Value, growth or both?

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The benefits of style neutrality. Read the AMP Henderson Investment Insights.

Thursday, September 11th 2003, 2:04PM

In recent years there has been a lot of talk about the importance of style in managing equities. Two key styles are value and growth. The reason style matters is that certain economic or market environments favour one style over the other. In the late 1990s equity managers who favoured growth stocks outperformed those who focussed on value. In recent times this trend has reversed violently, having a significant impact on the returns generated by such funds. For example, over the last three years typical global equity funds using a growth style lost an average 20 per cent per annum against value funds, which lost an average 5.6 per cent.

With value now having outperformed growth over the past three years, an obvious question is, will it soon reverse again (with some indications suggesting that this may already be happening). More importantly, it can be demonstrated that the optimal approach is to have a blend balancing both value and growth-style equity managers.

Value and growth defined

Value stocks are conventionally defined as stocks trading on cheap valuations measured, for example, by price-to-earnings multiples or price-to-book value. Value managers tend to focus on these stocks when assembling their portfolios. By contrast, the growth stocks that growth managers focus on have superior long-term earnings growth and return-on-capital potential.

Style through the cycle

Over time the relative performance of growth and value stocks, and hence growth and value equity managers, can vary significantly. In a very rough sense this is often related to the economic cycle. Normally, as the economy begins to slow, quality growth stocks (eg health care) tend to out-perform as investors seek safety and sell cyclical stocks. Because of their superior long-term earnings growth potential, growth companies normally perform better in weak economic conditions. Then, once the economy begins an upturn, investors move to value stocks (or cyclical stocks which have since become good value, such as building material companies). This cycle can be seen in the following chart, which shows the relative performance of value and growth stocks in global equity markets.

The periods when value stocks have clearly out-performed growth stocks are highlighted by the falling arrows. These periods have normally coincided with a recovery in economic growth, such as in 1975-77, 1981-84 and 1992-93.

Style rotation

Given this cycle, many investors have experimented with approaches designed to switch between these different styles through the course of the economic cycle in order to take advantage of both the upsides and the downsides. However, this has provided mixed success, reflecting a range of problems.

• Firstly, the economic cycle is not a foolproof guide to the relative performance of growth versus value stocks. Two examples stand out in the previous chart – both the 1987-88 and 2000-01 episodes of value outperforming growth did not reflect a normal cyclical relationship. For example, in 1998/early 2000, technology companies were seen as growth companies and their subsequent performance drove the ‘growth’ style through an extended and dramatic rise. However, when this run burst in 2000, investors turned to anything representing ‘value’, initially aiming for the cheaper defensive companies and then later for the cheaper economic cyclical stocks. As a consequence, value outperformed growth in 2000 and 2001 at a time of global economic slowdown, which would normally be associated with growth outperforming.
• Secondly, as the previous chart indicates, the shift from growth to value can be swift as investors quickly re-rate cheaper companies at the expense of more expensive growth companies. Get the timing slightly wrong and you can miss out big-time.
• Thirdly, the swings only occur every five years or so. If you get it wrong you may have to wait a long time to make up for lost value. This can be illustrated in the table below which shows which style was in favour in global equity markets each year over the past 28 years.

Best returns by year, global equity markets

Implications for the investor

For an investor in managed equity funds there are essentially three options to help deal with the value versus growth style issue:

• Switch between fund managers professing to manage in accordance with growth and value styles. Given the under-performance of the growth style in recent years you would probably now have a leaning towards growth style managers. This is also supported by the fact that it is now harder to find good value stocks. However, for the reasons already discussed previously, trying to time the growth/value rotation is very difficult. The normal cyclical relationship has been turned on its head by the surge and subsequent collapse in technology stocks. There is also a significant cost in terms of manager fees in making such switches.
• Choose a fund manager that neutralises their exposure to value and growth stocks.
• Blend a mix of value and growth managers.

The benefits of blending

In AMP Henderson’s assessment there is a strong case to adopt a blend of value and growth style fund managers with respect to equities. The chart below shows the rolling 12 month return over the past six years for an average of two strong global equity value managers and two strong equity growth managers, all of who are available to local Investors. It also shows the return profile that would have been achieved if an equal exposure to all of these managers was blended into one style-neutral portfolio.

The benefits of the blended style-neutral approach can be especially seen over the last few years. Whereas an exposure to global value managers would have seen massive underperformance in the late 1990s this would have been followed by massive outperformance in the last few years. The blended mix would have provided a much smoother ride.

The following chart plots the risk and return for each of these exposures over the 1988-2003 period.

The blended 50/50 mix of growth and value managers over this period would have resulted in much lower risk than growth alone. Although value came with a higher return this in large part reflects the period shown (ie, 1988- 2003) which is dominated by the last few years of poor returns from growth managers.

AMP Henderson’s analysis, which assumes equal long-term returns from value and growth styles, indicates that the optimal blend is close to a 50/50 mix of value and growth-style managers.

The main benefit arising from a blended style-neutral mix of growth and value managers comes about because it effectively neutralises a large part of the impact coming from the economic cycle (via swings in the growth/value theme) on overall performance. This should enable growth and value managers to successfully pick stocks in the growth or value styles that they have a comparative advantage in, without these efforts being periodically swamped by swings in the growth/value theme.

A style-neutral blend can be combined with an enhanced index and/or style neutral manager, both of which serve to stabilise or anchor the overall portfolio over time.

Should investors have a skew to value?

Some would argue that over the long-term the value style should outperform the growth style. The first chart provides some support for this theory, as over the period since 1975 the ratio has fallen as value has outperformed growth. Likewise, for the last chart shown above where value outperforms growth for the period since 1988. However, this is period-specific – if the first chart started in January 1980 and ended twenty years later, growth would have outperformed. The long-term outcome will also depend very much on the economic environment. While there might be a case to have a slight bias to value, it is marginal. In fact, the main value in the value/growth style delineation is in terms of being aware of its influence over the course of a market cycle.

Conclusion

Understanding how the value or growth style employed by a fund manager will impact on the returns they achieve over the course of an economic cycle is critical. If the growth (or value) style is out of favour, no matter how good a stock picker a growth (or value) style manager might be, it is still likely to under-perform. However, this under-performance should not be seen as indicating that the manager lacks skill or should be replaced.

In the absence of reliable methods to switch between the growth and value investment styles over time, the best approach is to combine a mix of value and growth style managers into an overall equity portfolio.

This issue of Investment Insights is based on an article by Dr Shane Oliver, chief economist and head of investment strategy for AMP Henderson Global Investors (Australia)

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