(By Christine Benz) Have investors given up on growth stocks? Recent fund-flow data would seem to suggest so. Although growth-oriented exchange-traded funds have seen inflows to the tune of $10 billion in the past 12 months, $65 billion in assets has flowed out of the large-, mid-, and small-cap growth fund categories during the same time frame.
You don't have to search high and low to see the source of the disillusionment. Growth stocks became perilously overpriced during the dot-com bubble and rightfully bore the brunt of the 2000-02 correction. Nor did they distinguish themselves during the recent financial crisis, with the typical large-cap growth fund in Morningstar's database losing more than its counterparts in the large-blend and large-value categories. In part because of these two epic busts, the large-growth fund category has also demonstrated the highest volatility, on average, of any diversified domestic-equity categories during the past decade. Investors often base their purchase decisions on past performance, and the risk/reward profile of large-growth stocks and funds just hasn't been very attractive in the past 10 years.
Demographic trends might also have a role in investors' flight from growth equities. As the first wave of Baby Boomers ventures into retirement, they're adding to safer asset types and shunning many riskier assets. Thus, it's possible that outflows from growth equities are the flip side of investors' extreme interest in bond funds and dividend-paying equities during the past few years.
Yet even as it's sensible to take risk out of a portfolio as retirement draws near, investors of all life stages could be taking their growth-stock aversion too far. If you can look beyond performance during the past decade, there's a reasonable fundamental case for maintaining a position in growth equities, and that holds true for retirees as well as accumulators. Moreover, there are ways to add growth stocks to a portfolio without dramatically elevating its risk level.
Fundamental Case Strong
The first reason to consider growth stocks might seem obvious: When growth is slowing, as is clearly the case across the globe right now, you want to make sure your portfolio includes exposure to companies that can grow no matter what. One appealing attribute of growth stocks at a time like this is that they're more beholden to their own product cycles than they are the macroeconomic environment. For example, even though Apple's (AAPL) iPhone sales have disappointed recently, the firm has still managed to get consumers to pay a premium price for its phones and tablets for several years running. Biotech firm Alexion Pharmaceuticals (ALXN), meanwhile, has been able to charge high prices for its drugs that treat rare diseases.
Of course, fast growth is only appealing if you can buy it at a reasonable price, but growth-oriented companies don't appear to be trading at unreasonable valuations right now, even though growth equities have generally trumped their value peers since stocks began to rebound more than the three years ago. The stocks in Morningstar's Large Growth Index have a price/fair value ratio of 0.88, meaning that our analysts think the universe is roughly 12% undervalued currently. That's just a touch higher than the price/fair value (0.85) for stocks in the Large Value Index, and even lower than the price/fair value for the Large Core Index (0.90).
Taxes Another Potential Tailwind?
The potential increase of the dividend tax rate in 2013 provides yet another reason to make room for growth stocks, especially if you hold equities in your taxable account. Barring Congressional action, the dividend tax rate is set to jump to investors' ordinary income tax rates next year, up from 15% currently for most investors. Although companies of all persuasions have recently been feeling pressure to show investors the money in the form of dividends, growth companies still have lower dividends, on average, than core or value equities. Morningstar's Large Growth Index currently has a dividend yield of 0.90%, versus more than 2.00% for the Large Core Index and more than 3.00% for the Large Value Index. Small- and mid-cap growth stocks are even less likely to pay a dividend than those in the large-cap growth category.
That means that if the tax rate on dividends does increase, your aftertax return from growth equities will generally be higher than is the case from value or core stocks, even if the pretax returns from all three categories are in the same ballpark. (Just make sure that you don't opt for a fast-trading growth fund that incurs a lot of short-term capital gains because you'll simply be trading one type of tax liability--dividends--for another, short-term capital gains.) Moreover, less favorable dividend tax treatment could stoke demand for nondividend payers in the years ahead. Of course, higher dividend tax rates aren't a done deal, but if they do go through, growth stocks will look better by comparison.
Possible to Keep Volatility in Check
Finally, even though the volatility profile of growth stocks in aggregate has been higher than is the case for core or value stocks, it's possible to obtain growth exposure without going too far out on a limb. Using Morningstar's Premium Stock Screener tool, I recently screened our equity analysts' coverage universe for those stocks with at least Morningstar Ratings of 4 or 5 stars, meaning our analysts think their valuations are reasonable; fair value uncertainty ratings of medium or low, indicating the analyst is at least somewhat confident in his or her fair value estimates; and moat ratings of narrow or wide, which points to a sustainable competitive advantage. Fifty-four stocks made the cut as of July 26; Premium users can click to run the screen themselves or tweak it to fit their specifications.
Fund investors can also identify lower-risk options within the various growth categories, and several of our top-rated picks within those groups are run by managers who aim to minimize losses while also searching for companies with healthy growth rates. Aston/Montag & Caldwell Growth (MCGFX) and Jensen Quality Growth (JENSX) are good examples of growth funds that emphasize higher-quality stocks. Meanwhile, the various offerings managed by the Primecap team, such as Primecap Oddysey Stock (POSKX), employ a contrarian growth strategy that tends to keep them out of overheating areas, the bane of many growth funds historically.
Perhaps the most straightforward way to control risk in a portfolio that includes growth equities is to own them in conjunction with other investment styles, especially value stocks. Growth and value stocks have exhibited a closer performance correlation during and since the financial crisis, but historically their performance pattern has been dissimilar. Although value equities fared exceptionally well from 2000 through 2002, for example, growth stocks generally outperformed from 2003 through 2007. Investors can achieve style diversification by balancing growth stocks and funds alongside value holdings, and simplifiers can take heart in knowing that a basic total market index fund will provide them with equal shares of growth, value, and core stocks.
Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success.