Building a secular and cyclical case for U.S. large capitalization growth stocks starts with the basics--what constitutes a growth stock? Notwithstanding the arguments for low P/E investing, when have/should U.S. large cap growth stocks outperform? What are the risks for such growth stocks?

In our view, a growth stock is defined by superior, sustainable fundamental characteristics, including growth in assets or equity, high returns on sales, total capital and equity, as well as high profitability and margin expansion. Especially for growth stocks, the future is worth more than the past. Therefore, as studies bear out, the best performing growth stock managers own growth stocks of the future and not the past. Growth, after all, is a dynamic quality. It involves forecasting fundamentals and looking for accelerating earnings growth, positive earnings surprises, upward estimate revisions, and favourable cyclical timing.

The case for U.S. large cap distils to the observation that over the years U.S. large cap companies have become better managed, have provided higher earnings growth, higher returns on equity, more free cash flow, and a more diverse earnings base. The measurable improvement is over their history and, with a few exceptions, relative to their global competitors. For example, from 1948 to 1998, U.S. large cap equities returned just over 13%, of which 9% was price appreciation and 4% was dividend yield. The 9% price return consisted of 6% earnings growth and 3% P/E expansion.

Above Historic Average Returns
However, during the five-year period 1994 to 1998, the sector returned an above historic average of 24%--and there are sound fundamental reasons for those higher returns. The 24% return consists of just under 22% price appreciation and 2% dividend yield. But, interestingly, of the 22% price performance, P/E multiple expansion accounted for under 9%, with 13% coming from good old-fashioned earnings growth within the large cap sector.

To explain the rising relative P/E multiples for U.S. large cap stocks versus the rest of the universe, look first at the history of return on equity (ROE) differentials between the former and the latter, and second, look at free cash flow. Over the 30-year period 1968 to 1998, using the 1,500 largest U.S. stocks, the ROE differential between the top 20% and bottom 80% of stocks by capitalization was 1.5% in 1968, declined steadily from 2% in 1974 to under 0.5% in 1980 and was again 1.5% in 1982. By mid-1998, the ROE differential was over 3.5%!1

If ROE is a measure of management quality and business model efficiency, then the outperformance of large cap stocks recently is more understandable. From 1994 to 1998, cash flow after dividends and capital expenditures for the Standard & Poor's Industrials has been strongly positive, $13.01 per share for 1998 and similar expectations for 1999. Those indicators of corporate balance sheet health were negative from 1964 to 1986, and close to zero in 1973.

Now, why growth stocks, particularly actively managed growth stock investing? Growth stocks outperform the market and value stocks when earnings growth expectations diminish. As the supply of earnings growth shrinks, the price assigned to that earnings growth, the P/E multiple expands. Of course, this is not an open-ended argument. At some level multiples do become unjustifiable. We believe that we are not there yet, that for truly consistent growth stocks the multiple will expand further. Even if the multiple awarded to a growth stock contracts, ultimately, earnings growth will bail out a certain degree of multiple contraction. That assumes, of course, that the stock will in fact exhibit consistent future earnings growth. Hence the emphasis in successful growth investing is on active management and picking growth stocks of the future, because their earnings growth will either be rewarded with a higher multiple or the earnings growth provides some buffer against multiple degradation.

Scarce Commodity
An additional argument for active management of growth stocks is that consistent growth is a scarce commodity. From 1988 to 1998, only 11 listed U.S. companies had at least 10% earnings-per-share growth each year! None grew at least 25% each year, and only two grew 25% for nine out of the 10 years! Consistent earnings growth drives stock performance over any appreciable period of time. Relative price performance follows relative earnings growth.

In summary, current growth valuations appear reasonable given the economic backdrop. True growth stocks attract higher valuations in a slowing corporate profits environment. Also, active growth styles are more likely to deliver excess returns than passive growth styles. Successful active growth style investing must be focused on the future rather than the past, since only by focusing on the future fundamentals of a growth company can true growth stocks be identified. Mathematically, those true growth stocks will always beat the market over a reasonable time period, as relative price eventually must follow relative fundamentals. Thus, the undeniably critical task of a growth manager boils down to the identification of true growth stocks and then prudent portfolio construction around those stocks.

Endnote
1. Sanford C. Bernstein data smoothed over three years.

Syed Hasnain is the Senior Vice-President and Large Cap Growth Portfolio Manager with Alliance Capital Management in Toronto.