From the January 2008 issue of Wealth Manager Web • Subscribe!

Growing Up

Beginning in 2000, growth stocks suffered a seven-year drought. During that period, mid-cap growth funds returned 0.1 percent annually-- lagging mid-cap value by more than 11 percentage points, according to Morningstar. But the harsh times could be ending. During the first nine months of 2007, mid-cap growth returned 16.6 percent, 10 percentage points better than mid-cap value.

Growth's revival could last much longer. Traditionally, growth and value have jockeyed for market leadership, with one sector often racing ahead while the other lags. After taking the lead, the hot sector tends to stay in front for at least three years. Now there are good reasons to believe that growth could enjoy a long run. Following years of poor performance, the average mid-cap growth fund has a price-earnings ratio of 23, a moderate figure for the group. In addition, the economy appears to be slowing. During such sluggish patches, growth stocks often excel as investors bid up the prices of the few companies that are still reporting strong earnings.

To find the best mid-cap growth choice, Wealth Manager once again turned to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the field from 681 down to 80 finalists. The top performer was Rainier Small/Midcap Equity, but it was closed to new investors. Other strong finishers were BlackRock U.S. Opportunities and Delaware American Services. But we awarded the title to Munder Mid-Cap Core Growth, which had strong returns and a relatively high alpha.

Munder compiled its record by following a cautious growth strategy. While many of its competitors emphasize such growth sectors as technology and health, Munder stays broadly diversified. Portfolio manager Tony Dong seeks to roughly match the industry weightings of his benchmark, the S&P 400 mid-cap index. "I want my utility stocks to do better than the utility stocks in the index," he says. "Our alpha comes from stock selection--not from trying to time the market or bet on sectors."

Besides staying diversified, the fund pays close attention to valuations. Dong prefers growth stocks that do not sell at stratospheric prices. Stocks in the portfolio have been increasing earnings at an annual rate of 32.9 percent--about 25 percent higher than the figure for the average competitor. But Munder has a price-earnings ratio of 21, a figure that is a bit lower than the average for the mid-cap growth category.

To find long-term winners, Dong sticks with companies that have superior businesses. In most cases, earnings from the current quarter must be higher than they were a year ago. Dong often buys stocks that are rising, but he is willing to take shares that are languishing. "A lot of investors look for the best-performing stocks," he says. "But we want the companies that are showing the best business growth."

A favorite holding is Cognizant Technology Solutions, which provides outsourcing solutions in India and the U.S. Dong figures that the stock sells for 28 times 2008 earnings. "That doesn't sound cheap," he says. "But the price is reasonable because we expect earnings to grow 32 percent in 2008."

Dong says that the shares of Cognizant and other outsourcers have been hurt because investors worry about rising wages in India. He argues that the fears are unfounded. "Cognizant is growing so fast that its margins should not be hurt by wage inflation," he says.

Another holding is GameStop, a retailer of video games and entertainment software. Despite tough competition from Wal-Mart, the specialty chain has thrived by selling a broad selection of games, including high-end choices. "They sell to the serious gamer," says Dong. "Because they carry a wide variety of game consoles, they can do well consistently--no matter which brands are hot."

An overlooked stock in the portfolio is General Cable, says Dong. This company makes wires and cables that are used to transmit power. The stock sells for a price-earnings ratio of 21, yet the earnings have been growing at an annual rate of 44 percent. Dong says that the strong growth is likely to continue because power providers around the world are rushing to expand their electrical grids.

A stock that should thrive during any economic slowdown is LKQ Corp., which refurbishes auto parts taken from wrecked cars. Big customers include insurance companies, which are pleased to acquire used equipment at prices that are sharply discounted. Earnings should increase at a 20 percent rate in 2008, even if the economy slows, says Dong. "The company buys a wrecked car for very little and then sells off the parts," he explains. "They can sell the parts for much more than what they paid to purchase the total car."

Such stocks should help Munder thrive as long as growth stocks remain in favor. But even if value re-takes the lead, the fund should do reasonably well. Because Dong keeps a tight rein on risk and stays broadly diversified, Munder should avoid huge losses. By following a cautious strategy for picking growth stocks, Dong should continue delivering steady results in a variety of market environments.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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