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Large-Cap Growth Poised for Rebound

While value funds have been flying high for the past several years, large-cap growth funds have shown lackluster performance. However, earnings at large-cap companies have been high in recent months, while their valuations have been beaten down, suggesting that the market cycle might be staging a comeback for large-cap growth, said Larry Puglia, vice president at T. Rowe Price of Baltimore, during a webcast last week.

Growth funds have lagged small- and mid-cap, value, and international funds by a considerable margin, Puglia noted during the webcast, "Large-Cap Growth: An Important Role in a Diversified Portfolio."

Since the beginning of 2000 through June of this year, the Russell 1000 Growth Index has fallen an average of nearly 6.5% a year, while the Russell 2000 has risen more than 7%, the Russell 1000 Value has climbed just over 6%, and the MSCI EAFE Index has delivered about 3%.

Soaring prices for energy, commodities, real estate and utilities have led to strong outperformance for value stocks, said Puglia, who has managed the T. Rowe Price Blue Chip Growth Fund since its inception in 1993. Investors have also flocked to riskier investments, such as small-caps and value stocks, he added.

From 1995 to 1998, large-cap growth funds were "king of the hill, and for the past five to six years they have been at the bottom of the heap," he added. One of the most dangerous strategies is to buy funds in an area that has been hot for several years, so it is important to look for emerging opportunities in areas that have not performed well the last couple of years, he emphasized.

Thus, looking to quality large-cap growth stocks, Puglia pointed out they typically have significant financial strength, strong free cash flows supporting dividend growth and are able to make value-added acquisitions during periods of economic weakness.

Large-cap growth funds have recently begun to outperform, and this could be a continuing trend. One factor could be that interest rates have risen, which can drain liquidity from the financial system and subsequently move investors to take a more cautious view on higher-risk investments, Puglia said. The overall economy has shown signs of a slowdown with a 1.6% GDP growth.

"As profits are impacted by cooler economic activity, investors are drawn to established companies with sustainable earnings growth potential," he said.

In addition, relative to small-caps, valuations on large growth stocks are near 25-year lows; since the beginning of 2000, the valuation of the Russell 1000 Growth Index has fallen 61%.

"As an investment sector, large-cap growth offers a wide range of opportunities, including biotechnology, the Internet, new financial products and oil services companies," Puglia said. Companies such as American Express and State Street Bank, which had 22 years of double-digit growth earnings, are favorable companies to be included in portfolios, he said.

Technology has not been a hot area, but the area is not as homogenous as people think. "Technology has been an inconsistent area, but there may be opportunities," Puglia said. The free cash flow margin overall is the highest it has been in many decades, he noted.

Technology companies that specialize in wireless interactive, handheld devices and multimedia companies, such as Apple and Adobe Systems, have bucked the trend in the technology sector and performed well. On the other hand, companies have struggled within the semiconductor arena and the Internet, with the exception of Google, Puglia said.

Biotechnology companies are typically long duration assets with high future payoffs, he added. Financial intermediaries and asset management firms are sometimes underrated in the growth area. Global wealth management is an important and growing business, and there are other financial areas that are growing as well.

Of course, there are risks to be mindful of when investing in the large-cap growth arena. Many investors buy stocks and anticipate superior earnings growth. Earnings disappointments can result in sharp stock declines when investors pull out of the funds. Additionally, growth funds invest a high portion of earnings in their own business, and their stocks may lack the dividends that can cushion share prices when the market heads downhill, Puglia added.

With the Congressional mid-term elections taking place this week, Puglia pointed out that specific sectors could be favorably impacted if the Democrats take control of the House and/or the Senate. Financial service stocks such as Freddie Mac could do well, he said. On the other hand, he continued, Democratic control would negatively impact healthcare, tobacco and defense stocks. Many investors fear the Democrats would put pressure on drug prices overall, particularly generic drugs. If the Republicans maintain control, the concerns will be less vexing and a lot of pressure will be taken off the healthcare services area, such as pharmaceuticals, HMOs and drugstores, Puglia said.

But not everyone agrees with his prognostications. "There have been predictions for a couple of years now that the large-cap growth category was on its way back, but the numbers aren't there yet, at least not in the U.S.," said Lynette DeWitt, associate director in the retail investment market group at Financial Research Corp. of Boston.

Investors have continued to shy away from domestic large-cap growth funds, with $3 billion of net redemptions so far this year and twice that amount during 2005, she pointed out.

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