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Investment Strategy
Friday, February 1, 2002
Look for balance

The last decade has witnessed enormous change in the South African investment management industry. None more so than the large number of South African based independent asset managers that have started operations and the many prominent international managers that have based themselves in South Africa.

It became increasingly important for these asset managers to distinguish themselves from one another in order to attract money. Investment style and its application is one of the most fundamental aspects on which asset managers base their uniqueness in terms of their approach to money management. In conjunction with the proliferation of unit trusts and unit trust management companies’ endeavours to launch appealing specialist funds, this differentiation has contributed more than any other aspect to the debate on investment style or style bias funds.
The unprecedented performance of growth stocks during the first half of 2000, followed by the equally spectacular outperformance of value stocks during the latter part of 2000 and into 2001, has also accentuated the debate on investment styles. This in turn has challenged financial advisors and clients as to which investment style should be utilised for savings and investments.
The short answer is that there is no such thing as a best investment style. However, to advise on the optimal investment or saving strategy, it is important to understand the two most important styles, value and growth.

What is Growth Style?

A growth style asset manager, or a fund with a growth bias, concentrates on holding shares that are expected to generate higher rates of return than other shares with similar risk characteristics. Growth shares are businesses that have the opportunities and abilities to earn high rates of return.
To exploit these outstanding opportunities, these firms generally seek to retain profits; that is, they do not have high dividend payout ratios). These are used for reinvestment and to let their earnings grow faster than those of the typical firm. These companies do have to take higher risk relative to value type companies in order to exploit these exceptional opportunities. Also, these companies retain earnings in order to invest in high return projects. There is always the risk that the earnings may be lower or not forthcoming at all. This also increases the risk of such a share because share price is simply a function of future cash flows in the form of dividends.
The Association of Unit Trusts (AUT) defines Growth Funds as funds that seek maximum capital appreciation as their primary objective through investment in growth companies. It defines growth companies in turn as those whose earnings are on, or anticipated to enter a strong and sustainable upward trend and typically trade on high Price/Earnings ratios (see table).
Growth style asset managers have a high degree of confidence in their ability to predict accurately the long-term future cash flows. Consequently, they are willing to pay a high price for shares of companies that they predict will have extraordinary high growth.

What is Value Style?

Value style asset managers or funds invest in shares that are judged to be undervalued for reasons besides earnings growth. Value style proponents believe that share prices are far more volatile than the underlying company’s earnings. They therefore argue that companies are often undervalued because of market sentiment, either because certain industries may be out of vogue, or because investors have overreacted, driving a share price significantly lower than it should be.
Value investors utilise long-term historical data and short-term future cash flow estimates to arrive at an estimation of the fair value for a share. They would buy the share if it trades at a significantly lower price than their estimated fair value. This simply means that the share is under priced and that it will recover in the future, rendering returns at low levels of risk - a bit like buying straw hats in winter!
The obvious shortcoming of this approach is that certain shares may stay out of favour with the market for long periods (many years in some cases) or may not be undervalued at all, but are at low levels for good reason. Value investors maintain that markets are irrational in the short-term, ignoring or unduly punishing certain shares, but rational in the medium- to long term, rectifying under priced shares to their proper value and even overreacting again, propelling these same shares to prices higher than they should be. The AUT defines value funds as funds that seek out “value” situations by typically investing in shares that are trading at a discount to their net value.

Which Style Wins?

Several studies have been conducted to determine which style provides the best returns. These studies do, however, have limitations because there are obviously good and bad asset managers within both disciplines. Moreover, the use of value and growth indices automatically incorporates the biases and shortcomings inherent to indices.
Earlier studies done on the Cambridge Associates Mid-to-Large Cap Indices for value and growth indicate value as a clear winner over growth for the period 1973 to 1995. From 1995 to 1998 their performance was very similar, and from 1998 to 2000 growth outperformed value. However, due to the demise of technology stocks, value shares dramatically outperformed growth shares over the last year.
From 1993 onwards a significant trend developed, in that the value and growth orientation have both outperformed the MSCI from 1993 to 2000; 1993 is used as a starting date because it is the inception date of the Frank Russel Indices used in this article.
Both these approaches to active management thus delivered returns in excess of the market (passive) over the stated period. Interestingly, the value and growth styles rendered the same return to investors over the seven-year term.
Of greater significance to investment advisors and clients alike are the distinct cycles of different relative performance from 1993 to 2000, during which there were clearly four distinct cycles. Value investors outperformed quite strongly over the period 1993 to 1995, whilst performances were fairly similar for the following three years. Financial markets witnessed the greatest run in growth stocks in history from 1998, peaking in mid-2000. This was led by the run on the NASDAQ index, which in turn was fuelled by technology, media and telecommunications stocks. These stocks have strong growth characteristics.
The demise of these TMT shares led to a period of dramatic outperformance by value shares. An example of the magnitude of outperformance was the Sage Global Value Fund, outperforming the total universe of unit trust funds in South Africa over the last year.

Impact on investment planning

The first step in investment planning is to have at least a conceptual understanding of growth and value styles as well as the fact that markets tend to go through cycles when one of the two styles outperform. Recent history has also shown that this outperformance can be dramatic.
Secondly, the risk factors need to be taken into account. Growth investment can be very rewarding but shares in such funds may be risky and volatile. The general rule is that growth shares or funds are more risky than those with a value bias. An investor who is risk averse or has liquidity constraints (for example, he is nearing retirement) may not want to be over-exposed to the growth style. Moreover, over-exposure to any one style increases risk as markets may go through prolonged periods of favouring a particular style.
A portfolio with a balance between styles would be more prudent than trying to predict which style would outperform and for how long this relative outperformance will last. By Kallie van Vuuren, Investment Marketing Sage Life.

Copyright © Insurance Times and Investments® Vol:15.1 1st February, 2002
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