(PUB) Investing 2016

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

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Growth Stocks are Fairly Priced

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

2.00

Growth Idx./Total Stock Mkt. Average

1.75

1.50

1.25

1.00

0.75

Ratio of growth stock p-es to total market p-es 0.50

8/96

8/98

8/00

8/02

8/04

8/06

8/08

8/10

8/12

8/14

8/16

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

Still Decent Growth 3-Yr Return

3-Yr Return Through Aug. ‘16 Diff.

Through Aug. ‘13

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.

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