Growth investing may still have a spot in portfolios

If you read academic investment research, growth investors belong somewhere between people who believe the Earth is flat and those who get their stock tips from talking dogs.

Nevertheless, from time to time — actually, for long periods of time — growth investing works quite well. We may be entering one of those periods. The question is whether the gains from growth stocks are worth the pain when growth goes sour.

Growth investing holds that a company's stock price closely follows its growth in earnings. A company with above-average earnings should see its stock price grow faster than average.

Naturally, this is not as easy as it sounds. The stock market looks forward, not backward. Successful growth investors have to forecast corporate earnings growth, and, as Yogi Berra observed, it's tough to make predictions, especially about the future.

Nevertheless, growth investing has a long and storied history.

T. Rowe Price, founder of the Baltimore-based mutual fund company that bears his name, was one of the first big advocates of growth investing. So is James Stowers, founder of the American Century funds in Kansas City, Mo.

Peter Lynch, former manager of Fidelity Magellan fund, was one of the most spectacularly successful growth investors, turning in a 2,475% gain over 13 years, vs. 508% for the Standard & Poor's 500-stock index.

And growth had a long run. The Lipper Large-Company Growth Fund index soared 3,072% the 20 years ended Dec. 31, 1999, vs. 2,579% for the S&P 500. Value funds, which look for beaten-up stocks of companies that Wall Street hates, gained 1,944%.

But the past 10 years have been brutal for growth investors. The average large-company growth fund has plunged 32% the past decade, vs. a 1% loss for large-cap value funds.

Not surprisingly, growth has been shunned by investors, who have yanked an estimated $185 billion from large-cap growth funds the past decade, more than triple the amount they've pulled from large-company value funds.

And many noted investing experts, from Warren Buffett to University of PennsylvaniaWharton School economist Jeremy Siegel, maintain that value investing is the best long-term investment strategy.

Nevertheless, growth funds have taken the lead this year — and, in fact, for the past five years. Can you make a case that growth will continue to lead for the next few years?

Robert Millen, portfolio manager of the Jensen fund, is a growth manager worth listening to: The fund is in the top 5% of all large-company growth funds the past decade. Millen notes that when corporate earnings growth is rare, investors bid up stocks of the few companies that post exceptional growth. He thinks the nation is in for a slow economic recovery, which means that companies with high earnings growth will be rare indeed.

Millen thinks the recovery will be slow because the nation's households and corporations will be focused on paying down debt, rather than spending. But you can add two other factors into the argument for sluggish economic growth:

•Interest rates. At the moment, the Federal Reserve is keeping its key fed funds rate near zero, which means that there's really only one direction for short-term rates: up. The government's massive borrowing could also push up long-term interest rates.

•Taxes. Current income tax rates are low, and federal deficits are rising. The current maximum tax bracket is 35%, down from 91% in 1950 and 50% in 1985. Although higher taxes would help pay off the deficit, they would also create a drag on economic growth.

Millen likes big, quality growth companies such as Colgate-Palmolive and Emerson Electric, in part because they have good exposure to rapidly growing global economies, such as China.

Lynch, long retired from fund management, says that growth works best in small and midsize companies, because they can grow for longer periods of time. And it's much harder for a mature company to grow its earnings by 25% than a midsize one.

"I'd rather buy in the second inning and sell in the sixth," Lynch says.

If you buy Lynch's logic, then a midcap growth fund is probably the best place to be. The top funds are in the chart.

But bear in mind that growth funds are just one style of investing. The people who get hurt the worst in a downturn are the ones who put all their faith in one theory of investing.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is Twitter: