NEW YORK ( TheStreet) -- Growth funds have been rallying lately. During the past year, small growth funds returned 26.5%, compared to a return of 15.9% for small value, according to Morningstar. Now many growth stocks are beginning to look rich, says Will Muggia, who is portfolio manager of Touchstone Mid Cap Growth ( TEGAX - Get Report), which has returned 6.9% annually during the past 10 years, outdoing 83% of peers. "In the last several weeks, it has gotten tougher to find bargains," he says. "In the past when our analysts had trouble finding things to buy, it was often a sign that the market was about to pull back." Muggia follows a cautious form of growth investing. He looks for increasing earnings -- but he is not willing to pay top prices. The aim is to spot stocks that come with limited downside risk. To find bargains, Muggia ranges widely, assembling a portfolio that includes stocks from all areas of the growth universe. Some holdings are slow growers, while others are delivering rapid earnings gains. The fund holds stocks that seem poised to grow for years as well as cyclical companies that seem likely to enjoy only a brief surge. This strategy is different from the approach of many competitors who tend to focus on the fastest growers or some other narrow segment of the growth universe. "We will take a stock that is growing at only a 10% rate, if it is trading at 8 times earnings," he says. "If the stock is growing at 30%, we will pay a higher price." To prepare for a possible downturn, Muggia has been selling high-priced technology and energy stocks. He is shifting to defensive names, including undervalued industrials and reliable health care shares. Some of the moves are unusual for the manager, who has been buying growth stocks for 25 years. During his entire career, he never owned auto stocks because the industry had sluggish growth. But these days he is buying auto suppliers since they are reporting big earnings gains -- and still sell at modest prices.
A holding is Lear ( LEA - Get Report), a maker of auto seats. After sinking badly during the recession, earnings have rebounded for seven consecutive quarters. In the most recent quarter, earnings jumped 48% compared to the period a year ago. The stock sells for a P/E multiple of 10. Based in Michigan, Lear is likely to gain market share as Japanese companies struggle to rebound from the earthquake, says Muggia. Another cheap stock is Warner Chilcott ( WCRX, a pharmaceutical company that sells for a forward P/E of 6. In the most recent quarter, sales and earnings sank. Muggia says that in the past the company acquired a series of businesses that were in decline. The idea was to milk the shrinking drugs. The acquisitions often worked, but the stock was ignored by growth investors. Then in 2009, Warner Chilcott bought the prescription drug business of Procter & Gamble ( PG for $3.1 billion. Muggia says that the acquisition came with a promising pipeline of drugs that can transform Warner Chilcott into a growth stock. "All the sudden this has become a business that can grow," he says. Another health stock is CareFusion ( CFN, which supplies systems for intravenous and respiratory therapy. The company was spun off from Cardinal Health ( CAH in 2009. Since it became an independent business, CareFusion has been working to cut costs, Muggia says. He figures that the new efficiencies will help to raise profit margins by a percentage point or two for the next several years. Muggia says that there should be increasing demand for CareFusion's products because they can help to cut medical costs. He also likes Avis Budget ( CAR - Get Report). While the car rental business has been a sluggish sector, it has been consolidating. That should enable survivors to raise prices and boost profits, Muggia says.
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