IN times of economic uncertainty, you would think that investors would flock to traditionally defensive stocks, like shares of stable utility companies or value-oriented dividend-payers.
Yet in the current slowdown, which may turn into a full-blown recession, money managers are betting on what has often been a riskier segment of the market: growth stocks.
These stocks are shares of fast-growing companies whose earnings tend to expand more rapidly than the market as a whole, and they are often more volatile than the broader market, too.
So far, growth has been a winning bet. Since the stock market became jittery in July amid fears about a slowing economy, growth stocks in the Russell 1000 index have advanced 2 percent. By comparison, defensive-minded value stocks — beaten-down or overlooked shares that tend to appeal to cautious investors — have lost more than 7 percent.
Even as slowdown fears are turning into recession worries this year, many investors still favor growth. “I still think growth is where you want to be,” says Jeffrey N. Kleintop, chief market strategist at LPL Financial Services in Boston. Mr. Kleintop said he particularly favors large-capitalization growth stocks in the technology, health care and industrial sectors.
A recent survey of investment managers by the Russell Investment Group in Tacoma, Wash., found that three out of four money managers described themselves as “bullish” on large-cap domestic growth stocks. And nearly four in five were optimistic about technology stocks. By comparison, less than half described themselves as bulls on emerging-market stocks and less than a third were upbeat about value.
But why bet on growth stocks, which are riskier and throw off less dividend income than value shares? There are several compelling reasons.
For starters, until last year, large-cap growth stocks had long underperformed the broad market. From 2000 through 2006, such stocks lost nearly 5 percent a year, in contrast to annual gains of nearly 8 percent for value shares and about 2 percent for the broader stock market. So the argument goes like this: If the stock market is on the verge of a recession-driven downturn, growth may have less room to fall.
Moreover, the Federal Reserve has recently been lowering short-term interest rates to bolster economic activity and head off recession. Many market watchers expect the Fed to keep lowering rates this year, especially if the housing market continues to cool.
Historically when the Fed cuts rates, growth stocks benefit. Since 1974, growth stocks in the Standard & Poor’s 500-stock index have advanced 11 percent, on average, in the six months after the first in a series of Fed rate cuts. During those same periods, value stocks gained just 7.9 percent, according to an analysis by Sam Stovall, S.& P.’s chief investment strategist.
Money managers recommend focusing on stable growth companies for another reason. In times of slowing growth, investors are apt to choose companies with more reliable earnings growth, said Ernest M. Ankrim, Russell’s chief investment strategist. This would point to traditional growth sectors like technology and health care.
Sure enough, growth stocks have shown stable — and enviable — earnings of late.
Consider the third quarter of 2007. While profits among companies in the overall S.& P. 500 fell nearly 5 percent, on average, earnings of tech companies in the index rose 17 percent, and those of health care companies in the index grew 13 percent.
More of the same is expected for the fourth quarter. The consensus on Wall Street is that the tech earnings grew 22 percent and the health care earnings 15 percent in the final three months of last year. Those figures are in stark contrast to the 9.5 percent drop in overall fourth-quarter S.& P. 500 profits that analysts are bracing for, according to Thomson Financial.
Here are some other reasons to consider growth sectors in this slowing economy:
TECHNOLOGY Tech sector funds returned more than 17 percent, on average, in 2007, one of the best years for the sector since the Internet bubble burst in 2000. “Big-cap tech had a great year, and I wouldn’t see any reason why that would change,” said Michael J. Cuggino, manager of the Permanent Portfolio, a mutual fund that invests in stocks, bonds and alternative assets.
Would a potential recession throw a wet blanket on this comeback? Perhaps. But keep in mind that 55 percent of tech sector revenues are now derived overseas, making technology one of the most globally oriented sectors in the S.& P. 500.
And because there are greater fears of a recession occurring in the United States than in the global economy, tech may be able to withstand trouble here better than some other sectors, market strategists said.
HEALTH CARE This sector in general, and pharmaceutical shares in particular, have been a disappointment lately because of a dearth of new blockbuster drugs.
But among classic growth sectors, health care is considered relatively recession-proof. After all, no matter how healthy the economy, people still get sick. And after years of being unloved, health care stocks in the S.& P. 500 are trading at a price-to-earnings ratio of around 15, on average. That’s roughly in line with the ratio of the overall index, though health care stocks have traditionally traded at a significant premium.
INDUSTRIALS While it’s true that the industrial sector is economically sensitive, it is now sensitive to the global economy. More than two out of five dollars generated by domestic manufacturers now come from overseas, according to S.& P.
And thanks largely to the falling dollar, the cost of doing business with domestic manufacturers is tumbling, making the sector even more appealing. David A. Rosenberg, an economist at Merrill Lynch, noted in a report that unit labor costs for domestic manufacturers were now 30 percent lower than the average for the rest of the industrialized world.
The dollar might weaken further if the Fed continues to cut interest rates, so concern about the economy could make the growth sector more attractive than other parts of the market — not less.
Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.
