In search of the perfect blend of styles

Style describes the investment philosophies and processes used by individual fund managers to manage investment portfolios. Their objective is to select stocks and construct portfolios by exploiting market inefficiencies.

The range of styles includes growth, value, indexed, style neutral and a recent, but questionable Australian variant, ‘growth at a reasonable price’. (It would probably be very difficult to find any manager promoting a ‘growth at an unreasonable price’ style fund!)

Two of the most popular and distinctive styles are value and growth. They are the best examples to illustrate the way managers can approach investment from two different perspectives.

The growth style looks to invest in companies with strong earnings and capital growth. A growth fund manager will concentrate on buying shares in companies that are growing at a faster rate than the economy and market as a whole.

Qualitative criteria such as assessments of a company, its market positioning, brand management and its ability to extract future earnings growth from its particular industry are important.

Quantitative indicators of interest to a growth investor include high price/earnings (P/E) and price/net tangible assets (P/NTA) ratios.

A high P/E, for example, suggests the market is prepared to pay more per share in anticipation of future earnings growth.

These indicators are considered in relation to a company’s immediate competitors. Companies with the highest P/E ratios relative to their industry will often be dominant within their market segment.

It is very difficult for a company to sustain earnings growth at a rate greater than the market over the long-term. A key research question is: at what point will a company’s growth slow or fall? At that point, a company would no longer be attractive to a growth investor.

A value fund manager concentrates on selecting companies that are fundamentally sound. However, their shares are relatively undervalued because the market’s confidence in the company or sector is low.

The value manager is looking for shares that are underpriced in relation to a company’s potential. Their view is that the market often excessively discounts stocks and as turnaround possibilities, these stocks have the potential to add to the value of a fund.

Investors tend to value perceived certainty highly and are prepared to pay for companies with that characteristic. They try to avoid losses incurred by holding stocks with falling prices and often ‘oversell’ these companies. Value investors seek to exploit this behaviour.

Quantitative criteria is important for a value fund manager.

They look for low P/Es and price to book, as well as high yields.

The key research question is: when will the company’s earnings recover or the market re-rate the company, enabling it to return to fair value?

The buying opportunity is identified when a company undergoing problems is perceived to have a good chance of recovery in the medium to long-term. Just as various asset classes perform differently, depending on prevailing market and economic conditions, so do investment styles.

There is no right or wrong investment style. In fact, chasing style performers can be as unproductive as trying to pick optimum market entry and exit points.

The chart shows the rolling 12-month return for the Macquarie Australian value and growth indices. This shows the significant divergence in returns from the two styles and the rapid change from growth to value that occurred at the end of 2000.

Taking these factors into account, the savvy adviser and investor will look to blend or mix investment styles.

The reason is that style-based diversification within Australian and international equities should result in smoother returns and lower risk. This is particularly the case with a blend of growth and value style funds.

Empirical analysis shows that an Australian equity portfolio performs more efficiently (it provides better returns for the risk taken) when it includes both growth and value styles.

The chart below shows the monthly returns for the Macquarie Australian value and growth style indices. To avoid a biased result, two 10-year periods have been selected — the 10 years to September 30, 2000 and to May 31, 2003.

The returns are for a mix of value and growth, with 100 per cent invested in either style.

The chart shows, for example, that a portfolio with a 20 per cent allocation to growth and an 80 per cent allocation to value had the lowest risk for the 10 years to May 31, 2003.

The lowest risk blend for the other 10-year period was 40 per cent growth and 60 per cent value.

It is not possible to be definitive about the optimal mix between growth and value. The evidence does suggest, however, that a blend of styles is more beneficial than reliance on one style.

The performance of growth and value styles fluctuates relative to the market average. This reflects different stages in the business cycle and investor sentiment.

However, growth and value styles are complementary rather than directly competitive. Consequently, over the long-term, returns are broadly similar.

For advisers and their clients then, style investing is a key means of reducing investment risk and providing more consistent long-term returns.

Mick O’Brien is chief investment officer atAXA Australia .