The stocks of large, well-established, stable companies that have a good record of producing earnings and paying dividends are referred to as “blue chips.” Many of these high-quality growth companies have been out of favor for quite some time, and there has been a significant divergence between their business and their market performance. For example, Intel has boosted its earnings by 173% over the past five years, but its stock price has actually decreased by 30%. However, based on valuations, earnings, fund flows, and the direction of the dollar, we think blue chip growth stocks are poised for a comeback and Sit Large Cap Growth is well-positioned to ride this rebound.

Valuations Favor Blue Chips
In March of 2000, when the last bull market peaked, the P/E (price/earnings ratio) of the 50 largest stocks in the S&P 500 was a rich 35.6, while the 50 smallest stocks in the S&P 500 carried a P/E of just 10.1. Clearly small cap stocks were the better value. And in the ensuing bear market and subsequent bull leg, small caps, as we all know well, sharply outperformed the blue chips.

Because of that strong relative performance from small caps, by March of this year, the valuation picture had reversed: Small cap P/Es had doubled to 20.3, while large cap valuations had been cut in half down to 17.3. Now large caps are clearly the better value.

The Economic Cycle Favors Blue Chips, As Well
Small caps enjoy their fastest earnings growth coming out of a recession or economic slowdown since they are typically more highly leveraged to the health of the economy than larger, more stable companies. Conversely, when the economy is losing momentum or actually contracting, large cap earnings tend to do relatively better.

While the economy remained strong in the first quarter of this year, most analysts (ourselves included) expect the economy to slow in the second half. The Federal Reserve has hiked rates 16 times (and more may come) in order to slow economic growth to keep inflation under control.

Another positive for blue chips is that US non-financial companies now hold $1.5 trillion of cash, double what they had 7 years ago with blue chips sitting on the biggest pile. Besides letting that cash pile up on their balance sheets, many big companies have used their healthy earnings of the past few years to reduce debt, buy back their stock and increase their dividends. In fact, the dividend yield offered by many big companies today is competitive with the 10-year Treasury's yield given the preferential tax treatment of dividends.

Then there is the psychological factor: In a weakening economy, investors tend to prefer bigger, safer, quality blue chip stocks such as General Electric, Home Depot, Microsoft, and Wal-Mart.

Small Cap Speculative Excess?
Small caps’ strong performance has attractive large asset flows that are currently suggestive of speculative excess. For all of 2005, investors poured $7.1 billion into small cap stock funds - a tidy sum. Yet in just the first two months of 2006, they added $6.4 billion more! As one of my old investment mentors phrased it, “the lure is always strongest at the top.”

The U.S. Dollar Under Pressure
Pressured by our persistently high budget and trade deficits, the dollar has been losing ground to foreign currencies. The dollar's downtrend was interrupted in 2005, thanks in large part to the continuation of the Fed’s persistent interest rate hikes. After 16 rate hikes, our short-term securities offer a much better yield than those in Europe or Japan, thus attracting foreign capital to our securities (and thus the dollar).

However, with the Fed now somewhere near the end of their rate hikes, while Japan and Europe are talking about beginning to raise rates, that favorable interest rate differential is expected to narrow. With that support removed, we expect the dollar to resume its decline. This benefits larger companies as they are more global; they do more exporting and own more foreign businesses than smaller competitors.

A Blue Chip Stock Fund: Sit Large Cap Growth
Sit Large Cap Growth (SNIGX) is an example of a blue chip large growth fund that we like right now. Sit was founded in Minneapolis, Minnesota in 1981 by Gene Sit with $1 million in working capital and a total staff of eight. Assets under management today exceed $6.8 billion and they now have a staff of over 80 people.

Sit's decision-making/portfolio construction is done through a team approach with active leadership from senior investment professionals. They have daily, weekly, and monthly communications between the analysts and management. The analysts come up with the majority of the ideas and the senior management makes the decision to buy or sell. Ultimately, Gene is the CIO and is involved in 95% of the investment decisions. The four senior investment professionals on the Sit Large Cap Growth fund are Gene Sit, his two sons, Ronald and Roger Sit, and Peter Mitchelson. Their average investment experience is 29 years.

They are extremely stable as an organization with very little turnover of investment professionals. Gene is a former chairman of AIMR (Association for Investment Management and Research) which promotes performance presentation standards. The analysts are sector analysts with average tenure of 10 years with the firm. The fund managers are compensated relative to their benchmarks and their analysts are compensated based on their individual stock picks. All of the portfolio managers are invested in the Sit funds and are aggregately the largest shareholders. Gene Sit is the single largest shareholder in all of the funds.

Philosophy & Process
Sit's management believes that earnings growth is the primary determinant of superior long-term results. They look for companies with market caps greater than $10 billion and earnings growth greater than 12%. About 80% of their stock picking process is based on a bottom-up fundamental approach, with the remaining 20% of their analysis coming from a top-down macro perspective. They are long-term investors with an average holding period of 18 months and a turnover of around 30%.

While looking for high earnings per share and revenue growth, they are not "growth-at-any-price" investors. Companies must be purchased at reasonable valuation relative to industry peers, historical levels, and earnings growth rates. That said, their holdings tend to have higher P/E ratios to go along with their higher growth rates.

They focus their research on companies that are world-class or regionally dominant, have new and/or distinctive products or services, and are innovative or responsive to change.
Typically, about 20% of the fund's assets are in what they call conservative growth companies, 40% in high and consistent growers, and 40% in cyclical growth opportunities.

After having some trouble in the early 2000's when they did not have stringent risk controls in place, they now use extensive quantitative risk monitoring tools. Today their portfolio is more diversified with 90 names and no single stock greater than 5% of assets. They will generally have just 2-3% in cash; they will not use cash to time the market.

Asset Allocation
The fund's largest sector allocation is to energy, which at 16.9% of the portfolio represents four times the weight of energy in the Russell 1000 (large cap) Growth Index.

Although underweight in technology (16.1%) and healthcare (16.0%) relative to the Russell index, they are still among the fund's largest positions along with energy.

While financials have a lesser (13.2%) weight, it represents the second largest overweight to the index.

Sector Breakdown % of Net Assets (as of 3/31/06)
Sector	Sit Large Cap Growth	Russell 1000 Growth Index
Energy	16.9	3.8
Technology	16.1	22.6
Healthcare	16.0	18.7
Industrial Materials	14.2	13.7
Financial Services	13.2	6.4
Consumer Services	9.6	13.7
Business Services	6.5	7.1
Consumer Goods	3.2	9.7
Telecom	2.3	0.7
Media	2.0	3.1
Utilities	0.0	0.5

% Total Return Performance (as of 4/30/06)
	1-Year	3-Year	5-Year
Sit Large Cap Growth	20.96	15.81	-0.77
Peer Group: Large Growth	18.82	13.16	-0.18
Russell 1000 Growth	15.18	12.05	-0.76
% Rank in Peer Category	33	22	56

Performance
Over the past 12 months, Sit Large Cap Growth was in the top 33% of its peer group. Its large overweight in energy (along with solid stock selection within energy) was a prime contributor to the fund's strong relative performance. A (slight) overweight and strong stock selection in industrial materials also contributed to performance. Another positive contributor was the fund's 7% weight in non-U.S equity exposure.

-- Rachel Zibrak