Growth is back!

That's the message from the strong start mutual fund investors have enjoyed since the New Year. Growth-oriented funds have trumped value-oriented funds in all three capitalization categories--- large, mid-cap, and small (see chart below).
Stock Buyers Tilt to Growth
This chart shows the year-to-date average performance of mutual funds in each of the nine domestic fund categories tracked by Morningstar.

Large Value 2.33 percent

Large Blend 2.90 percent

Large Growth 3.05 percent

Mid-Cap Value 4.36

Mid-Cap Blend 4.64

Mid-Cap Growth 5.03

Small-Cap Value 3.41

Small-Cap Blend 3.92

Small-Cap Growth 4.17

Source: www.morningstar.com, fund category averages for 2/08/2007
Some will say it's about time. Value stocks have provided higher returns than growth stocks for what must seem like forever to some. In fact, the record clearly shows that value stocks have done better than growth stocks for seven consecutive years--- 2000 through 2006. If you examine the long-term record, growth stocks pulled ahead of value stocks by a massive 51 percent between 1996 and 1999. It took value stocks the next six years to even the score and 2006 to pull ahead by a small amount, 10.3 percent.

So let's ask a rude question. If everything regresses to the mean, as it seems to be doing, should investors sell their value funds and pile into growth funds?

Not at all. It's just possible that we are now experiencing a private equity bubble for value stocks that will parallel the great IPO bubble for technology stocks. Here's the case to stay with value.

* Value provides nice returns in bull markets. But no one notices. The Vanguard Value Index fund (ticker: VIVAX) returned a whopping 29.8 percent, 14.6 percent, and 12.6 percent, respectively, during the Internet bubble years, 1997, 1998, and 1999. That's hardly a stick in the eye and well over historic stock market returns.

The problem was that growth stocks did so much better in the same period. The Vanguard Growth Index fund (ticker: VIGRX) returned 36.3 percent, 42.2 percent, and 28.8 percent during the same years.

So if 2007 ends as a bull market year, growth will beat value. But everyone will do well.

* Value provides a smoother ride. Stocks with lower price-to-earnings ratios, lower price-to-book value ratios, and stocks with dividend yields large enough to measure tend to be less volatile than growth stocks. One reason is that less of their price is riding on their "story." Another is that they don't have as far to fall if there is disappointing news. So if value stocks provided the same long-term return as growth stocks, we'd still be better off in value stocks because we'd have slept better while getting the return.

* Historically, value is a source of higher-than-market returns. Respected research by Eugene Fama and Kenneth French has shown that virtually all increases in returns over the broad market come from having a portfolio that is tilted toward either small-cap stocks or stocks with low-price-to-book value (value stocks). Growth buyers get the excitement and investment adventure stories to tell, but value buyers make more money. Warren Buffett didn't make his billions in technology stocks.

* There is a unique factor in the current market--- private equity deals. Those with a kindly view of private equity point out that the urge to take companies private is irresistible. The only limit is what they can borrow against to make the purchase. When you can borrow money at 5 or 6 percent, using assets that earn much more as collateral, taking public companies private is a good deal.

According to some estimates, about $1 trillion in publicly traded shares vanished last year, mostly to private equity deals. To put that in perspective, all the equity mutual funds in the country finished the year with $5.9 trillion in assets, according to the Investment Company Institute.

And the deals keep getting bigger. The Blackstone Group has concluded its $23 billion offer to take Equity Office Properties private. There is constant speculation on yet larger private equity deals, such as an offer for struggling Home Depot.

So what will private equity buy? It won't buy high-price-to-book value companies. It will buy value stocks--- the stocks of companies with assets that can be hocked. That means another good year for value stocks, even as their numbers diminish.

Eventually, you'll be glad your shares were taken for cash because Wall Street, where nothing succeeds like excess, has a new greater fool. This was once the job of Johnny Odd Lot, the small investor.

The new greater fool for 2007 is a fellow named Jonathan Megabucks III.
How Value Overtook Growth---The Seven-Year Climb
This table shows the annual percent returns on the Vanguard value and growth index funds, proxies for large-cap growth and value stocks. Growth stocks trounced value from 1996 through 1999. Value stocks trounced growth from 2000 through 2006.
Vanguard Growth Index Vanguard Value Index Growth minus Value Cumulative

1996

23.74

22.78

0.96

0.96

1997

36.34

29.77

6.57

7.53

1998

42.21

14.64

27.57

35.10

1999

28.76

12.57

16.19

51.29

2000

(22.21)

6.08

(28.29)

23.00

2001

(12.93)

(11.91)

(1.02)

21.98

2002

(23.68)

(20.91)

(2.77)

19.21

2003

25.92

32.25

(6.33)

12.88

2004

7.20

15.29

(8.09)

4.79

2005

5.09

7.09

(2.00)

2.79

2006

9.01

22.15

(13.14)

(10.35)

Source: Morningstar