(PUB) Investing 2016

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4 • Fund Family Shareholder Association
to make (though the bulls were still
charging), but it was spot on. As
you can see in the table below, all
of Vanguard’s large-cap growth funds
delivered decent returns over the past
three years—the only fund that failed
to advance at a double-digit pace was
STAR LifeStrategy Growth, which
faced twin headwinds, holding 20%
of its assets in bonds and a third of its
portfolio in foreign stocks—but all fell
far short of a near-20% annual pace.
Now, before jumping too far ahead: I
always think it’s important to comment
on the “growth” and “value” labels
that investors (particularly mutual fund
investors) like to toss around. Dan
and I don’t pay much heed to growth
or value labels when it comes to funds
and managers. Take the PRIMECAP
Management team as an example.
While often considered “growth” man-
agers, their modus operandi is to buy
undervalued stocks facing near-term
issues and hold onto them for years and
years—attributes typically associated
with value investors. The one thing they
don’t do is pay to chase rapid earnings
gains. So don’t get too caught up in
whether a manager is labelled “growth”
or “value.” What is far more important
is whether they have a disciplined,
repeatable investment process that has
outperformed over the long run.
In my book, a growth fund is one
where the emphasis is on capital appre-
ciation, not generating income. Some
fund managers aim to accomplish this
by searching for companies with busi-
nesses where profits are growing rap-
idly. Other managers look for com-
panies whose assets are undervalued,
believing a catalyst will unlock that
value and other investors will recognize
what they’ve missed, leading to great
price appreciation. To my way of think-
ing, those are two different roads to the
same destination. Or, in simple terms, a
growth fund should be the engine that
produces gains in your portfolio over
five, 10 or even 20 years.
Room to Grow
As I said at the outset, there certainly
is room for growth funds to continue to
run, but I’m a bit less optimistic than
I was in prior years. One factor that
gives me pause is the valuation picture,
which is mixed.
Let’s take Growth Index as our
proxy for large growth funds. Its price-
to-earnings (p-e) ratio—or the amount
an investor pays for each dollar of earn-
ings—of 27.3 is expensive on its own.
Over the past 21 years or so, the p-e
for Growth Index has only been higher
30% of the time, much of which was
during the tech boom, when its p-e
jumped above 50—an unsustainable and
unprecedented level. Over the past 10
years, what I regard as a more normal
period, the average p-e ratio for Growth
Index comes in at 21.3. So, at a current
27.3, one could reasonably say that large
growth stocks are absolutely not on sale.
However, after a nearly 250% run
for the stock market over the past seven
and a half years, nothing is particularly
cheap today, which means we need to
consider large growth stocks in the
context of the broader stock market.
The chart on the left looks at the ratio
of the Growth Index’s p-e to that of
Total Stock Market’s. Growth stocks
typically sell at higher p-es because
investors are willing to pay more for
above-average earnings growth rates.
On average, Growth Index’s p-e is about
1.25 times that of Total Stock Market’s.
But today it’s a bit below that average.
In this light, based strictly on earnings,
prices look relatively reasonable.
While valuations don’t look cheap
by any measure, one big element in
favor of growth funds and the stocks
they invest in is investors’ relative lack
of enchantment with them. When it
comes to investor sentiment, I look for
areas of the market where investors
have piled into stocks, and for areas
they may be neglecting. When everyone
agrees that growth stocks, for example,
are the place to be, then the party may
be over for that asset class or strategy.
You have to wonder, who is left to buy?
Opportunity lies in finding pockets of
the market that investors are avoiding.
This year, the hot ticket has been
low-volatility strategies and anything
with a decent dividend yield. That does
not describe the funds in this space, and
it’s safe to say investors have not shown
large growth funds much love these
past few years.
The strongest signal investors can give
is by voting with their feet—or rather,
their wallets. When looking at fund flows
of large-cap growth funds, there are a few
points to keep in mind:A number of these
funds are multimanaged messes—more
on this below. The best fund in the space,
PRIMECAP, is closed to new investors.
And finally, there has been a general
trend away from actively managed funds
toward index funds.
All of that said, consider the table on
page 5, which compares annual net fund
flows (this year’s numbers are through
August) for several dividend-oriented
funds and Vanguard’s large-cap growth
funds. Investors have added billions to
dividend-oriented funds, both active
and passive, while generally exiting
growth funds. Growth Index and Social
FOCUS FROM PAGE 1 >
Still Decent Growth
3-Yr
Return
Through
Aug. ‘13
3-Yr
Return
Through
Aug. ‘16 Diff.
Growth Index 19.0% 12.7% -6.4%
S&P 500 Growth ETF* 18.8% 13.9% -5.0%
Russell 1000 Gro. ETF* 19.1% 13.2% -5.9%
MegaCap Growth ETF 19.1% 13.2% -5.9%
Morgan Growth 18.1% 12.1% -6.1%
PRIMECAP 18.2% 14.5% -3.8%
PRIMECAP Core 18.6% 13.5% -5.1%
Social Index 19.4% 12.5% -6.8%
STAR LifeStrategy Gro. 12.6% 7.9% -4.7%
Adm Tax-Mg. Cap. App. 18.8% 12.1% -6.7%
U.S. Growth 19.3% 13.4% -5.9%
*3-Year returns through 8/31/13 are for underlying indexes as
the ETFs did not yet have three years of history.
Growth Stocks are
Fairly Priced
8/968/98 8/008/02 8/048/068/088/108/128/14 8/16
Growth Idx./Total Stock Mkt.
Average
Ratio of growth stock p-es to total market p-es
0.50
0.75
1.00
1.25
1.50
1.75
2.00