Growth Returns

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 (TXU) that is going to put $45 billion-plus into the market, Hub International (HBG) in Chicago bought out for $1.7 billion and the rumor emerges that Dow Chemical (DOW) 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 (TIN) 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.