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Three Solid Funds Left Behind in Growth's Rally

Why are these large-growth funds still lagging?

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Through mid-September, 2007 has been the year of growth stocks' rebirth. After seven consecutive calendar years in which value outperformed growth, the leading diversified domestic-stock fund categories this year are mid-growth, large-growth, and small-growth (in that order). Growth's rebound has been driven by the now-narrow gap in valuations between companies with highly cyclical businesses and leveraged balance sheets, and firms that generate substantial profit growth due to competitive advantages. (The latter group typically trades at a significant premium to the former.) And as interest rates have generally risen--despite the Federal Reserve's rate cut on Sept. 18--companies with shakier finances have found it more expensive to borrow. On a related note, rising rates helped bring on the cooling of the housing market, and issues with lower-quality mortgages have hit the financial sector (a favorite of value investors).

Yet despite the recent reversal, some of the large-growth funds that have fared worst in recent years--funds that prefer financially sound companies cranking out steady profit growth year after year--have continued to lag their rivals this year. That's because investors have instead turned to rapid growers with higher price multiples, often within technology and Internet-related areas. For example,  Research in Motion (RIMM), which makes the BlackBerry, and Internet retailer (AMZN) have enjoyed huge gains this year. We wonder how long this trend will last. If the U.S. economy's recent hiccups are a harbinger of a prolonged slowdown, investors may become less willing to pay up for such high-octane fare (and the firms' rapid earnings growth could slow, too). That in turn could lead to a flight to the "quality" firms that the lagging growth funds below tend to favor.

Certainly, there are some aggressive-growth funds that are fine long-term choices, but we think the following funds are attractive contrarian plays. Each one lagged its typical large-growth rival in 2003 (the first year of the post-bear market rebound, and when speculative firms had their best year since 1999), and has lagged again for the year to date through Sept. 19, 2007. (Each also lagged for most of the intervening years.) But although they haven't been in the market's sweet spot lately, these funds stand to benefit when financially sturdy, growing franchises return to favor. Each boasts veteran managers with sensible, proven approaches and moderate costs. (For our take on several other funds that are lagging their rivals this year, check out senior analyst Gregg Wolper's recent column.) It's worth noting that two of the three funds below don't invest heavily in mega-cap firms, which often sport a steady profile due to their sheer size and dominant market share within their industries. These funds have simply found companies across the market-cap spectrum that have kept competitors at bay and managed their finances well.

Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.