Putting stock in style

When George Bernard Shaw famously quipped last century that if “all economists were laid end-to-end they would not reach a conclusion”, he was probably not thinking to include fund managers.

However, the Irish playwright might well have extended the adage to fund managers were he in a position to ask them about their performance outlook for the Australian equities market over the next 12 to 18 months.

At any rate, an informal survey by Money Management of a handful of local fund managers failed to reach a consensus on the question of whether market conditions would favour growth or value style managers in the period.

The upshot was that the growth, value and style-neutral fund managers we talked to, as well as local researcher, Intech, see conditions favouring, well, both growth and value managers.

Some, notably the growth managers, suggested that value and growth managers should be able to outperform in any market on their stock-picking skills, notwithstanding the ongoing bull market that is the Australian equities sector.

For their part, the value managers believe strong private equity flows could continue to drive performance of stocks with good value characteristics.

But even at the fundamental level of whether sector conditions would favour growth or value-style managers looking forward, some gave the nod to value managers and others growth.

Russell Investment Group investment strategist Andrew Pease said the market is “heading into the second stage of the rally now, when earnings growth starts to slow, value is not at such a PE discount, and investors start to value firms that actually have earnings growth capacity”.

“As a result I’d say that throughout this year and next, you would normally expect that we’d be in the stage of the equity market cycle that favours growth over value.”

However, he described it as an anomaly that “growth managers have actually produced more value-add than have value-style managers over the past few years or so”.

“Normally, during the first half of the rally, which is what we’ve had, you would expect to see value outperform growth, and which is what we have seen in the USA more dramatically.

“It’s hard to say why the reverse is so, but maybe it’s because it has been a momentum-driven market, particularly with all the private equity flows coming in.

Having predicted a more favourable environment for growth managers, however, he said he hasn’t “seen an enormous premium to value in the Australian equities market over the past two to three years”.

He emphasised that Russell, as a style-neutral manager, does not “spend a lot of time thinking about when value is going to start to outperform growth, or vice versa”.

“There have simply been so many extraneous factors impacting on the market, including a preponderance of private equity flows, that has made it so much harder.”

Tyndall head of equities Bob van Munster said growth managers have “tended to outperform up until six months ago and since then value managers have come to the fore — largely because of all the market takeover activity and speculation.

“If you have an expectation that private equity activity and merger and acquisition (M&A) activity is likely to continue — as all the anecdotal evidence suggests — then there are going to be opportunities for value managers.”

By contrast, van Munster said, “momentum (growth) managers are going to struggle in this environment, or struggle a bit more, because you are probably going to see some fairly savage stock price movements”.

“Qantas, for example, was down substantially during the year, and then rebounded after a takeover offer that nobody expected to eventuate.”

Van Munster said there are still “some pockets of value” in Australian equities, although the market is “getting increasingly difficult for us as a fundamental investor”.

He said these pockets of value can be found within sectors such as energy, consumer staples, infrastructure, materials and banks and financial service.

The areas of the market he would “prefer to avoid as overvalued” include consumer durables, media stocks in particular, which have been “bid up strongly on takeover speculation”, listed property trusts and parts of the resources sector.

A number of factors have “contrived to make it a bit tricky to figure out who does what better in this bull market”, according to Platypus Asset Management executive director Donald Williams.

Chief among these is that value managers have been benefiting more than the growth managers from “all the corporate takeover activity” that has been going on recently in the market, he said.

Williams, who describes Platypus as a growth manager, also believes “good value managers should do well in an environment that favours growth managers, and vice versa”.

He generally believes the Australian equities market will go up at least 10 per cent in 2007 and, “since it’s already gone up 5 per cent, it may do even better than that”.

The key metrics for his optimism are that “additional interest rate increases are off the agenda, and the earnings numbers that have come out in this reporting season have been, on the whole, stronger than people expected”.

The only really negative metric for Aussie equities investors is whether individual companies on the market are overvalued or not in terms of their earnings, Williams said.

However, he predicted there will be “at least one or maybe two corrections this year, which could be of a similar magnitude to the 10 per cent fall that occurred in May last year.

“You would probably expect the value guys to do better through these down phases during the year, and, conversely, the growth guys to do better through the up phases.”

Any corrections this year would be instigated by both “profit taking, and also because share prices have started to go up faster than earnings”.

“So, if the market starts to get worried about earnings, you could expect Aussie share prices to go down by more than earnings.”

During the second half of last year it was “actually quite hard to outperform” (for Platypus), he said, with the reason partly because of “all the private equity and other corporate takeover activity going on”.

“Coles, for example, didn’t exactly shoot the lights out operationally in the last six months, but its share price was buoyed by the corporate activity.”

He anticipates this corporate activity will continue in 2007 at the “same high rate”, driven by the “amount of money that has been put into private equity, which needs to be invested”.

Intech Investment Consultants head of equities and property Ron Liling predicted that the Australian equities market will offer “more opportunities” to value managers to outperform.

“In the past year or two, and particularly in 2006, we’ve seen what I call speculative growth do really well, and if you believe value and growth come in cycles, which we do, that sort of favours value.

“Secondly, a speculative growth phase indicates that the Australian equities market is near its top, and value tends to do better when the market corrects.”

Liling said it’s “unlikely we’ll see another speculative year as 2006, in which value managers clearly had a difficult year, particularly those with a preference for higher quality companies”.

He said their task was made more difficult by the higher than average M&A activities, which can prove challenging for disciplined managers.

The median of the Intech Australian Shares (Specialist) Survey was 23.8 per cent for the calendar year 2006, a result that underperformed the S&P/ASX 300 Accumulation Index by -0.7 per cent.

Only 23, or 35 per cent, of the 65 managers in the Intech survey managed to avoid negative alpha in 2006, according to Liling, with “numerous value-style managers lagging the survey by material amounts”.

For example, AMP Value underperformed by -6.9 per cent, Tyndall by -4.2 per cent, Investors Mutual (-3.6 per cent), Lazard (-2.8 per cent), Perennial Value (-2.1 per cent), Perpetual (-2.0 per cent) and Maple-Brown Abbott (-1.9 per cent).

He said Intech research showed that managers that did not hold Zinifex and Paladin were “significantly disadvantaged”, and most value-oriented and quality-focused managers would not have held either stock.

“By not holding these stocks, managers started from a deficit alpha of about 1.7 per cent.”

Of the stocks comprising the S&P/ASX 300 Index at the start of the year, 30 companies (or 10 per cent by number) were subject to some sort of M&A activity during the year, Liling said.

“The common factor to all of them is an instantaneous impact on the share price of both the bidder and target, due to largely unforeseen and therefore unforecastable events, which makes it difficult for active managers to add value.”

The research also found that any cash not equitised by the manager would have proven a significant drag on the performance of value managers, he said.

“With the S&P/ASX 300 Accumulation Index up 24.5 per cent over the year, we estimate that each 1 per cent held in un-equitised cash would have reduced relative returns by about 0.18 per cent over the course of the year.”

Perennial Value Management portfolio manager Hugh Giddy said if market conditions “continue as they are doing now, it’s not going to be a value manager’s environment, and it hasn’t been so for some while now”.

“It’s the lot of the growth manager never to worry, but rather to have a happy time buying all the expensive stuff, while the value manager has a miserable time worrying.

“If you’re a growth manager you buy those higher priced stocks with good growth, such as CSL, AMP, and Cochlear, and if you pay 30 times price earnings for them you say, well, they are nice companies, and the management is nice.”

On the other hand, Giddy said, if “you’re a value manager, and you actually worry about your clients’ money, you’ll think this market is at a very high level on any measure, and I’m prepared to underperform for a while”.

“However, this doesn’t make it any less tough as a value manager to stick to your knitting, to pick the cheap stuff, and just watch things go to what seems like crazy prices, knowing you can’t own them.”

Giddy said the current market has “all the signs of a bubble, but I also know that next year the benchmark index could be even higher than it is now”.

He said that with the markets being “so crazy, you would think that stock picking has got to pay dividends, but being selective is not going to help in the midst of a bubble”.

“Often the most ridiculous-priced speculative stuff goes up the most in a bubble, and there is no way any self-respecting fund manager will buy a lot of that.

“The uranium explorers, for example, have no earnings, no dividends, and it is consequently very very hard to value them, because there is no benchmark for doing so. “

On the other hand, he said, if there is a return to a “more normal market, then stock picking will really help value managers, because they will have carefully selected the stuff that actually looks reasonable”.

“Not necessarily cheap, mind you, but stocks for which you can make a reasonable case for owning, other than merely because you think they are going to go up in price — things like they are well supported by good profits, good sales, and good assets.”