During the Rebound, Growth Remains Attractive

Ed Jamieson
President, Franklin Templeton Advisers, Inc.
and CIO,
Franklin Global Advisers

Growth stocks have outperformed value stocks so far this year through July-end, but the performance gap is narrowing as value recovers. Over the past year, when uncertainties were great and rumors of possible bank nationalizations caused financial stocks to drive the market lower, value indexes containing many financials underperformed. When it became clear that many financial companies would survive, these stocks rallied and value recouped some losses. Going forward, we believe there are ample opportunities for both growth and value funds to earn positive returns.

As the market continues to rally, growth stocks remain attractive on a relative valuation basis. Growth stocks normally trade at higher price-to-earnings (P/E) multiples than value stocks because of expectations for earnings growth, as stock prices are ultimately a function of earnings. Historically, Russell Midcap® Growth Index stocks have traded at higher P/E multiples than Russell Midcap® Value Index stocks by about eight times on average. At the moment, this gap is down to only about three times, which still shows significantly more price appreciation of growth stocks over value stocks based on historical average P/E multiples.

The next five or so years may be a period of sub-standard gross domestic product (GDP) growth as U.S. consumers deleverage, unemployment rises, housing prices stagnate and exports weaken from sluggishness in the world economy. If post-recession GDP is indeed lower than normal, we expect investors to pay a premium for growth, since any kind of growth would be a scarce commodity.

We are optimistic about growth stocks for two reasons. First, we are in the midst of the unlocking of the credit cycle. Improved conditions have been visible in the high-yield bond market and the convertible securities market. Yield spreads are tightening, and the securitization market is showing signs of life.

We believe we are at the end of the beginning of the stabilization of the financial markets and companies are beginning to have access to credit again. As a result, the stock market has been responding favorably to these developments.

Secondly, managers of well-run companies are not sitting idle. They have been slashing costs, renegotiating contracts, bargaining harder and making investments opportunistically. When we return to a period of even modest growth, we expect to see earnings rise sharply as a result of such cost-cutting efforts. We are already positioning our various Franklin Templeton growth-style funds for both a stock market run from the credit cycle unlocking and better-than-expected earnings in a modest growth scenario.

Within this environment, our Franklin Templeton growth-style funds are continuing to focus on growth, quality and valuation. Specifically, we have been interested in companies with the potential to produce sustainable earnings and cash flow growth. In terms of quality, we are looking for strong management and business models that may offer sharp earnings growth with the return to modest economic growth. Finally, we want to make sure we are paying reasonable valuation for these investments.

Please click for more information on the following funds:

FTIF - Franklin U.S. Equity Fund
FTIF - Franklin U.S. Focus Fund
FTIF - Franklin U.S. Opportunities Fund
FTIF - Franklin U.S. Small-Mid Cap Growth Fund