Style takes a spin

Value stocks have led the way during the past five years but there are signs that this is about to change. Funds with a growth bias could soon be winging their way back to the top of the performance tables.

A glance at the performance of the FTSE 350 Value index versus the FTSE 350 Growth index shows that it has been one-way traffic since March 2000, with value stocks outpacing their growth counterparts by a considerable margin. But since the start of the year, the graph lines have begun to change direction – the FTSE 350 Value has dipped slightly and the FTSE 350 Growth has started to climb. A cruder measure also suggests a shift in performance – equity income funds, which by their very nature tend to hold more value-orientated stocks, have underperformed the more growth-orientated UK All Companies sector since February.

When Anthony Bolton of Fidelity is reported as saying that growth stocks are beginning to look attractive, it could be time to take notice. He reckons that it could be a tough year ahead for value investing, with valuations on growth stocks at historically low levels.

John Husselbee, a director of Henderson Global Investors, argues that two indicators suggest growth will outperform in the months ahead: the flattening of the yield curve and the widening of corporate bond spreads: “The market is tentatively poised. In mid-February this year the yield on the 10-year Treasury climbed to 4.8% and if we see some inflation coming through, growth stocks will outperform. Inflation is said to be benign, but what is the measure? Talk to the man on the street about his household bills and he would probably disagree that there is no inflation.”

Several fund of funds managers who follow the “style mantra” of blending growth and value funds have taken tentative steps to increase their exposure to funds with a growth bias. Husselbee, who has been an ardent follower of style investors for many years, reckons that there is no such thing as consistency of performance – what is consistent is the style and approach the manager takes.

What style a fund takes will determine when it will outperform. Just as investors reduce risk by spreading their portfolio across British, European and American stocks, for example, investors should also ensure they hold a balance of value and growth funds to reduce volatility and help the portfolio deliver more consistent performance. To have a portfolio biased to one style at the expense of another could prove costly, for those who get caught out. Husselbee says: “Style investing is an asset class in its own right. I have a blend of styles because going solely for growth funds or value funds is risky.”

The maximum Husselbee opts for in any one style is 75%. A few months ago he was 60/40 in favour of value – today he is 50/50. He admits it is a gradual bet, because the growth resurgence was touted this time last year, only to prove to be a false dawn: “I have increased my exposure to Gartmore UK Focus, Martin Currie UK Growth and Liontrust First Growth.”

Husselbee is not alone. Craig Heron, fund of funds manager at New Star, is currently exploring his growth fund options. He has already taken steps to reduce the dividend yield exposure in Vhis portfolios and has taken bigger positions in M&G Capital and Martin Currie UK Growth recently. It is unlikely to stop there, he concedes, and he is scheduled to meet with more groups to discuss their growth funds in the coming weeks.

“We are going through the portfolio to make sure it is not skewed too aggressively towards value,” says Heron. “We are big believers in style as an important driver of both market and fund returns. It is well documented that value funds have delivered fantastic returns, but we would expect growth funds to start to outperform.”

The “style” way of investing is deeply embedded in the minds of American investors – both professional and private – unlike in Britain, where it has been slow to take hold. Investors across the Atlantic are more concerned about whether a fund is more weighted towards growth or value stocks, rather than worrying about where or in what sector it is invested.

With the fifth anniversary of the American technology-laden Nasdaq high just passed, many American experts say the types of stocks that inflated and then burst the bubble look like bargains today – in other words, growth stocks.

Since the Nasdaq peaked on March 10, 2000 at 5048, the average large-cap growth fund in America has fallen 38%. More conservative large-cap value funds, which hunt for relatively cheap stocks, have gained 32% over the same period. The shares in many companies that large-cap growth funds favour have fallen so far that even some bargain-hunting value managers in America are having a close look, wooed by rising profits, improving balance sheets and relatively modest price tags. The upshot is that there are many who believe it is time for growth investing to come back to the fore, after trailing the value approach in each of the past five years.

Sandy Lincoln, market strategist at Chicago-based Wayne Hummer Asset Management, reckons valuations, the earnings outlook and a weak dollar bode well for larger growth stocks. “The weak dollar should boost overseas earnings, and larger companies are likely to have a greater presence abroad than smaller companies,” says Lincoln. “Eventually, investors are going to say, here’s a segment that’s been out of favour for a long time, so you might see some rotation.”

Putnam Investments, the US group that pioneered style investing, also argues that large-cap companies should benefit from the rise in American interest rates and from slowing global economies.

Determining whether the stockmarket is in a growth or a value cycle can often determine a fund’s performance. Over an extended period of time, one of the two styles strongly outperforms the other, until the cycle suddenly switches. According to Style Research, growth – mostly large-cap growth – outperformed during the late 1990s, but since 2001, small-cap value stocks have outperformed dramatically. It adds that large-cap value stocks have outperformed during the past 20 years.

Britain had a crack at introducing the style formula in 2000, when Schroders and JP Morgan Fleming launched style ranges offering investors the chance to exploit either a growth or a value approach. It did not work out as planned for Schroders, which shut its range in June 2003, blaming the stockmarket crash, which had seen the appetite for shares slump. It was not economically viable to keep the funds running, which averaged just £5m in size, it said.

JP Morgan Fleming stuck with its range of style funds, which benefited from being marketed in both Europe and Britain. Five years after launch, the value fund has outsold its growth counterpart 10-fold (£2.7bn against £272m), which is not surprising given the comparable performance figures. According to Standard & Poor’s, the Luxembourg-domiciled Europe Strategic Value fund has increased 58% since it was launched in late February 2000, while the Europe Strategic Growth fund has plunged by 26% over the same period.

What is interesting is that since the start of the year, demand for the growth fund has gathered pace, and sales are up on the same period last year. “We have seen a notable increase in demand for growth funds since the start of 2005,” says Amr Seif, client portfolio manager at JPMF.

The debate on value versus growth has rumbled on for decades – ever since the 1930s when Benjamin Graham and David Dodd wrote their 1934 bestseller Security Analysis, which gave birth to the concept of value investing. Value is often defined by price-to-earnings ratios (P/E), price-to-book (the company’s share price divided by its net asset value) and dividend yield. Nobody, said Graham and Dodd, should buy shares with a P/E ratio of more than 16x.

The JPMF Europe Strategic Value Fund adopts a straightforward, objective approach, which involves identifying the cheapest 30% of stocks and then using bottom-up analysis to eliminate the value traps – the stocks that are cheap for a good reason.

On the other hand, growth investors judge a stock on its future return on equity (profit after tax divided by its shareholder funds, its earnings growth, sales growth and earnings forecasts). According to a pioneer of growth investing in the 1930s, T Rowe Price Jnr, growth stocks offer “favourable underlying long-term growth in earnings” and so can provide the only realistic prospect of outrunning the erosion of inflation.

One factor for the shift in sentiment towards growth stocks is the state of the global economy. Growth stocks tend to perform best when economic growth slows. Forecasts suggest economic growth will slow, albeit marginally in 2005. This should favour growth stocks as investors look to buy stocks that can grow despite the slowing economy.

“The robust global economy has been driven by low interest rates and lots of liquidity. This situation helps weak companies with weak balance sheets. Over the past few years, companies with stretched balance sheets that were struggling because demand was slow came roaring back,” says Tim Bray, a fund manager at New Star.

“But if the economy slows, investors will be prepared to pay a premium for reliable growth from good-quality companies rather than firms that rely on cyclical growth, which might vanish if the economic recovery slows. In short, you should then avoid companies that are vulnerable to a slowdown in the economy.”

Robert Schwob, chief executive at Style Research, says that the economic conditions are very similar to the early 1990s when growth stocks began their revival. This is why he thinks growth is in for a rebound: “In the early to mid-1990s inflation and interest rates were stable and the economic cycle was past its peak of recovery. The market was fairly valued regarding future earnings and in some cases undervalued. People then were starting to think about longer-term payouts, and growth moved forward,” says Schwob. “It was a very similar situation to the one we now find ourselves in.”

However, the style debate regarding growth versus value may not be as clear-cut as it once was. Distinguishing between growth and value stocks has become more difficult. The distinction has become blurred and there are many fund managers who believe there is better value to be found in growth stocks.

“When is a stock value or growth?” asks Bray. “Pharmaceuticals are on a discount to market and they have historically been seen as growth plays.” He also questions whether Vodafone can be described as a growth stock today if you follow the traditional way of separating a growth stock from a value stock.

He adds: “Companies with a high price-to-book would be perceived to be growth stocks and companies with a low price-to-book [the price is low compared with its net asset value] would be seen as value stocks,” he says. “Vodafone is on a P/E of around 15x, which is relatively cheap.”

The compression of value on growth stocks has also left question marks regarding whether there is such a thing as a ‘value investment’. Colin McLean, managing director of SVM Asset Management, says that taking Corus as an example shows how difficult it is to categorise shares as either growth or value.

In 2000, Corus – just formed by the merger of Hoogovens (a Dutch firm) and British Steel – had many of the characteristics sought by value investors and was owned by a number of prominent value investors. Corus’s shares then had a very high dividend yield, and were priced cheaply in relation to sales, assets and earnings.

“However, despite the shares then losing three-quarters of their value over the next two years, the investment began to look more like a growth stock. The earnings multiple was high, the dividend yield was low and substantial value in terms of assets had been destroyed,” says McLean.

Sanjeev Shah, manager of the Fidelity UK Aggressive fund, agrees that the distinction between value and growth has become spurious, and he is increasingly seeing “value” in “growth” situations. He says he tries to buy stocks that are mispriced by the market, but is cognisant of the valuation changes and is looking at so-called growth opportunities at the moment. “We have seen a convergence of valuations across the sector and within sectors, hence the potential for growth business models to be mispriced.”

He quotes support services group Mitie, which made up 3% of his portfolio in 2003, as an example of mispriced opportunities: “It had a good history of return on investment and was geared towards the public sector so it had strong levels of underlying growth. It had underperformed the market significantly, but the business model hadn’t changed – it was a growth franchise on a low valuation.”

The growth versus value conundrum is a hard call. If it wasn’t, there wouldn’t have been any lambasting of Tony Dye, the former UBS Phillips & Drew “value” fund manager in the late 1990s, who refused to follow the tech story. Fund managers who switched from growth to value in the weeks before March 2000 would have ended up making a killing – as it transpired, the vast majority did not.

“The only way to hit the jackpot is to guess when the growth style comes into favour,” says David Hambidge, portfolio manager at Premier Asset Management. “Get the timing right and you can make a lot of money. But I’m not convinced that the time to make an aggressive switch towards growth funds is now. Growth is being touted as en vogue, but companies are reluctant to reinvest profits and continue to increase dividends and embark on share buybacks.”

Second-guessing the market is a tricky game too. Husselbee increased his growth weighting modestly in March 2003, only to be forced to reduce it a few months later as it emerged that the value story was marching on. This time around he might be proved right, if data from Style Research is to be believed. Its data shows that value stocks have had as many negative periods as positive over the past few months.

In Britain and Europe investors are beginning to look at companies with high sustainable growth measures, showing sustainable profit margins, says Schwob, who admits the growth turnaround is very much in its infancy. “Over the past two months there has been a rebound in growth stocks, but it will take time to take root. It needs to win the trust of investors to look beyond the appeal of dividend payouts to focus on longer-term rewards,” he says.

“Company management will also have to show heroics to divert profits into the business rather than buybacks or dividends. But in three or four months’ time I think investors will recognise the fundamentals we are seeing today as a growth phase.”

Views of advisers
Shane Mullins, managing director of Fiscal Engineers, selects funds on the basis of asset class and market capitalisation and uses a blend of value and growth funds to act as a diversifier in portfolios. He reduces or increases exposure significantly, but this will be on a case-by-case basis depending upon the investor’s needs.

“If we want to increase the potential for returns we would increase exposure towards small-cap and value stocks, as these have produced the greatest returns over the long run across the main equity markets of Britain, Europe and America. Whatever your view on value or growth stocks the fundamentals remain the same, buying companies with healthy cashflows and the prospect of sustaining or increasing dividends. We take “growth” to mean stocks with stronger earnings growth. The industry as a whole views them this way too, but seems to think this translates into stronger growth of investment returns. A risk-based perspective dictates the opposite: on average, stocks with stronger earnings growth have lower costs of capital, and therefore lower expected returns.

“Many people believe the secret to investment success is to be able to forecast which sector is going to do well over the next year or two. We allocate to value versus growth based on investor appetite for risk rather than a market forecast or consensus. Many active funds suffer from style drift where the manager might make a decision on whether he prefers value or growth at any given time. We prefer passive funds that stay true to label such as Dimensional’s UK Value Fund, which is invested in UK companies exhibiting strong value characteristics, such as low price-to-book value and high income streams.”

Views of advisers
Tim Cockerill at Rowan & Co Capital Management, says that the distinction between value and growth has become blurred. “We feel that with P/E ratios having become compressed, it may be harder for managers to identify value opportunities. The compression of P/E ratios suggests that across the market company valuations have broadly become similar, and that the market is making less distinction between those that are good and those that are bad. For this reason companies that are growing their market share, have above-average earnings growth, or are expanding their business in other ways are looking increasingly attractive.

“We will tilt portfolios towards growth or value if we can see clear benefit in doing so; however, we have to ensure that portfolios remain balanced. Funds such as Framlington UK Smaller Companies and Merrill Lynch UK Dynamic have strong growth characteristics and both are held in our portfolios. On the other hand, both the M&G Recovery fund and the Schroder Recovery fund have distinct value-based investment processes. The tilt is towards growth and we don’t have any plans to change that at present; although if we do change, it will almost certainly tilt towards more growth. I have been looking at the SVM Continental European fund – the manager was talking about the best opportunities within Europe being in growth stocks, because the valuations within Europe are so tight. Consequently, he thinks stocks with the best growth profiles will outperform – and that’s from a value manager.”