NO MATTER WHAT'S

happening in the markets, Joseph McNay, the overseer of $3.1 billion in assets at Boston-based Essex Investment Management, finds a way to profit from it. That has led to superior performance in the flagship long-short fund that McNay has managed for some 25 years. These days, this godfather of growth-stock investing is going organic focusing on industries expected to show strong growth regardless of economic conditions and choosing the highest-quality stocks delivering dynamic growth in their core businesses. And he's convinced that this is the year value yields to growth.

Barron's: What did you make of Tuesday's selloff?

McNay: It puts people on notice. It is going to force money to quality growth stocks and away from cyclicals. The economy is flattening out and therefore cyclical stocks will become more at risk, and the opportunity will be in companies that have organic growth, without regard to the economy.

Tuesday was a wake-up call. Greenspan mentioning a possible recession was magnified by the Chinese moving to cool investor speculation, and on top of it the system wasn't geared for the level of action. That was quite scary, and it is also a reflection of the significance of exchange-traded funds and how hard it is to accommodate the higher level of trading. From my point of view, it is all very constructive, and the market will grind higher as money and there is still plenty of money out there flows to quality growth stocks.

So you are optimistic about the market?

I do like the market. But a correction is very constructive, although painful. I see a set of conditions that are extremely positive. There is so much money available, it has to go someplace. What are the sources of that money? One of them is all the money being raised by the leveraged-buyout firms. We are early to right in the middle of that trend. It is going to feed on itself. Secondly, there is a lot of money going into venture capital.

Two weekends ago was a great example of what is going on: a buyout of TXU that is going to put $45 billion-plus into the market, Hub International in Chicago bought out for $1.7 billion and the rumor emerges that Dow Chemical will be bought out for another $45-plus billion. That's $90 billion to $100 billion of money added to the system.

And no deal is too big.

That's what is really impressive. Large companies are being bought. Then you get Temple-Inland talking about splitting itself up. These are just add-ons, but the major point is there is so much more money available. These LBO firms also borrow a lot of money, so you are increasing debt, which is an increase in money supply.

So what brings this party to an end?

At some point, the competition for deals becomes so great you start to get prices so high they are no longer economic. This will ruin itself. But this is the beginning phase. I don't think anyone dreamed we would see a TXU get bought out or a Dow Chemical, should it happen.

What other conditions exist that are making you optimistic?

We need a decent economy, and in spite of Greenspan saying we could have a recession, I think the economy overall is doing pretty well. The economy has recovered from the recession and is now plateauing. I'm not wildly bullish about the economy, but I'm not negative, and I see worldwide economies continuing to do just fine. From time to time, both China and India will try to slow their economies to contain inflation and/or the value of their currencies. But that's because things are too good, not because they are bad.

What about profit margins peaking? Won't that have a negative impact?

Profit margins are peaking and this is going to cause, to some degree, a topping out of the cyclical value stocks and will drive more money toward organic-growth companies. I have a set of charts from Steve Leuthold that shows, in this five-year recovery, that the market has gravitated to value stocks instead of growth, whether they were small-, mid- or large-cap stocks, and it has gone to cyclical stocks instead of growth. We had a recession, companies tightened up substantially, then the economy started to pick up. As business picked up, their profit margins expanded and earnings went nuts.

That move is finished to a large degree, and we are moving into a period where the money will look for organic growth. It will go to small-, mid- and large-cap growth, but you get faster growth in the mid- and small-caps than you do in large. But you get more security in large, so all three categories will do well, but, in general, organic growth is where the real action is going to be. That's contrary to what a lot of people think.

Most people think the days of small- and mid-cap domination are over. You think they could be further extended?

Yes. The charts show that the small-cap domination was in depressed cyclical companies. I would use as an example United States Steel, which was trading at $10 a share in 2003 and is now around $88. It went from a market cap of $1.2 billion to about $11 billion. How about that? I'll never forget going to an investment committee meeting where I am a trustee and a small-cap manager came in with U.S. Steel as their stock and I said, "Hey, wait a minute, this used to be part of the Dow Jones Industrial Average." Phelps Dodge has gone from $12 to $120, up 10 times. It was a $2.5 billion market cap and now it's $25 billion.

Where do you stand on interest rates?

I stand with [Federal Reserve Chairman] Ben Bernanke and that is, until such time as there is a reason, he isn't going to change. With the economy flattening, it takes away the desire to increase and, at the same time, with the money supply increasing and rates staying low, there is no reason to decrease. So rates will be stable.

Inflation isn't troubling you?

Inflation goes on all the time. The question is: At what rate? The value of the dollar continues to erode, but it is on a consistent basis. The only positive right now is that it appears the European countries aren't very different from us, so the dollar isn't eroding versus the European currencies. It will erode against the Canadian, New Zealand and Australian currencies, where you have natural resources and a more positive set of conditions, but it won't be a big issue. It will be a little more of an issue with gold, which continues to fluctuate but edge higher on a long-term basis. The continued erosion of our currency makes gold an important asset for a long-term position.

Where are you finding companies with organic growth?

In industries that have good growth characteristics, such as biotechnology or Voice-over-IP [Internet Protocol], the Internet and nanotechnology. Not to mention energy in general.

And alternative energy is a place where there is some great organic, dynamic growth. One has to be sensitive to valuations. But I've been invested in solar companies for quite a while, and I met with the managements of a number of solar companies recently, and if anything the growth is accelerating, not decelerating.

What about headwinds from the housing market? Are they likely to disrupt your thesis at all?

I look upon it differently. I look upon it as a negative area and one in which I'm willing to take a negative position. The outlook for subprime mortgage lending and real estate and home development continues to be poor. It is weakening, and weakening more than most admit. Every time we get a report from one of those companies, the outlook is worse than one had expected.

If Bernanke and our government were to have any one concern, it would be about the loss of value in homes and the problems that have been created by adjustable-rate mortgages, subprime mortgage loans and the very high prices in residential real estate. If we were to see unexpectedly lower rates, it would be because of this area. It does affect some areas of retail and personal consumption and financial institutions, and there are a series of financial institutions that have already begun to show the negative signs of this. I don't see that changing, particularly.

This is an area that will consistently worsen, more so than many people expect. We are in the early phase of it. We had a nice rally in the home-building stocks and now we are moving back to reality, and so I am less interested in retailers or in makers of products that are sold to low-income people, frankly.

Let's get to the areas you really love.

I still love energy from a broad point of view, and that includes a few of the leading service companies. Schlumberger is an example of a large-cap energy company and Core Laboratories is a small-cap in the oil area.

Hasn't it gotten a lot tougher to invest in energy?

Yes, but there is no question that the long-term demand continues to grow. Also, we have been drawing from the existing strategic reserves, to some extent. OPEC [Organization of the Petroleum Exporting Countries] has drilled additional wells in their existing reserves, which means in the long term they are running those reserves down a little faster. It is much more difficult to find any significant new resources and much more expensive. You have to go further offshore and much deeper. This period is nothing like what occurred in 1976 to '80, when there were so much major available reserves out there to find and when they found so much they didn't know what to do with it all. This time it is dramatically more costly, probably between $45 and $60 a barrel to find it and get it.

We are in a static period for a while, but later the price of oil will go higher. For investors, it is a matter of isolating companies that are going to do well because of their own internal set of conditions: Their business is very good and their products are in big demand. Schlumberger is a global oil-services company, and their business is pretty good. Core Laboratories is a Dutch company that does something no other company can do: They have an injection system that helps get more oil out of existing wells and gets oil out of new wells faster. I've reduced my energy exposure, but I still have one; I am much more selective.

What do you like on the alternative-energy side?

MEMC Electronic Materials, which produces polysilicon used in making semiconductor wafers for the solar industry. A couple of years out, should conditions stay as they are, it would appear the company will earn between $5 and $7 a share, up from $1.66 in 2006. The stock is around $52.

There's a controversy about whether there is a shortage of polysilicon or not.

I've talked with the buyers and producers and sellers of it, and I believe it. The growth in the area is stupendous. I also like SunPower as both a supplier of electric-power products and also of solar cells, solar panels and inverters. It is a broad-based company, and it is growing at 150% to 200% every quarter. I also like Suntech Power and First Solar and even Canadian Solar and Trina Solar, but some of those have now reached levels where I feel one must pull back and be careful for a while.

You mentioned nanotechnology is still a favorite of yours.

I do like nanotechnology. I like Fei, which makes nanotechnology equipment. It is the leader in the field, with 70% of the business. It has a very good growth rate; in its most recent quarter, sales were up 41% and earnings were up in a major way. It is not well-known or exploited, yet it is the absolute leader, and it is really just getting going.

Of course, I still like Harris & Harris, a venture-capital firm for nanotech companies. They have a couple of very good companies in their portfolio, one or two of which I think could go public in the next six to 12 months.

What do you like in biotech?

The leaders, from my point of view, are Gilead Sciences, the No. 1 company in making drugs for HIV and hepatitis B, and Genentech, which has a very good earnings profile and will have a good showing this year, even though investors were a little unnerved by the competition between two of its drugs used to treat macular degeneration, Avastin and Lucentis.

Avastin is a cancer drug and not approved for macular degeneration, but some use it to treat the eye disease because it costs $2,000 a treatment versus $14,000 for Lucentis, which is approved for macular degeneration. On the surface, they appear to be somewhat the same in terms of their impact. The National Institutes of Health is doing a comparison test of the two, but that is going to take something like two to three years to get done, in my opinion. Meanwhile, Genentech wins either way.

Any others?

Another, I think, that will ultimately be a big deal, is Vertex Pharmaceuticals. Information on its hepatitis C drug will start coming out in April, May and June at some major conferences. From all I can tell by talking to people in research areas of some medical institutions, it still appears to have a very good shot, although one must always wait and watch because one never knows for sure how something will come out.

What about technology stocks in general?

I like some of the lesser-known technology companies.

I love Focus Media, which is an audio-visual display company for advertising in China. This company has grown, so far, over 200% every quarter in the last three quarters and it's a leader in its business.

I also love Voice-over-IP, and there is a company called Synchronoss Technologies that offers software that allows communication-services providers to manage their customer orders. Synchronoss grows about 30% to 35% every quarter and is the absolute leader in the field.

A company that just had a secondary distribution, Riverbed Technology, absolutely epitomizes what I'm interested in. This company has been growing between 200% and 500% every quarter. It provides services to improve the performance of data applications in wide-area networks. They have equipment that makes it go faster, and they absolutely lead this business in the U.S.

Are you still a fan of Google?

I love Google still. And I love Baidu.com. Baidu has given major competition to Google in China and has gone from roughly 25% to 65% of the market there, while Google's share has dropped from 35% to 15%.

Google owned part of Baidu and, unfortunately, sold its stake because they felt they weren't able to work together. But it is a company that really is dominating the fastest growing market in the world, and it certainly is a good company.

Talk about Google. Do you see any signs of problems there?

If it had any one problem it would be that the size of success gradually becomes a bigger problem, because maintaining a growth rate at a very high level is impossible. But they continue to absolutely dominate the market.

They are really first-class. They are cash-rich and can afford to buy into the technologies of companies like YouTube. YouTube has certainly had some controversy over what it shows and over franchise rights, but it is evolving into a good business.

Does Google go up from here?

I think it goes sideways for a while longer, then it goes higher.

Thanks a lot, Joe.