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Insights: Finance—Seduced by Growth Stocks

Although the market is more challenging, wisely chosen growth stocks are still a good investment
Mario J. Gabelli
From the Print Edition:
Kevin Costner, Nov/Dec 00

As always, there are lots of things for investors to ponder. There are the usual economic issues (inflation, interest rates, earnings growth prospects). This year, there are political considerations (will it be Bush or Gore). Investors are also looking for direction. Should they focus on absolute or relative returns? Should they invest in fixed-income securities or equities? Within the equities arena, should they exploit deep discounts in value sectors or stick with the growth stocks that have done so well in recent years? Big-cap stocks or small-cap stocks? Domestic or international? Should they shift their money into passive (index funds) or active (managed portfolios) styles of money management? 

I cut my teeth on value investing with Professor Roger Murray at the Columbia University Graduate School of Business and have had great success employing value principles. But I've always understood and appreciated that there are other effective ways to skin the investment cat. Gabelli Funds Inc. reflects this. We have a risk arbitrage partnership and two convertible securities funds. We have large-cap (capitalization, i.e., market value of company) funds, small-cap funds, all-cap funds, growth and value funds, and domestic, global and international funds. We have "select" funds investing in specific industry sectors, including telecommunications, multimedia, utilities and gold stocks. We have a hedge fund product and, in an upcoming issue, we will provide a history of hedge funds and how they fit into portfolio structures.  

In this edition, I introduce Howard Ward, the portfolio manager of the Gabelli Growth Fund, which has earned a five-star ranking from Morningstar, the mutual fund industry's leading rating service. Ward will detail the competitive advantages of growth stocks, tell you the kind of growth companies he favors, and give you the names of a few stocks you may want to consider buying.


Despite the market's volatile nature of late, investors in growth stocks are looking and feeling good. This is especially true for investors in large growth companies that play vital roles in the new Information Age economy. Those who had the foresight to buy and hold some of these rocket ships over the past few years have seen their original investments multiply several times. The list of winners reads like a Who's Who of the information highway. There's Cisco Systems, whose routers direct traffic over the Internet. There's Sun Microsystems, whose client server computers have become the hardware of choice for Internet service providers. There's EMC, the leader in data storage products, where the Net is driving high rates of growth ever higher. Other power stocks include Texas Instruments, the top producer of digital signal processors (DSPs), which are increasingly in demand for use in a broad range of communication devices, and Intel, whose microprocessors dominate the market for personal computers.

By definition, growth stocks are supposed to grow earnings throughout the stages of the macroeconomic cycle. As earnings growth rates rise, the compounding of earnings becomes all the more powerful. A company growing earnings at a 7 percent rate (pretty average) doubles its income every 10 years. But a company that grows profits at a 14 percent rate doubles those profits in five years. Further, a company growing at 25 percent, like some of these tech titans, doubles its earnings in less than three years. Wall Street analysts prize high-growth companies and investors reward them with high valuations. Sometimes, these valuations become too high. Yes, you can overpay for these Wall Street "darlings" and get burned.


In 1974, when OPEC got serious about raising the price of oil, the great bull market in growth stocks, known as the Nifty Fifty Era, came to an end. Some blue-chip stocks lost more than 90 percent of their value in the following 12 months. This took a toll on investor psychology and helped keep investor expectations in check for years. Of course, few of today's investors experienced the pain of 1974. To be sure, we have seen pockets of "irrational exuberance," to use Greenspanspeak, especially among the Internet stocks late last year and earlier this year. The Internet sector of the stock market, which comprises emerging growth companies as opposed to the established or seasoned growth companies we favor, has fallen dramatically since March, as investors have started to cry for profits and not just promises. Indeed, a growing number of former dot-com darlings are closing their doors. Don't let anyone tell you that earnings and valuations don't matter. Anyone who believes that has never lived through a bear market.  

The best growth stocks possess one or more competitive advantages. Examples of such would be proprietary products, exemplified by patented drugs or technology. Think Amgen. Think Intel. A dominant brand can be a competitive advantage; just ask Tiffany or America Online. Some companies have a limited degree of competition, and that's a special advantage. This could be the result of massive capital or intellectual barriers to entry, regulation, or years of industry consolidation. There is only so much broadcasting spectrum available. There are only so many cable television operators, and they each have near monopolies. Good luck displacing Intel, with its $4 billion research budget. You may have a better-tasting cola than Coke, but shelf space is hard to come by, and the established giants like Coke and Pepsi will fight to keep you out of the game. You get the picture. It's hard breaking into the major leagues. These guys play hardball.    


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