Soaring Growth Funds

NEW YORK (TheStreet) -- Growth funds have been leading the pack. During the past year, small growth mutual funds returned 35.8%, compared with 29.7% for small value funds, according to Morningstar.

Now some analysts worry that growth stocks may be too expensive. Maybe so. But if the economy keeps expanding, the rally should continue as growth companies generate record earnings. To bet that the bull market will persist, consider the hot growth funds from RS Funds.

During the past year, RS Growth (RSGRX) returned 38.6%, outperforming 94% of its large growth peers and topping the S&P 500 by 10 percentage points. Other funds that finished in the top 10% of their categories include RS Mid Cap Growth (RMOX) and RS Small Cap Growth (RSEGX).

All the RS growth funds seek stocks that can deliver double-digit earnings gains consistently for the next four or five years. The aim is to find companies that can grow because they have compelling advantages, such as new products or low-cost production.

While some of the RS funds take fledgling businesses, most holdings are proven winners with fat profit margins of more than 20%. Such high-quality growth stars prospered in the roaring bull market of 2013. Among the big winners for RS Growth last year were Facebook (FB) and Google (GOOG).

While the recent returns were compelling, investors should keep in mind that the RS managers are willing to pay above-average prices for the best companies. The expensive stocks can drop rapidly in downturns. During the market meltdown of 2008, most of the RS growth funds suffered big losses and finished in the bottom half of their categories.

RS portfolio manager Scott Tracy concedes that the price-earnings multiples of his portfolios are higher than they were a few years ago. But Tracy says that the prices are justified because the RS holdings stand to enjoy big earnings gains as the economy grows. "We are seeing a lot of earnings growth from our companies," he says.

In their disciplined approach, the RS managers estimate future growth of each holding and develop yardsticks to judge the progress. Companies may be expected to open a certain number of facilities or increase market share by a target amount. If a company fails to achieve the goal, the managers begin considering whether to sell.

One holding in RS Small Cap Growth is MarketAxess Holdings (MKTX), which operates an electronic system that enables cost-efficient bond trading.

When RS began buying the stock about four years ago, MarketAxess controlled 7% of its market. The analysts figured that the growing business could control 15% in the next five years. The business met the target. Now the RS managers are continuing to hold the stock because they believe that the company can control 30% of the market in the next five years.

"They are using their technology to transform the European industry," Tracy says.

MarketAxess isn't cheap. The stock has a P/E multiple of 34. But its revenue rose 34% last quarter, and the company has a profit margin of 31%.

One holding in RS Mid Cap Growth is Core Laboratories (CLB), which takes core samples and uses other techniques to help drillers locate oil and gas.

When RS started buying the stock five years ago, the company had operations in about 400 of the largest 4,000 oil fields. Now the company is in 1,000 fields, and RS figures that the business can grow to serve 2,000.

"Core Laboratories has new products that will allow it to penetrate more oil fields," Tracy says.

One holding in RS Growth is Precision Castparts (PCP), which makes parts for aircraft. The company's revenue rose 23% in the last quarter. Tracy says that Precision Castparts will take market share from competitors by producing parts that are lighter and stronger.

At the time of publication, the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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