Hot stocks, cool prices: as the market surges, here's how to invest in growth stocks without overpaying.

GROWTH IS GOOD. AND THE EARNINGS NUMBERS ON WALL Street look strong. In the first quarter of this year, the median company in the Standard & Poor's 500 stock index posted year-over-year earnings growth of 10.1%--marking the 19th straight quarter of double-digit growth, according to Zacks Investment Research. And with the Dow Jones industrial average up 22.5% since January of last year, investors may be scratching their heads when trying to find untapped investment opportunities.

These are market conditions that take Randy Philip, who heads a health insurance agency in Alexandria, Virginia, back to the tech boom of the late '90s. Like so many investors, when the market was peaking, Philip, 40, failed to capture the paper profits of his tech investments. Ultimately, he came to recognize that he didn't have the time to do the necessary homework, so he's out of the stock picking game. Instead, he invests through mutual funds.

Philip recently added a mutual fund to his portfolio and he's glad he did: "My new fund, T. Rowe Price Growth Stock (PRGFX), has a strategy I like: It buys good stocks at depressed prices." Philip has followed this strategy himself. Several years ago, he invested in cruise line operator Carnival Corp. (CCL), after its stock fell from more than $50 to $24 a share. Now back up to $50, the shares are still in Philip's portfolio, but he's not looking to make any more bets on individual companies. The Growth Stock fund accounts for about 10% of his portfolio, and Philip now seeks the investment advice of Dywane Hall, a principal in the Alexandria office of LPL Financial Services. "Our goal is to bring him up to a 25% allocation in funds following this discipline, in order to maintain our growth allocations yet reduce our risk in the event that the markets turn down," says Hall.

The discipline that Hall refers to is known as growth at a reasonable price, or GARP. It's a style that's a blend of both growth and value investing. That is, GARP investors buy growth stocks--companies expected to post above-average increases in sales and profits. At the same time these investors take a value-stock approach, looking for situations where the share price is low, relative to earnings and cash flow.

"You can divide growth stock funds into three categories," says Karen Dolan, a mutual fund analyst at research firm Morningstar in Chicago. "There are classic growth funds, which look for good stories, indicating a company will have above-average earnings growth. There are aggressive growth funds, which may have a momentum strategy--they like stocks that have performed well recently. GARP funds, in the third category, might be considered the most conservative of growth funds because although they pay attention to growth, valuation is an important consideration as well."

MEASURING GROWTH

To start, GARP investors look for some minimum level of growth, such as an expected annual increase in earnings per share of 10% or better. They also look at valuation measures such as the price-to-earnings (P/E) ratio. A company trading at $12 per share, with earnings of $1.20 per share, would have a P/E of 10. To help put those two measures in context, one factor in GARP investing is the so-called PEG (price/earnings to growth) ratio. "We bought Lowe's (LOW) in early 2007," says Ron Taylor, portfolio strategist at T. Rowe Price Growth Stock. "Stocks related to housing were falling, but we like how this retailer of home improvement supplies is managed." He says Lowe's is growing earnings around 15% a year, and shares have a P/E ratio of 15, generating a PEG ratio of 1.

"GARP investors usually look for a PEG ratio of 1 or lower," says Tom Roseen, senior research analyst at fund tracker Lipper, based in Denver. "Funds following this strategy may have more consistent returns than other growth funds." Generally, the lower the PEG ratio the better, as it indicates how much an investor is paying for each unit of growth.

PEG ratios are not the only buy sign, but they are important, says Monica Walker, co-manager of the Lou Holland Growth fund (LHGFX), which also follows a GARP strategy. She says her fund owns shares of the insurer Aflac Inc. (AFL). "Earnings are growing at around 15% a year while the P/E ratio is in the mid-teens, so the PEG ratio is about 1," she says. "It's not always possible to buy companies with PEG ratios of 1 or less, though."

Technology stocks, for example, may have high P/E ratios, which can push up the PEG ratio. Walker says that her fund also owns shares of CDW Corp. (CDWC), a hardware and software retailer. "It has shown that it can keep growing, even during difficult times," she says. Walker puts CDW's P/E ratio around 18 and earnings growth in the 12% to 14% range, giving it a PEG ratio of 1.3 to 1.5, which she feels is an attractive metric for exposure to the tech sector.

Indeed, PEG ratios up to 1.75 merit consideration by Eugene Profit, who says that his Profit fund (PVALX) employs "value-sensitive growth investing," which is a GARP strategy. In 2005, Profit recalls shares of the software company Adobe (ADBE) were trading at less than $30 per share. "We thought the company had good growth potential, and we calculated the PEG ratio around 1.4, so we bought the stock," he says. Profit's fund sold Adobe in April at $42.15 per share.

When looking at PEG ratios, investors should keep in mind that earnings growth estimates are just that--estimates. A company with a very high P/E, say of 30 or more, can have a PEG ratio of 1 if projected growth is 30% per year. Before making such an investment, make sure you understand the assumptions behind such an aggressive estimate and feel confident that it is attainable.

FINDING A FUND

If this type of fund appeals to you, how can you find one? "Read over a fund's prospectus to see if a growth fund also talks about capital preservation," says Dolan. "In addition, strong relative performance during the 2000-2002 bear market might be a sign of a GARP fund that did not get carried away during the bull market."

During the go-go years of 1995 to 1999, when large-cap growth funds returned 20% to 40% each year, GARP funds may have lagged due to their more conservative holdings. The tables turned in the next three years, when funds holding large-cap growth stocks lost 12%, 20%, and 27%.

T. Rowe Price Growth Stock was up only slightly in 2000, and then lost 10% and 23% in the next two years. This was among the best performances in the large-growth category, indicating the defensive nature of its GARP strategy. Going back 10 years, over bull and bear markets, this fund's return is better than 9% a year, placing it in the top 10% of its category.

Similarly, Lou Holland Growth handily outpaced the average large-growth fund during the last bear market. Its 7.1% 10-year annualized return was far ahead of its benchmark, the Russell 1000 Growth Index (up 4.53% a year). At the Profit fund, annualized 10-year returns were a benchmark-beating 8.5%.

Nor are these the only GARP funds available to investors. Roseen names Legg Mason Partners Dividend Strategy Fund (CSGWX) while Do]an adds primecap Odyssey Growth (POGRX), Jensen fund (JENSX), and American Funds Growth Fund of America (AGTHX) to the list.

If the major market averages continue to soar, such funds might merit increased interest from investors. "A few years ago," says Hall, "almost all growth stocks were reasonably priced, so selection wasn't as much of a concern. Today, with the market higher, it's harder to find growth companies that give you the values you want." GARP funds may deliver the best of both worlds--growth and value--as well as performance that can run with the bulls while taming the bears.

GARP FUNDS SNAPSHOT

                                      Minimum
                     Total Return     Initial     Expense
Fund (Ticker)      1-year   5-year   Investment    Ratio    Load

American            22.8%    12.9%          250     0.63%   5.75%
Funds Growth
Fund of
America (AGTHX)

Legg Mason           24.8      6.8        1,000      0.85    8.50
Partners
Dividend
Strategy (CSGWX)

Lou Holland
Growth (LHGFX)       19.8      6.7          250      1.35   none

Primecap Odyssey
Growth (POGRX)       21.7     N/A         2,000      0.89   none

Profit (PVLAX)       20.0      9.6        2,500      2.45   none

T. Rowe Price
Growth Stock
(PRGFX)              27.5     11.0        2,500      0.70   none

DATA AS OF 6/18/07 SOURCE: MORNINGSTAR INC.