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Domestic Equity—Growth | February 2013

Companies with strong and sustainable growth have been trading at compelling valuations

By Thomas Ognar, CFA; Joseph Eberhardy, CFA, CPA; and Bruce Olson, CFA—Portfolio Managers, Wells Fargo Advantage Premier Large Company Growth Fund

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In a market environment characterized by low interest rates and economic uncertainty, many investors have turned to the perceived safety of income-producing investments with less regard for longer-term growth opportunities. As investor demand for yield has increased, we believe that many investors have paid a higher premium for stocks that offer relatively high dividend yields but provide low earnings growth potential. Consequently, we believe that high-growth companies, those with long-term estimated earnings per share (EPS)1 growth of greater than 15%, are trading at compelling valuations, particularly when compared with higher-dividend-yielding stocks.

As illustrated in Chart 1, investor demand for stability and income has lifted the valuations of higher-dividend-yielding stocks close to parity with the broad equity market (as measured by the S&P 500 Index2). By comparison, stocks with strong and sustainable growth prospects are currently trading on a forward price/earnings (P/E)3 basis only moderately higher than their 10-year lows.

Growth stocks shown have projected EPS growth above 15% for the next 3–5 years.
Past performance is no guarantee of future results.
This chart is for illustration only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.
Source: FactSet

Chart 2 illustrates the valuation relationship between higher-dividend-yielding stocks and high-growth stocks within the S&P 500 Index since 2002. Over the past several months, higher-dividend-yielding stocks have been trading at elevated levels not often observed over the past 10 years when compared with valuations of higher-growth stocks.

Higher-dividend-yielding stocks in series have dividend yields above 3%.
Growth stocks in series have projected EPS growth above 15% for the next 3–5 years.

Past performance is no guarantee of future results.
This chart is for illustration only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.
Source: FactSet

Since early 2011, investors seem to have been more aggressive at times in their pursuit of higher-dividend-yielding opportunities. This trend was particularly evident as longer-term U.S. Treasury yields declined, partly due to the Federal Reserve's quantitative easing measures. From early February 2011 through the end of December 2012, the U.S. 10-year Treasury yield significantly declined from approximately 3.7% to 1.8%. This time period corresponds to when valuations for higher-dividend-yielding stocks were rising relative to both high-growth stocks and the broad equity market.

In our view, this valuation dichotomy offers a unique proposition for investors seeking companies with solid long-term growth prospects. We have identified several companies that we believe have strong, secular tailwinds that may support sustainable organic growth under a variety of economic conditions. However, despite solid growth prospects, many of these secular growth companies are trading at P/Es that are below their long-term growth rates. This dynamic, in our opinion, presents a favorable valuation-to- growth profile.

In many respects, the current low corporate earnings growth environment should lead to premium valuations for robust and sustainable growth opportunities. But going forward, we believe that it will be increasingly important to determine which companies are best capable of rewarding shareholders with sustainable revenue and earnings growth rather than simply paying out dividends.

Concluding observations

We believe that investors should consider multiple factors when making equity investment decisions rather than just a singular view of risk-to-reward in the context of dividend yield. An analysis of earnings estimates and valuations reveals a unique opportunity to build a portfolio of companies with robust and sustainable growth potential that is being underappreciated by other investors. Our analysis identifies strong growth companies that are effectively reinvesting cash flow in an effort to expand their businesses and successfully grow their revenues and earnings. We believe that companies consistently executing in this regard are likely to be rewarded with higher share prices over the long term through a combination of both solid earnings growth and potentially higher valuations.

The portfolio managers also manage the Wells Fargo Advantage Growth Fund,4 the Wells Fargo Advantage Large Cap Growth Fund, and the Wells Fargo Advantage Emerging Growth Fund.5

Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund's prospectus for additional information on these and other risks.

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