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Beware of Rising Valuations

Even in a lofty market, these funds' price multiples stand out.

This article was originally published in the October 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

The current bull market is the second longest in history, and the S&P 500 advanced 18.7% annually from March 9, 2009, through October 2017. Plus, mid- and large-cap major growth indexes gained about 1.4 percentage points more than the S&P 500, annualized, from March 2009 through October 2017.

Given the market's climb, it's not surprising that many funds' valuation multiples have reached or exceeded pre-financial-crisis peak levels. Some managers argue that high valuation multiples make sense in a low-interest-rate environment. Others are willing to pay premium prices for what they consider to be high-quality companies. Some think valuation just doesn't matter much when growth potential is huge. Each case has merit, but history shows that occasionally there are sharp corrections in stocks with the highest multiples. Probably the most dramatic case was the 2000-02 bear market when sky-high tech stock valuations were crushed and the Nasdaq 100 lost about 75% of its value.

We've highlighted four growth funds with lofty valuations as of September 2017. The funds have a history of investing in stocks with above-average price multiples, but the differential between the fund's average and the benchmark has widened recently.

The managers at  Marsico Focus (MFOCX), which has a Morningstar Analyst Rating of Neutral, follow macroeconomic themes to determine the fund's overall positioning, which led to an overweighting in consumer cyclicals through the first three quarters of 2017.  Netflix (NFLX) and  PayPal (PYPL) carry lofty valuations and contribute to an average price/earnings ratio of 33.5, compared with the Russell 1000 Growth benchmark's 26.3. The fund's holdings aren't widely dispersed either--58% have a P/E ratio that exceeds the benchmark. This is somewhat balanced by a price/sales ratio more in line with its bogy.

Neutral-rated  Touchstone Sands Capital Select Growth (PTSGX) has always been a high-volatility proposition. Lead manager Frank Sands is a true growth investor and is happy to pay premium prices for firms as long as their competitive advantages remain intact. But the fund's potential risks look especially acute these days with Netflix and  Amazon.com (AMZN) soaking up a combined 10% of the (September) portfolio, contributing to an average P/E ratio of 42.1. Plus, a recently added 1.0% position in  Snap (SNAP) coincides with the fund's spiking average price/sales ratio of 7.5 versus its bogy's 2.9.

The managers at Bronze-rated  Polen Growth (POLRX) target high-quality firms with strong earnings potential over a five-year investment horizon.  Alphabet (GOOG) soaked up 9.4% of the fund, and  Visa (V) and  Mastercard (MA) combined were 8.7% of the fund as of Sep. 30, 2017. The fund's 31.3 P/E isn't as steep as other funds included here, but it has increased about 30% in the past three years while the Russell 1000 Growth Index has increased about 15%. Similarly, the fund's 30.1 debt/capital is below its bogy, but this has more than doubled in the past four years.

Mid-cap growth fund  Baron Asset (BARAX) receives a Bronze rating. Rather than looking for shooting stars, manager Andrew Peck wants companies with sustainable competitive advantages and management teams that he can partner with for the long term, and turnover is usually less than 20%. Peck will hold on to a strong pick while the valuation is supported by his projections of long-term intrinsic value. For example,  Guidewire Software (GWRE)  is 3.1% of the fund and was first added in late 2013. Its P/E has climbed alongside the stock's 63% annualized gain since landing in the portfolio. But what's also boosted the fund's price multiples are richly valued new additions to the fund such as Align Technology (ALGN) and Ultimate Software . Overall, the fund's P/E and price/sales ratios have soared to 34.5 and 4.0 compared with the Russell Midcap Growth bogy's averages of 27.6 and 2.3, respectively. 

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