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

When Size Matters

When markets began slipping in 2000, large-growth shares fell out of favor. For seven years, investors shunned growth names and embraced value stocks. Then, with problems in subprime mortgages making headlines last summer, growth champions gained attention. Seeking safety, investors fled to familiar companies with reliable earnings. During July 2007, the large growth funds tracked by Morningstar edged ahead of large value. When Wall Street rallied in September, growth stocks surged. For the first 11 months of 2007, large growth funds returned 13.5 percent--outdoing large value by more than 10 percentage points.

Now there are good reasons to believe that large growth can continue leading the markets. The stocks that dominate the category include major exporters--companies that are benefiting from the rapid growth in overseas economies. Such multinationals are getting a boost from the fall in the dollar, which increases the value of sales recorded in foreign currencies. Even if large-growth funds sputter, they are still worth owning. Solid funds in the category hold the kind of reliable blue chips that can form the core of most portfolios.

To find the best large-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 1,870 contenders to 53. The finisher with the top five-year returns was Fidelity Growth Company, but that fund was closed to new investors. Other strong performers were Ivy Large Cap Growth and Mainstay Large Cap Growth. In the end, we awarded the title to Brandywine Blue, which had high alpha returns that were among the best.

Brandywine beat the competition by seeking companies that are increasing earnings at an annual rate of at least 20 percent. Portfolio manager Bill D'Alonzo favors stocks that are poised to exceed Wall Street's earnings estimates. In some cases, the companies are about to launch a new product or improve productivity--developments that are not yet reflected in share prices. To find information that has not been recognized on Wall Street, Brandywine analysts interview a company's customers and competitors.

While the fund often owns stocks for several years, D'Alonzo looks for businesses that can show a quick earnings spurt. "We are focused on developments that are likely to unfold over the next six or nine months," he says. "The idea is to make the best use of our assets by holding the most promising stocks."

While D'Alonzo wants fast growers, he is not willing to pay astronomical prices. The average stock in the portfolio sells for a price-earnings multiple of 19-times estimated 2008 earnings. No matter how attractive a stock may appear, D'Alonzo does not pay more than 35-times estimated earnings.

Besides seeking strong growth, Brandywine favors companies with solid balance sheets and at least $3 million in after-tax income. These requirements have helped keep the fund away from high-flyers that are about to crash, and Brandywine tends to outperform competitors in downturns. Because it avoided profitless Internet companies in the 1990s bull market, the fund returned 6.8percent in 2000--a year when the S&P 500 lost 9.1 percent.

In 2002, another down year, Brandywine outdid the S&P 500 by 8.6 percentage points. The fund accomplished the feat by favoring health-care and food companies which had solid earnings and little debt. "Our investment discipline requires us to stick with companies that have clean accounting and reasonable P/Es," says D'Alonzo. "That kept us from owning Enron, WorldCom, and some of the other high-profile companies that ran into trouble."

A winning holding has been Hewlett-Packard, which the fund bought in 2006. At the time, a new CEO was cutting costs and focusing on improving printer hardware. Since then, the changes have proved fruitful. Earnings have been growing at a 26 percent annual rate.

Another holding is Goodrich, a maker of electronics systems and other equipment used in commercial and military aviation. The company enjoys strong margins for the landing gear that airlines must purchase to replace original equipment on aging planes. Earnings have been increasing at a 38 percent rate, yet the shares sell for a trailing multiple of 20. "The investment community's radar has failed to fully capture how increased air traffic will boost already strong demand for repair work on existing jets," says D'Alonzo.

Beginning in 2000, Brandywine had limited holdings in technology. But in the past year, the fund has been overweight the sector. D'Alonzo has been particularly keen on VeriSign, which is responsible for registering domain names on the Internet. The company recently announced a fee hike for registering names. In addition, VeriSign is cutting costs, which should help earnings grow by more than 30 percent in 2008, D'Alonzo says.

With the market favoring growth stocks in recent months, Brandywine's technology shares have been climbing. During the first 11 months of 2007, the fund returned 21.0 percent--more than 14 percentage points ahead of the S&P 500. But whether or not growth remains in favor, Brandywine Blue's disciplined style should enable the fund to maintain its track record for delivering competitive results in bull and bear markets.

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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