After three years of numbing declines and a disappointing first quarter, the stock market suddenly staged a vigorous rally with the S&P 500 Stock Index rising 18% from March through September and the Nasdaq Composite Index surging 33%. In this interview, Bob Smith, manager of the T. Rowe Price Growth Stock Fund (PRGFX), reflects on the market rally, potential opportunities, and his general outlook for growth investing.

Q. What were some of the primary factors for the market's turnaround?
A. First, I think the strong bond market in recent years allowed many companies with bad balance sheets to refinance their debt at much lower rates. Second, while Iraq is still a big unknown, the quick end of the invasion lifted much of the uncertainty troubling the economy. Once people saw the direction was no longer downward, it was a lot easier to believe that the market environment would improve. Third, investors' conviction that the economy would continue to improve was bolstered by the Fed, which clearly was going to do whatever it could to avoid a sluggish economy.
       As the economy improved, high-growth stocks and economy sensitive companies spiked up first as we saw with the sharp rise in semiconductors, biotech, and Internet content companies. But I don't think there has been a huge amount of investment conviction. In coming months, I think we will see a new phase, as people want to own stocks for the longer term instead of just trading them. I also think they will shift to more attractively valued large, established growth companies with better potential for sustainable growth.

Q. Technology stocks have defied the most optimistic expectations. Have the fundamentals improved enough to justify the huge gains?
A. I don't think so. It's natural for investors to flock back to the area that had endured the most pain. Technology stocks still seem to be favored predominantly by short-term investors who buy and sell based on marginal news - renters instead of owners. At the moment, marginal news is getting better in the tech area, so the stocks are trading higher, but it can easily reverse.
       While there should be a rebound in fundamental growth, I think it will be relatively small in terms of true demand. If that's true, the tech sector appears to be overvalued. Strategically, I think other sectors offer better opportunities, such as media and retail, and certain financial stocks such as Merrill Lynch and Citigroup with exposure to the capital markets.

Q. What appeals to you about the media and retail sectors?
A. Advertising spending has been picking up, which helps the media sector. The TV market turned positive in the second quarter, and radio should follow. Companies like Clear Channel, Univision, and Interactive Corp. should benefit over a two- to three-year time frame. Over that time horizon, I also think eBay's business is going to grow dramatically.
       Retail has performed well this year in anticipation of an improving economy. Home Depot, for example, has rebounded, and we think it still has mid-teens growth potential. We still like Target quite a bit. It should be able to grow its earnings at a 15% rate for a long time. We also like Best buy. The consumer electronics space is attractive, and Best Buy has taken a lot of market share from Circuit City.

Q. Health care has always been an important sector in the fund, and Pfizer and UnitedHealth Group (an HOM) rank among the largest holdings. What is your outlook for these companies?
A. UnitedHealth Group has been a strong performer and has benefited from firm HOM pricing. We are a little bit concerned now because we think it is about as good as it gets from a pricing point of view. But the majority of improvement in this company has been driven internally by focusing on cost, investing in new products, and taking market share. We expect that to continue so the company should still have strong growth.
       Pfizer is a company whose stock has under performed for an extended period. The valuation has come down pretty dramatically because its growth in the '05/'06 time frame is expected to slow. So, we are monitoring their new drug pipeline.

Q. Corporate earnings have rebounded dramatically over the past year. Do you expect this to continue?
A. Earnings have been very good, especially for U.S. companies. In the first quarter, earnings and cash flow were better than expected and revenues were a little weaker. Expectations in the second quarter were revised lower due to the war, and, for the most part, revenues were about as expected while earnings and cash flow remained stronger. For the third quarter, I think all three will exceed expectations.
       Technology, retail, and financial companies have cut costs sharply, enabling them to produce good profit margins in a weak environment. In the future, such advances are going to require revenue growth, and the presence or absence of this will drive the stocks. (Since investors buy growth stocks expecting superior earnings growth, earnings disappointments can lead to sharply falling prices.)
       In general, I think corporate managements will be conservative until they see two consecutive good quarters, and then spending will slowly start to pick up. I expect both capital spending and consumer spending to begin to increase in a methodical fashion.

Q. Given the sharp rebound in the stock market, how do you view equity valuations in general?
A. With the economy getting better, investors lately have wanted to own stocks with economic sensitivity such as technology instead of stocks like Procter & Gamble, General Mills, or Pfizer. But prices of economically sensitive stocks have now reached a premium. I think you really need sustained strong growth in the economy to support some of the movement in these stocks.
       At some point investors will have to decide if they really want to pay 40 times earnings for a semiconductor company, even if demand is improving, compared with 15 times for a quality company with 10% to 12% growth.
       When I think of valuations, I think of price-to-free cash flow. If you have a company that trades at about 20 times free cash flow, it has about a 5% free cash flow yield. That's a reasonable price with 10-year Treasury bonds yield 4% to 4.5%. Recently, companies with no free cash flow seem to be highly valued and those with fast-growing cash flow are highly valued, but we focus on consistent growth companies with 10% to 12% growth rates, and those valuations look okay.
       To me, companies like AIG, UnitedHealth Group, and Citigroup are very reasonably priced. I don't think they should be trading at the same P/E multiple as the market when they have had far better growth rates.
       Valuations for blue chip growth companies are currently very similar to that of the broader market. Over time, growth companies tend to grow faster than the market, so you are paying the same price for a potentially faster growing asset.
       As the economic recovery progresses, investors will focus more on sustainability of earnings and companies with more attractive valuations. That should favor the relative performance of higher-quality growth stocks.