Riddle me this, savvy investor: When is good news actually bad news?
By way of an answer, consider Genentech (NYSE: DNA ) , Home Depot (NYSE: HD ) and Time Warner Cable (NYSE: TWC ) . Each of these companies has a higher forward price-to-earnings ratio (P/E) than the S&P 500. However, over the past 12 months, they've also lagged the S&P in stock-price performance. The same is true of Wipro (NYSE: WIT ) , Freddie Mac (NYSE: FRE ) , and Veolia Environnement (NYSE: VE ) .
So what's the problem? Call it the "rosy scenario" syndrome: Analysts expect double-digit earnings growth for each of those stocks over the next five years.
Isn't that good news?
In the abstract -- and if the analysts turn out to be right -- that's good news indeed. But the market is especially efficient when it comes to pricing in (or discounting for) growth stories. When macroeconomic data or industry-specific news comes along and shakes up the sunny growth story, highfliers like these will drop in a hurry.
I'm not saying you shouldn't own these stocks. Companies with high growth prospects are nothing to sneeze at, particularly if you have a stomach for volatility. But even if you consider yourself an investing genius, world-class mutual funds can offer you a smarter way to snag the market's pricier prospects. You'll get the market-beating potential of growth stocks, along with a smartly constructed portfolio that should help tame wild performance swings.
Two for the price of one
But not just any fund will do. As part of the Fool's fund research team, I'm constantly on the lookout for:
1. Strategic tenacity: Growth investing has been in the doldrums since the market melted down in early 2000. In this climate, we're especially interested in growth funds led by managers who have stuck to their guns during this downturn, snapping up the companies they like at substantial discounts to their earnings-growth potential. After all, investing in otherwise rock-solid companies while their area of the market has fallen from favor means that managers are buying quality at discounted prices.
2. Healthy skepticism: Managers who fall in love with a stock's "story" don't make the cut. When it comes to growth investing in particular, it's too easy to become overly wowed and fall prey to "irrational exuberance." (See the late 1990s for the gory details.) With that in mind, we want growth managers to be as unemotional about their work as possible -- and to have defined sell criteria. Yes, we should all be inclined to let our winners run. We shouldn't, however, let them run away.
3. Intelligently placed bets: Risk is baked into growth investing, and because we want to beat the market and get a good night's sleep, we favor managers who run intelligently diversified portfolios. We're not averse to funds that pack considerable sums into individual names or certain areas of the market. But at the same time, you likely won't find us recommending, say, a tech-sector fund, either. There are smarter ways to get the growth job done.
Speaking of which ...
If you'd like to invest fearlessly in the market's "scariest" stocks, consider taking the Fool's Champion Funds service for a risk-free spin. Our overall list of recommendations is spanking the market as I type. And yes, we do have a selection of terrific growth funds -- hand-picked go-getters that have what it takes to get the market-beating job done.
Click here to give Champion Funds a test-drive, and find out more about why top-notch mutual funds make the ideal safeguard for your money.
This is adapted from a Shannon Zimmerman article originally published Jan. 16, 2007. It has been updated.
Fool analyst Adam J. Wiederman thinks of himself as a daredevil with brains. He owns no shares of any company mentioned above. Home Depot is a Motley Fool Inside Value recommendation. You can check out the Fool's strict disclosure policy by clicking right here.