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‘Growth’ was hot; ‘value’ was not

Growth funds rallied while value funds mostly lost ground in the three months ended Sept. 30, one of several significant shifts during a wild time in financial markets.

Overall, most stock funds made money in the quarter, despite extraordinary market turmoil triggered by a global credit crunch.

But if the trends underlying stock funds’ recent returns continue, investors’ portfolios could be facing a radical turnabout from what they’ve known for much of this decade.

Value-oriented stocks and funds, paricularly in the US have mostly ruled the market since 2000, as many investors sought relative safety in shares that appeared cheap based on their earnings or other measures. That’s the classic definition of value on the markets.

By contrast, many growth stocks — shares of companies whose earnings are expected to grow at an above-average pace over time — have been in the doghouse since 2000. That was the beginning of the crash in technology shares, which had long epitomized growth investing.

But look who’s back on top this year. In all three broad size categories of stocks (large-capitalization, mid-cap and small-cap), growth-focused mutual funds significantly outpaced value-focused funds in the third quarter and the nine months.

Growth-stock fund managers had been telling their shareholders for two years that a rebound was overdue.

Many market professionals say the gains in the growth sector, and the sell-off in value, reflected some simple math: As growth stocks lagged in recent years they began to look inexpensive relative to their underlying earnings.

The opposite was happening to value stocks. As the shares rose, they began to look pricey compared with earnings.

Valuations have been compressing for years between value and growth stocks, Growth just got too cheap,

Apart from valuations, the shift to growth and away from value was helped along by the midsummer market upheaval.

The credit crunch fueled by the U.S. housing sector’s woes raised doubts about the US domestic economy’s health. That boosted demand for shares of companies that seemed to have a good shot at outpacing a weak economy. THis includes companies that provide dividends.

At the same time, bank and brokerage stocks were hammered by the credit squeeze and fears of rising defaults on high-risk mortgages and other dicey loans. Financial stocks have long been one of the mainstay sectors of value investing because of their typically low price-to-earnings ratios.

Funds that focus exclusively on financial stocks were among the biggest losers in the third quarter,

Another classic value sector that has struggled this year: real estate-oriented funds, which mainly own shares of real estate investment trusts.

The rush to growth stocks was a global affair in the third quarter. Foreign large-cap growth funds were up in the quarter, on average, compared with a rise for foreign large-cap value funds,

Still, it isn’t certain that value funds will go into a long-term fade. Savvy value-fund managers may find bargains in places they wouldn’t ordinarily look.

What’s more, if the economy should sink into recession, it isn’t clear which stock sectors would hold up best. That might depend on the nature of the recession — whether it’s marked by a pullback in consumer spending or a decline in business outlays, for instance.

Nonetheless, among investment professionals there is strong evidence of growing bias against small- and mid-cap value stocks, in particular.

In a survey of 342 institutional investors conducted in late August and early September, Russell Investment Group found that just 13% were bullish on small-cap value stocks over the next 12 months, and 25% were bullish on mid-cap value issues.

By contrast, 69% were bullish on large-cap growth stocks.

Even if value is going out of favor for a while, shifting entirely away from value funds could be a mistake. That’s because there’s no telling when the sector might be back in style.

One way to avoid an all-or-nothing bet on growth or value: Choose a fund that owns both.

Funds that tend to own a mix of growth and value stocks returns often fall somewhere in between the returns of pure growth and pure value.

THis is a more prudent approach as something is always ticking. You will never get the highest returns, but neither will you get miserable returns.

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