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Move over, value: It's growth's turn again
Value stocks broke out of their bear market last year, but now it's time for growth to step up. One way to play the shift: Jensen Fund.
By Timothy Middleton
Maybe the stock market is writhing like a teen taking the PSAT because it's about to have a growth spurt.
Last year, the Russell 3000 Value Index ($RAV.X), which tracks the stocks with the lowest price-to-earnings multiples, broke out of the bear market that began in 2000. It has since surged nearly 20% above its level five years ago.
But the Russell 3000 Growth Index ($RAG.X), which follows the priciest stocks, has enjoyed no such revival. It languishes about 40% below its 2000 level.
"Large-cap growth remains significantly undervalued relative to large-cap value," says this month's Perception for the Professional, a monthly research report by Leuthold Group, a prominent institutional research firm.
And whenever that kind of disparity goes on long enough, it reverses. In the 1990s, growth and big stocks led the market, only to surrender leadership to small and value names five years ago. The value/growth cycle usually runs for five to seven years.
So within a few months or years, value's popularity will fade and growth stocks will enjoy a windfall of profits. So if your portfolio has grown lean on growth during this value cycle, it's time to bulk up again on those stocks.
The way to play a coming trend
Funds worth looking at include the Jensen Fund (JENSX), which struggled mightily last year, hammering out a 6% gain -- or 45% less than the market. It bore all of growth's burdens, right down to a heavy stake in Merck (MRK, news, msgs).
"If you want to explain why we underperformed last year," Merck was one of the reasons, says Bob Millen, co-manager.
The others included a big stake in other health-care names, as well as avoidance of low-growth, but suddenly fashionable, sectors like energy, basic materials and utilities. So enamored are investors of these cyclical areas that the premium investors have been willing to pay for high-growth stocks, particularly large-capitalization growth stocks, has gone from a P/E multiple of 2.5 times the market average to just 1.8 times.
Value has become so popular that mutual funds investing this way are being flooded with assets, and some of the best have closed to new investors, including Dodge & Cox Stock (DODGX).
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I first spotted Jensen three years ago, when I included it among eight elite funds (another was Dodge & Cox Stock) that, as I wrote then, "make money in bad markets, as well as good ones."
Wouldn't you know it? Jensen promptly sank 11% that year, 2002, which turned out to mark the nadir of the bear market. But throughout the past three years, Jensen has continued to rank among the top 20% of big-cap growth funds. The odds are that sometime in the next three years it will rank among the top 20% of all big-cap funds, and remain there for at least a few years after that.
Having faith in a discipline
That's because Jensen sticks faithfully to a discipline that produces success more often than failure. It believes stock prices ultimately reflect free cash flow, and therefore companies that grow those flows the most, and the most consistently, will do best in the market.
Now, Jensen believes, those companies include names like these:
| Jensen Fund top holdings | | Security | Sector | % of fund assets | | Stryker (SYK, news, msgs) | Health care | 5.8 | | Omnicom Group (OMC, news, msgs) | Business services | 5.3 | | MBNA (KRB, news, msgs) | Financial services | 5.2 | | General Electric (GE, news, msgs) | Industrial materials | 5.1 | | Emerson Electric (EMR, news, msgs) | Industrial materials | 5.0 |
|
Note: As of Sept. 30, 2004.
Source: Morningstar Inc.
Free cash flow is a company's reported earnings, adjusted for depreciation (which is added back) and capital expenditures (which are subtracted). "This tends to lead us to businesses that have a sustainable competitive advantage and returns in excess of the cost of capital over long periods of time," Millen says.
That is, it leads the fund to growth stocks. And it leads away from deeply cyclical industries like energy, basic materials, telecommunications and utilities, which just happened to be among last year's most successful sectors.
It also leads toward health care, an industry that has everything on its side -- demographics, profitability and innovation -- except last year's headlines.
Jensen, usually a very patient investor with an average holding period around eight years, dumped Merck the day the Vioxx news came out. "It made Merck a no-growth company for a number of years," says Millen. Merck's place in the 25-stock portfolio was given to brewer Anheuser-Busch (BUD, news, msgs).
The alternative to Merck
But health care remains Jensen's top theme, at 27% of assets, and Merck rival Pfizer (PFE, news, msgs) remains a top holding. Its COX-2 inhibitor, Celebrex, hasn't been withdrawn from the market. "We don't think there's much risk in the market on Pfizer, and there's a whole lot of upside from here," the manager says.
Health care has gotten cheap before, notably in the early 1990s during Hillary Clinton's abortive attempt to nationalize the industry. Today it joins the whole growth group, Millen says, in the bargain basement.
Jensen only buys shares it feels are priced significantly below their potential to deliver annual growth of about 15% for at least 10 years. "We can put cash into virtually all of our companies right now, and that isn't usually the case," Millen says.
When I first mentioned Jensen (under the headline "The best mutual funds you've never heard of") it had assets of $250 million. They have since swollen to $2.5 billion, despite market-lagging performance. That suggests to me the fund appeals to patient long-term investors, the best kind to invest alongside of.
By the same token, the fund is hardly without risks. Its founder and long-time manager, Val Jensen, retired last year, although some of his colleagues from the beginning remain in place. Its expense ratio of 0.88%, while half the industry average, could be a quarter of a percentage point less if the fund eliminated its 12b-1, or marketing, fee.
And the fund owns only 25 names, which makes it more sensitive than the usual fund to individual positions. For this, Millen doesn't apologize. "The more names you own, the closer you are to being an index fund," he says.
What he's buying
Despite Big Pharma's woes, "We're buying Pfizer right now," Millen says. Health care is by far the fund's biggest sector bet. "We haven't seen pharmaceutical companies priced this low in 10 years, since the threat of a national health-care plan," the manager says. "These companies produce huge amounts of free cash flow."
Stryker is the fund's top position because its managers like it best. The maker of orthopedic devices such as hip and knee replacements "over the past 10 years has averaged 26% growth in free cash flow," Millen says. He expects growth of sales and profits over the next decade in the range of 15% to 20%, roughly twice the rate of corporations in general.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Dodge & Cox Stock.
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