Pondering the Demise of Nontech Growth Stocks

Shares of Merck (MRK Quote) hit a wall this year, and it's hard to figure out exactly why.

Certainly you can come up with theories for the 21.4% drop -- that after a big run last year, it was due for a drop, that investors betting on an upturn in the economy drew money out of the drugmaker to deploy in more cyclical areas of the economy, that in a skittish market it carried too high a multiple, that there were concerns over a possibly tougher regulatory environment.

Yet it seems there may have been a less fundamental reason for the general decline in the stocks of companies with strong, steady earnings growth like Merck: Growth funds, facing redemptions, were being forced to sell.

The way it seems to have worked is this. At the March 10, 2000, peak on the Nasdaq, growth and aggressive growth funds were heavily overweight tech stocks. As tech stocks declined, fund managers began to incrementally move money to other areas of the market, but because they were, by definition, growth managers, there were limits on where they could go. So they sought out companies like Merck and Colgate-Palmolive (CL Quote). Wall Street traders started whispering about Janus, the Denver-based fund complex with a penchant for growth, taking down big blocks of Boeing (BA Quote) in the fall. By year end, it was Janus' 11th-largest position.

Although their portfolios took some heavy hits, aggressive growth and growth funds saw inflows throughout 2000. Their shift away from tech meant that nontech growth stocks got an increasing amount of new money pumped into them. And this helped their performance -- big time. Merck tacked on 57.2% between March 10 and the end of the year, Colgate added 56.4% and Boeing went supersonic, gaining 104%.

New Year Downdraft Merck retreating after strong 2000

But in the first 12 weeks of this year, U.S equity funds have seen net outflows of $3.9 billion, according to TrimTabs.com estimates, and while growth funds have apparently seen an incremental amount of money go into their coffers this year, it's been nothing like the huge inflows last year. As for Janus, according to Boston-based fund consultancy Financial Research, it saw outflows in excess of $2 billion in the first two months of this year.

"As the flow of money to growth funds has slowed," says Banc of America Securities equity strategist Tom McManus, "not only have technology stocks been hit, but also growth stocks outside the technology." And how. The Amex Consumer Staples Select Sector (XLP Quote) fund is loaded with the kind of nontech growth stocks funds were shifting money into last year. After gaining 45.9% from March 10 through the end of 2000, it has dropped 14.7%. Strange given that staples is one of the areas of the market where companies are least affected by the downturn in the U.S. In fact, these companies' big appeal is that they grow earnings regardless of what's happening in the economy.

It may have even been the case that growth managers have been liquidating their nontech holdings more quickly than their tech.

"It appears that growth managers may have been selling their drug stocks and holding tech," says Merrill Lynch quantitative strategist Kari Bayer. "The feeling is they're waiting for the Nasdaq to run."

If this has happened, then managers may have fallen into the old investing trap of holding on to their losers for too long and selling their winners too early -- in effect, throwing the baby out and keeping the bath water. With signs of stability making their way into the market, it may be that growth areas outside of technology will see renewed strength. In fact, given the stability of their earnings, the case can be made that they will be the leaders on the next leg up.

"We've been in a temporary lull for growth outside of tech," says McManus. "The primary driver for stock prices is the fundamental outlook -- i.e., earnings. If fundamentals are improving, stocks can shrug off a multitude of sellers."