Funds New Economy ANEFX.

Mixing It Up

Few managers stick to just one kind of growth strategy. Instead, most blend a variety of stock-picking approaches. Fidelity Large Cap Stock FLCSX, for example, owns both steady growers and more economically sensitive names, but management attempts to buy them when they trade cheaply relative to their growth prospects.. Thanks to this diversity, these funds can perform better than their narrower peers across a wider variety of market environments.

Quiz 402
There is only one correct answer to each question.

1 A manager following an earnings-momentum style would be most likely to sell which stock?
a. The stock of a company that has just announced strong quarterly earnings.
b. The stock of a company that has announced it will merge with another company.
c. The stock of a company that has reported lower-than-expected quarterly earnings.
2 Moderate-growth stocks such as Wal-Mart are likely to be found in which type of growth fund?
a. A fund that buys stocks featuring steady and consistent annual growth rates.
b. A fund that is willing to buy stocks that don't have earnings.
c. A value-oriented fund.
3 GARP stands for:
a. Growth and revenue pressure.
b. Growth with annual rates in excess of price.
c. Growth at a reasonable price.
4 Which one of the following funds is likely classified as a blend fund according to Morningstar?
a. A fund that follows a GARP style.
b. A fund whose stocks have an average annual growth rate of 20%.
c. A fund that buys momentum stocks.
5 Momentum strategies typically produce funds with:
a. High portfolio turnover and low risk.
b. High portfolio turnover and high risk.
c. Low portfolio turnover and good tax efficiency.
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