This year's model

Looking for growth stocks when there is not much growth

THE catwalks of Paris are not the only places where fashion is on display. It works in investment too. And this year has seen as dramatic a shift as that 25 years ago when hot pants and disco suits gave way to big hair and padded shoulders.

Growth stocks are the new retro chic. Having dominated the financial markets in the late 1990s, the growth style of investment has fallen mightily out of vogue since the collapse of the dotcom bubble.

But this year, according to Wisdom Tree, an investment firm, growth stocks have beaten their “value” counterparts by 12 percentage points among large American stocks, 16 points among smaller companies and by ten points on international (non-American) markets.

Not everyone accepts that the world of investing should be divided into growth and value and it is certainly a simplistic classification. But, broadly speaking, the growth school concentrates on businesses with outstanding prospects, and worries less about the price it pays for shares. In contrast, the value school takes the price it pays very seriously, and worries less about the prospects of the business.

Why has the change occurred? In part, it is because stockmarkets are naturally inclined to overreaction. Back in 1999 and 2000 everybody wanted to buy shares in the hottest companies, and were willing to pay the equivalent of 100 years' profits for them, or indeed to buy shares in companies with no immediate prospect of profits at all. That made the value shares look very cheap by comparison and created the conditions for an extended period of catching up.

By the end of 2006 there was a much narrower range of valuations in the market. In other words, investors had to pay less of a premium to buy companies with growing profits. Growth had become cheap by historical standards.

A change in economic outlook has also prompted the switch. From 2002 onwards, output recovered swiftly from the dotcom setback and American profits in percentage terms grew at double digits. Almost every company was doing well; there was no need to pay a high price for growth stocks. But the American economy slowed in 2007 and the outlook for 2008 is gloomy. Profits of S&P 500 companies actually fell in the third quarter.

That has prompted investors to opt for companies where the profits outlook is both robust and reliable. As Brian Belski, a sector strategist at Merrill Lynch, says, “When growth is scarce, it becomes more valuable.” Given the stronger economic performance of the developing world than the developed, investors have naturally favoured larger, international stocks. That change in trend was reinforced by the slowdown in takeover activity, which had tended to be focused on small and medium-sized companies. As of December 7th, the Dow Jones Industrial Average of 30 big American firms had risen 9.3% on the year, whereas the broader Russell 2000 index was down 0.3%.

This market background is proving to be difficult for the fund-management industry. Active managers—those who try to outperform the market—tend to do best when smaller stocks and value bets are thriving. They are more likely to find bargains among the small-cap stocks that are less well researched than the likes of Microsoft or Exxon Mobil.

Paul Lavin of WestLB Mellon Asset Management has found a close correlation between the performance of hedge funds investing in shares and the breadth of the stockmarket. When most stocks are rising (which means smaller companies are doing well), the hedge funds outperform, but they suffer when small stocks start to fall. The poor performance of value stocks seems also to have been behind the problems of the “quant” (computer-driven) hedge-fund managers in August and November.

Those funds that invest on the basis of dividend income have also suffered badly. Alex Stewart, a strategist at Dresdner Kleinwort, says 2007 has been an annus horribilis for income investing. Such investors have traditionally shunned mining stocks, but by late November the European mining sector was up 30% on the year. Meanwhile, banking, a popular income sector, was down 20% over the same period.

These kinds of sector moves can ruin a fund manager's reputation. The long trend in favour of value made lots of managers look smart, when they may really just have been lucky. But changing the investment approach may simply look like intellectual inconsistency. So if the growth trend continues for much longer, fund managers may be damned either way; follow fashion and lose credibility or stay on course and underperform the market.