Energy Sector Fuels Growth Stock Funds In Quarter

SAN FRANCISCO – Katrina and Rita didn't deter mutual fund investors, but Alan might.

Federal Reserve chairman Alan Greenspan (search) blew storm clouds around real estate and interest rates, but U.S. stock funds stayed aloft in the third quarter, building on a modest advance begun earlier this year. International markets, especially Latin America and Japan, rewarded fund investors with near double-digit gains, but nearly every U.S. fund category managed respectable results.

Diversified U.S. stock funds rose 4.7% on average in the period, according to preliminary data from fund tracker Lipper Inc. (search) , with growth-stock strategies outdoing their value-style counterparts.

The shift to growth has become more apparent as evidence mounts that earnings for the recent quarter and perhaps the year could disappoint.

Soaring energy prices and rising interest rates are pressuring consumers' willingness to spend — especially on discretionary goods and services. Meanwhile, more companies are saddled with higher business and manufacturing costs.

In that climate, investors gravitated to shares of companies that promise robust earnings, supporting the Wall Street adage that when growth is scarce, the market tends to value it like diamonds.

"Investors are anticipating measurably slower profits growth," said Mark Zandi, chief economist at Economy.com. "As a result, they're valuing companies that can produce good, solid earnings in an environment where earnings are going to be harder to come by."

Energized leaders

The third quarter favored small-cap and midcap U.S. growth funds, a pattern that began in April, with large-cap growth offerings also running strong.

Multicap growth funds, which can invest in stocks with any market valuation, topped all diversified U.S. stock-fund categories with a 6.8% gain - almost twice the 3.7% return from multicap value funds.

Midcap growth funds averaged a 6.2% gain compared with a 4.7% rise for their value counterparts. Small-cap growth funds advanced 5.7%, topping small-cap value's 4.4% rise. Large-cap growth funds added 4.5%, ahead of large-cap value's 3.8% gain.

Many of the biggest U.S. stock funds fared well. American Funds Growth Fund of America (AGTHX) , a large-cap growth portfolio, rose 6.7% in the 13 weeks through Sept. 30, while large-cap value sibling American Funds Investment Company of America (AIVSX) added 4% and the Vanguard 500 Index Fund (VFINX) , tacked on 3.3%.

Energy stocks fueled the growth-stock rally, as many fund managers increased exposure to the sector and rode the surge.

"The whole story has really been oil for the last quarter," said John Coumarianos, a fund analyst at investment-research firm Morningstar Inc. "As those smaller exploration and production companies have taken over, that's benefited a lot of mid- and small growth funds."

The quarter also brought gains for other growth-oriented sectors. Natural-resources funds sprinted ahead 2.5% on average, while telecommunications funds added 7.9%. Science and technology funds gained 7.6%, and health and biotechnology funds rose 7%.

Health care achieved "favorite" sector status at Merrill Lynch. Richard Bernstein, the firm's U.S. strategist, told clients in an early September research note that health care is a "classic defensive sector that is consistently gaining attractiveness."

"If you're looking for growth, you're not going to find it in the cyclical stocks that gave you those high returns in 2003 and 2004," added Rick Drake, co-manager of the large-cap growth ABN AMRO Growth Fund (CHTIX) , who is bullish on technology companies including Qualcomm Inc. (QCOM) and Texas Instruments Inc. (TXN) , and bearish on energy.

"There's been a lot of hype around oil prices and oil stocks," Drake said. "The energy sector feels a lot like technology did six years ago."

Notably, one hot sector switched places with a market wallflower.

Real estate funds, the second quarter's big winner, posted a 3.2% average quarterly gain — a reaction to Greenspan pointing to "froth" in certain real estate markets and signs that further short-term rate hikes are likely.

"We've had no exposure to home builders and little exposure to retail," said Alex Motola, manager of the Thornburg Core Growth Fund (THCGX) , which rose 8.4% in the quarter.

Motola said he is looking for technology and health care to carry the day. "That's where the most economic growth is occurring," he said. Among his recent purchases: security software provider Checkpoint Systems Inc. (CKP) .

Gold funds, in contrast, benefited from investors' caution, rising 20.7% on average as gold futures approached $500 an ounce.

"The move in gold has been astonishing," said Jerry Jordan, manager of the Jordan Opportunity Fund (JORDX) . "Gold stocks, relative to the price of gold, are historically pretty cheap."

Peak performance

The economic crosswinds that played havoc with investors in the quarter are also giving stock pickers a chance to shine.

The quarter's top U.S. diversified fund, up 17.4%, was CGM Focus Fund (CGMFX) , a concentrated midcap growth offering that manager Kenneth Heebner has stocked with oil and gas investments.

Indeed, energy has become a line in the sand for fund managers. Some, like ABN AMRO's Drake, want nothing to do with the sector, and their performance has suffered accordingly. Others are wading headlong into the oil patch, optimistic that these companies will still pull in the profits even if prices decline.

"High oil prices are here to stay," predicted Jill Evans, co-manager of the Alpine Dynamic Dividend Fund (ADVDX) , which rose 5.6% in the quarter. "As long as oil prices stay above $40, the economics in the E&P and drilling sector are compelling. Drillers have been a great opportunity; they are also generating record amounts of cash."

The U.S. market so far has shown resiliency even with energy prices steaming higher. But if the bill for heating oil and gasoline spikes too rapidly, consumers — particularly lower-income households — will bear the brunt, with a predictable downward impact on spending.

"Christmas might be on the soft side," ventured Economy.com's Zandi. "Consumers are not going to be nearly as aggressive. Broadly speaking, they'll do their fair share — but that's a big comedown from the outsized contribution to growth they have provided."

"Something's got to give," added Jordan, the Jordan Opportunity manager. "We have taken the market back up to its highs and failed to push through. We are right on the cusp. This is where you buy 'em or you sell 'em."