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Go for growth

The cycle is turning and growth offers big potential.

Five years ago, value stocks were universally hated and were offering investors poor prospects for growth trading on just six or seven times earnings. Growth stocks, by comparison, were all the rage with companies such as Vodafone trading on price/earnings ratios of anything up to 90.

Then, the TMT bubble burst and value stocks stormed back into fashion, aided by a fall in global bond yields, which has sparked demand for high income stocks (as bond proxies). Retail investors have been piling into equity income funds ever since, a trend which shows no sign of abating. In 2004, the equity income sector took in 1.75bn net while the all companies sector – the traditional home of growthorientated funds – attracted net sales of just 217m.

From a superficial perspective, this makes perfect sense. Income stocks have performed phenomenally well over the last five years but the fact is value stocks no longer look such good value relative to their growth counterparts.

What has happened since 2000 is that growth stocks have come down in valuation while value stocks, which have enjoyed their best performance in decades, delivering the growth that the tech firms failed to do – have been going the other way (and have subsequently been re-rated).

In fact, the convergence in valuations between the two has been such that stocks like Imperial Tobacco are now trading on similar price/earnings ratios to companies such as Vodafone and Misys. This is a major problem for value because the tobacco industry is a mature market while the mobile telephony and software sectors are very much not – they still have huge potential for growth.

What we are seeing, essentially, is a situation where com-panies with superior growth prospects are on the same rating as those with poorer outlooks. Therefore, growth stocks – by definition, companies which can grow faster than the average – must be cheap simply by virtue of the fact that they are trading on the same price/earnings ratios as value stocks. This, in our opinion, represents a significant opportunity for investors.

I say “in our opinion” because there is no consensus on the subject. In fact, many commentators seem to think the growth story has yet to happen, that it is one for the future.In my view, they are falling into the consensus trap – or anchoring – where investors refuse to acknowledge the evidence because by and large they have already made up their minds.

But I also think there are other issues at play here. Many fund groups appear to have come to their views on growth and value based on a superficial screening process. Part of the problem is that many groups consider some sectors to be superior growth sectors when clearly they do not fall into this category.

Housebuilding is a good example. Some groups will argue that housebuilding is a superior growth sector because of strong performance over the last few years but, like the mining industry, its growth is cyclical. Earnings tend to rise and fall in line with the performance of the wider economy.

Sectors and stocks which do fit the superior growth theme include mobile phones, media (CapitalGWR), IT (DiData) and life insurance (Prudential). Further down the market capitalisation scale, we continue to favour internet-related stocks such as Lastminute and BetonSports and broadband-related companies such as Pipex.

These are the areas where we see huge growth potential but this is not to say that many growth stocks have not delivered already. Sportingbet, for example, was about 30p when we started buying it 18 months ago – now it is 10 times that price.

Despite this kind of growth, equity income funds remain hugely popular. Value has become the new consensus. Investors have been chasing yield for a few years now and it will take a long time for them to get out of that mentality and look beyond the income herd. In my view, there are three factors that will probably prove to be the catalyst for this.

First, rising bond yields. Once yields climb to a more attractive level, the case for income stocks will become that much weaker. Why buy a proxy when the real thing is at least as appealing?

Second, investors will start thinking in the longer term as passing time eases the pain of the bear market. Once they start thinking in five to 10-year time horizons instead of two or three, they will naturally gravitate towards growth.

And third, the superior numbers being delivered by growth stocks will not go unnoticed for long. It is a cliche to say that investors always invest too late but I think it is fair to argue that they will invest in growth sooner or later – it is just a question of when.

Overall we are not saying that investors should ditch their income/value investments and plough into growth. Investors in income are unlikely to lose money and I am sure that many of them will be happy with the returns they are getting – and should continue to get. All we are saying is they are likely to make less money than investors in growth.A company such as Sportingbet is uncommon – not many firms generate a 10-fold share price increase in 18 months – but plenty of other companies out there have the potential to deliver substantial returns.Do not listen to the naysayers. Now is the time for growth.

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