Forget the bull-vs.-bear battle. Try the race between the tortoise and the hare, a pair sometimes referred to as value stocks and growth stocks.

Growth stock funds finally showed their rabbit-like speed, passing value stock funds in the last month. Through April 7, large-cap growth funds were up 2.65%, while large-cap value ones were up 1.32%, compared with a 1.61% return on the S&P 500, according to Morningstar.

The victory is worth noting because large-cap growth funds have consistently underperformed their slow and steady competitors in the first quarter of 2004, as well as just about every other period in the past 10 years.(See chart.)

But before value investors consider jumping on the growth-fund bandwagon, they should take a closer look at the holdings of their funds, because they may find some surprises. What they once thought was a growth stock during the bubble might have been transformed into a value stock during the bust. And of course, vice versa.

Growth Spurt

Rosanne Pane, a mutual fund strategist at Standard & Poor's, says growth funds would have outperformed value for the entire first quarter of 2004, but their momentum was interrupted in February and March after consumer confidence numbers started to fall and investors became cautious about both the strength of the economic recovery and the longevity of the stock market rally.

For the full first quarter of 2004, S&P reported that large-cap value funds outpaced large-cap growth ones 2.51% to 1.36%, while the S&P 500 gained 1.51%. Morningstar's quarterly results came in slightly different, with large-cap value returning 2.37% and large-cap growth returning 1.4%.

Over the past four weeks, however, Pane says investors have recovered from their late winter crisis of confidence, particularly with the surge in March nonfarm payrolls.

"Standard & Poor's believes that growth will reassert itself when first-quarter earnings come out, and currently recommends that investors overweight information technology, health care and consumer discretionary," says Pane.

Value Funds Grow on Investors
Performance Review
Fund Category 1 Month YTD 3 Month 1 Year 3 Year 5 Year
Large-Cap Growth 2.65% 3.22% 1.28% 29.76% -1.19% -4.47%
Large-Cap Value 1.32 3.45 2.43 35.25 3.45 2.88
Source: Morningstar

Pane says her prediction is based on the historical pattern that growth stocks typically outperform value stocks in the second year of an economic recovery. S&P is forecasting GDP growth in the 4.5% range this year, after surprisingly strong growth in the second half of 2003. But Pane has one important caveat: "The influence of terrorism and the war in Iraq could make people fearful again and switch back to value stocks."

Tom Roseen, a senior research analyst at Lipper, also sees a "natural rotation" from value into growth, especially because "growth has been a laggard in comparison."

The Growth Manager

T. Rowe Price Growth Stock ( PRGFX) fund manager Bob Smith says he has been seeing more money flow into his large-cap growth fund from value funds over the past few months. He expects the trend to continue as long as the mega-cap names in his portfolio, such as Cisco ( CSCO), Pfizer ( PFE) and Citigroup ( C), keep beating earnings estimates.

Smith also says he is not surprised when people ask him what a "value" name like Citigroup is doing in his portfolio.

"The terms value and growth screw everybody up," says Smith.

The usual definition of a growth fund is a portfolio of stocks that have capital appreciation as their primary goal. Growth funds, therefore, invest in companies that reinvest their earnings, using them for expansion, acquisitions and/or research and development.

Value funds, on the other hand, tend to buy companies that use their cash to pay shareholders a high dividend. Value stocks more often than not also sport low price-to-book and price-to-earnings ratios compared with those of their growth-stock counterparts.

Of the 988 members of the Russell 1000 index, as of March 31, 406 were categorized as value stocks, 254 were considered growth stocks, and 328 were labeled both growth and value.

T. Rowe's Smith makes a stab at his own definition: "Growth investors buy companies because they are cheap compared to where they will be in three to five years. Value investors look for companies that are cheap relative to where they should be trading right now."

Smith defends his classification of Citigroup as a growth stock. "Citigroup has had better than 15% compounded growth, and it trades at 12 times forward earnings," says Smith. "Even if multiples don't go up, you should get attractive returns."

Smith is unconcerned that Citigroup's P/E ratio is low compared with that of your typical growth stock. As a counterpoint, he highlights chipmaker Motorola's ( MOT) multiple of 30 times 2005 earnings estimates -- more than double Citigroup's -- despite the lack of growth by the company.

The Value Manager

Despite its appearance in Smith's growth fund, Citigroup is confined to the "value" camp in the Russell 1000. But there's no need to worry about getting lost in translation, because Smith's peer on the value side of T. Rowe Price's fund family, John Linehan, has the company in his T. Rowe Price Value ( TRVLX) fund.

Linehan also says investors should not read too much into the recent growth spurt, since value funds have historically beaten their rivals.

"Benjamin Graham who wrote the book on value investing and is considered the mentor of Warren Buffett said that growth stocks are 'stocks of mystery,'" says Linehan. "Over the long term, if you pay up for stocks of mystery, you are going to underperform, so you are better off buying value stocks."

When it comes to defining a value stock, Linehan says, "I know it when I see it", a reference to Supreme Court Justice Potter Stewart's answer when he was asked to define pornography.

Although the classifications have become a bit blurred, Linehan says he still looks for the classic criteria when picking a stock for his fund. Those include a low P/E ratio, a reasonable dividend yield and, most importantly, a long-term secular growth rate of lower than double digits.

Linehan says International Paper ( IP), which was recently dropped from the Dow Jones Industrial Average, is an example of a classic value stock that "a growth manager would not touch with a 10-foot pole."

"IP has a top-line growth rate of 4% to 5%, which is right in line with GDP, and the long-term cyclical growth rate of the paper business is not that great," says Linehan. "It has a high dividend yield, low capacity growth and a high cash flow due to a high depreciation rate. The only question remaining is, how do you reinvest the cash?"

Another one of Linehan's top 10 holdings is Microsoft ( MSFT), a company which, like Citigroup, is often curiously found among the holdings of both growth and value fund managers.

"Microsoft is becoming a value stock. It will probably be included in the Russell 1000 value stocks soon," says Linehan.

Soon but not yet. Microsoft's hyperbolic growth may have ended, and it now pays a dividend, but it is still listed as a purely a growth stock in the Russell 1000.

Linehan says Microsoft is a good example of the new breed of "tweener" companies that fall within both classifications. "There are far more tweener companies now, due to the bursting of the bubble," says Linehan.

According to Linehan, a clearer bifurcation between growth and value might be found in the telecom sector. He places fixed-line companies such as BellSouth ( BLS) and AT&T ( T) in the value camp and wireless companies such as Nextel ( NXTL) (NXTL) in the growth category.

Contrary Indicators

The semantic argument between analysts as to what exactly constitutes a value or growth stock is intriguing, but what investors really care about is whether this sudden turn to growth is for real, and not just a rabbit in a tortoise shell.

Russ Kinnel, Morningstar's director of fund research, says, "Lots of contrary indicators are saying that value is well worn and it's time to turn to growth. One contrary indicator is that investors are chasing value funds like the Dodge & Cox Stock ( DODGX) fund, which has now been closed to new investors. People have also been replacing growth managers with value managers."

Even with contrary indicators lining up against value funds, Kinnel isn't jumping into the growth pool with two feet just yet. "Growth had a pretty darn good year last year, so it's not a screaming buy either."

Lipper's data indicate that large-cap value funds narrowly outperformed large-cap growth funds in 2003 with respective returns of 28.35% and 26.6%, suggesting that value funds have been narrowing the gap for some time now. The S&P 500, in comparison, returned 28.68% over the same period.

Morningstar data even show large-cap growth beating large-cap value by a slight margin of .09% for the full year 2003, but large-cap value outperforming large-cap growth for the one-year period ending April 7, 2004, by a healthy 5.49%.

The measurements, much like the classifications, make it an interesting, if somewhat confusing, race, now that it's become a close one.