Defining Growth Funds

Fund managers look at several variables to determine whether a stock should be considered to be a growth stock. Most of the analysis is quantitative, although some may be considered qualitative. In general, growth fund portfolios contain stocks that fund managers believe will outperform others within similar sectors as well as the rest of the market.

WHAT ARE GROWTH FUNDS, ANYWAY?

Morningstar, Inc., defines growth funds as mutual funds with the objective of achieving capital appreciation by investing in growth stocks. A growth stock is defined as one in which the earnings and/or revenue are growing faster than its industry or the overall market. If that's the case, then, at least in a bull market, growth funds should perform better than the overall market. The key to their performance lies in the selection of stocks, which is the responsibility of the fund manager.

Each fund manager will utilize unique analytic processes, which they will incorporate to find the correct mix of stocks to create their mutual fund. Though managers' analytic processes have their personal quirks, most growth fund managers look for some common key characteristics when it comes to selecting companies. These include:

1 Historical growth rates
2 Future forecasts
3 Company fundamentals.

One of the more popular methods of measuring earnings growth among analysts is the price/earnings (P/E) ratio. The P/E ratio is calculated by dividing the security's current stock price by the earnings per share (EPS) of the previous four quarters. Generally, a stock with a high potential for growth will have a higher P/E ratio because, simply put, when there is the increased likelihood of growth opportunities, the company's stock price will be high relative to earnings. The idea is that as earnings increase, the value of the company will also increase, which in turn should be reflected in the increased appreciation of the stock price.

The P/E ratio shows how much an investor must risk to gain $1 of the company's earnings per year. Here's an example of how to calculate P/E ratio using Microsoft Corp. (MSFT) as an example.

As of January 17, 2001, the current stock price was $53 and the total earnings per share for the past year was $1.76. The P/E ratio is equal to $53 divided by $1.76, which is approximately 30 (53/1.76 = 30.1). This value is the P/E multiple and indicates the firm's growth opportunities.

Merely looking at the company's P/E ratio is not enough. You must compare it with others to get an idea of how much more growth potential the company has over similar products. A common approach is to compare the P/E ratio of companies within the same industry. Those with faster earnings growth are probably the ones with the greatest growth potential. However, a high P/E ratio does not mean that the company is guaranteed to experience growth. "The company is way overvalued, considering they have no earnings!" was a common phrase during the dotcom craze prior to the tech correction of the spring of 2000.

Strong and consistent growth forms the essence of a company's ability to succeed. Suppose a company has a P/E ratio that suggests strong growth but for some reason experiences inconsistencies in its growth. The company may no longer be contributory to the objectives of the fund. At that point, the manager must decide whether to keep the company in the fund.

Since there will be several companies that exhibit strong and consistent growth, it is in the managers' best interest to select the cream of the crop. They do so by comparing growth rates with others in the same industry. All else being equal, those with the strongest accelerated growth rates are better. Even then, there may still be too many candidates; managers will cross-check the remaining companies with fast-growing sectors. The theory is that a fast-growing company in a fast-growing sector should yield the best results. Sometimes, however, poor management thwarts that idea. Therefore, growth fund managers will favor strong management over any or all of the previously mentioned characteristics. Some managers even include technical analysis as an added tool in their decision-making process.

The techniques used by managers to select stocks differentiate one fund from another. Many of these company characteristics are judgment calls made by the fund managers.

AFTER THE FACTS

Now that you know what growth funds are, why haven't they come out smelling like roses? Growth funds are made up of stocks that are targeted to move in a positive direction. Unfortunately, all of the stocks can't sustain the positive growth rate every year. The situation is similar to a stock that has shown strong performance but reaches a point where it can't sustain that rate of growth, which then leads to periodic price corrections. In Figure 1, you can see that this happened to Microsoft (MSFT).

FIGURE 1: ONE OF THE MOST WELL-KNOWN GROWTH STOCKS OF THE 1990S, MICROSOFT (MSFT). For years, Microsoft had an excellent growth rate, but even this behemoth could not sustain that growth forever. Prices stayed pretty much above the one-year moving average until early 2000 before it came a-tumblin' down. A year later, Microsoft may once again be ready to step into the growth mode.

Since growth fund managers are interested in fast-growing stocks in an effort to ride a growth momentum to obtain above-average returns, they will purchase shares even if prices seem relatively high. As long as the stocks continue to show good growth rates, the fund managers are satisfied and hold them on their growth fund lists. However, when a stock shows weakness, it can fall out of favor and affect the overall return of the growth fund.

You should invest in growth funds with the intention of holding them for the long term. Figure 2 shows how growth funds tracked by Morningstar, Inc., have fared in the last three months. Take a look at the best- and worst-performing funds. You can see that growth funds did not perform well during this short time frame.

FIGURE 2: RETURN IN PERCENTAGE FOR THE THREE MONTHS IN STUDY. Dark green represents the best-performing funds during the study period and red represents the worst-performing funds. Value funds have done very well, while growth funds have been in the pits.

Now take a look at Figure 3, which displays the best-performing funds over the last five years. The best-performing funds are those in the growth sector. These results clearly display that growth funds have been the best performers in the last few years and only recently experienced weakness -- weakness that has resulted in an alarming fall.

FIGURE 3: RETURN IN AVERAGE ANNUAL PERCENTAGE FOR THE FIVE YEARS IN STUDY. Dark green represents the best-performing funds during the study period. The majority of the best-performing funds have been growth funds.

During bull markets, expect your fund to do as well, if not better, than the market. However, during bear markets your growth fund could do worse than the market itself. By exercising a long-term buy-and-hold strategy, your losses will be overshadowed.

What it boils down to is that growth funds in general are equivalent to the high-flying trapeze act in a circus. If you get the high-risk maneuvers right with good timing and teamwork, the show is spectacular, but if things go wrong, it's a fast and scary fall. But have no fear; provided you have a net, those who fall can get right back up again, smelling like a rose.

Han Kim can be reached at HKim@Traders.com.