Insights: Finance—Seduced by Growth Stocks

Although the market is more challenging, wisely chosen growth stocks are still a good investment

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.    


While a company's competitive advantages are central to establishing its growth stock credentials, so too is how the company is positioned relative to major socioeconomic trends. If the world is changing to your benefit, you may enjoy the experience of swimming downstream. It clearly beats swimming upstream, as any salmon will tell you. The aging of the population, the information revolution and economic globalization are three trends that influence our investment decisions. Companies in the crosshairs of these trends have little to fear. The aging of the baby boom generation in America, Japan and Europe has implications for how we spend our time and money. We need more health-care and financial services. The lack of growth in the labor pool results in more substitution of capital for labor as we are forced to improve productivity. This usually means we spend more on technology.

The days when growth stock investors could ignore those volatile technology stocks are over. In case you haven't noticed, most of the new jobs created in this country recently are in the information technology sphere of the economy. Technological advances in hardware, software and telecommunications are changing the way we work, play and communicate. The Internet is the information highway. It is an agent of change. The companies building the new technologies are at the center of this new economy. Companies that are leading this revolution are experiencing turbocharged growth. These are Cisco Systems, Sun Microsystems and EMC, among others. Companies that are using new technology to improve the productivity of their businesses gain, too. These include drug companies like Pfizer and Merck, financial service companies like State Street Boston and Charles Schwab, media companies like Time-Warner and Viacom, and communication companies like Qwest and Vodafone.

Thanks to modern communications and management tools, and a world economy based more and more on capitalism, we have an increasingly global economy. About 95 percent of the people on this planet do not live in the United States. Many new markets have opened for multinational companies to exploit. Globally, we see strong demand for American and European technology, pharmaceuticals, airplanes, movies, fast foods, consumer brands and a wide range of capital goods.

Sure, companies that do business throughout the world will encounter bumps in the road from time to time, but the long-term payoff should compensate for the headaches. To be sure, American or European products are not in demand absolutely everywhere, and establishing a presence in some locales is costly in the short run. However, the markets are vast and represent major opportunities for the companies that master the complexities and stick it out. Ask IBM, Intel or Microsoft what their earnings would be if they only did business in the United States. Ask the drug companies. Ask Time-Warner how much profit it makes from the overseas distribution of films and music. Big companies want and need big playing fields. 


We don't know how long America's love affair with blue-chip growth stocks will last. The past five years were richly rewarding, but are 20 to 30 percent annual returns really sustainable? It won't be easy and may not be likely. Additionally, there are times when the best stock price gains are generated by "value," foreign or small-company stocks. Stock market history suggests there is a cycle to returns by investment style. Diversifying by style makes sense as a means to control risk. That said, if the economic background for stocks remains favorable and the earnings of many of these companies continue to grow at 20 to 30 percent rates, then investors in these stocks are likely to reap additional rewards. Common sense seems to dictate that you should have some portion of your portfolio in these celebrity stocks. Ignore them at your peril. To own them is to love them.

Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.