The Style Book
A new way to diversify
your investment.
Contents
More information
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2 Style investing — the new diversification 4 The growth style — talent spotting 8 The value style —bargain hunting 10 The core style — ignoring style 12 How style can work for you 16 How to blend investment styles
Style investing —
the new diversification
You’re an investor who likes to be in control of your investments. You don’t like nasty surprises but you are prepared to take the time to understand how to get the most out of your investments. You are the reason we have produced this guide to style investing.
Style investing is a sophisticated yet simple way to diversify your investment portfolio with the aim of reducing the ups, downs and turns of investment markets without compromising long-term performance.
That is why we call style investing ‘the new diversification’. Diversification follows the wisdom of the 17th century Spanish author of the classic Don Quixote, Miguel de Cervantes, who wrote that a wise man will ‘not venture all his eggs in one basket’. Traditional diversification is based on spreading investment dollars across different asset classes such as Australian shares, international shares, property, fixed interest and cash.
Style investing allows you to take this wisdom one step further. By combining share funds from investment managers with different styles, your portfolio will have an extra level of diversification.
Why style matters Most investment managers classify their investment style in one of three categories — growth, core or value. These investment styles often behave differently throughout the economic cycle. For instance, growth managers generally performed better than value managers in the four years leading up to 2000, however, since then, value managers have generally eclipsed growth managers. Investing in a combination of growth, core and value managers allows you to diversify your investment portfolio throughout the economic cycle.
An investment manager’s style guides the important decisions that must be made when managing a fund. For instance, style has a bearing on the choice of stocks that make up a share fund at any given time plus those stocks that the fund avoids. Some investment managers prefer to own shares in companies with a proven ability to grow their business; some seek underpriced shares; while others focus purely on company fundamentals.
Good investment managers usually have an explicit commitment to a particular style. That’s important for two reasons. Firstly, it allows managers to refine their process and maintain its consistency. And secondly, it helps them build specialised knowledge in their chosen style.
An investment manager’s commitment to a particular style is important for you as an investor because it means their actions are true to label and therefore more predictable. To get the maximum benefits of style investing, it is imperative that investment managers do not drift from their stated style. We will discuss this in further detail in our discussion of blending different styles.
Throughout the following pages, we explain the basic tools of style investing plus give you tips on how style investing can help you to build a truly diversified portfolio.
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“Fashions fade, style is eternal” Yves Saint Laurent, 1975
The growth style —
talent spotting
All investors want growth from their investments — nobody likes to lose money. However, when it comes to style investing, growth has a very different and a very specific meaning.
Simply put, investment managers who follow the growth style (growth managers) believe the best way to achieve consistent long-term returns is to buy com-panies with a history of rapidly growing their profits — and the ability to keep doing it.
These types of companies are commonly referred to as ‘growth stocks’. Growth managers scour sharemarkets for companies that have a track record of rapidly growing sales, revenue and profit. They find this information by poring over company profit and loss statements and cash flow statements.
Once these rising stars are identified, growth managers seek to predict the likelihood that the stellar growth will continue. This is where the deep analysis comes in.
Analysts examine three fundamental areas of a company to diagnose the likelihood the company will continue its rapid rise. Firstly, they scrutinise the company’s business strategy in terms of its positioning in relation to competitors, suppliers and customers as well as the structure it has shaped to meet this positioning.
Secondly, they look at the company’s management in terms of their experience, track record and ability to work as a team. Finally, they analyse the industry in which the company operates, looking at such things as its maturity and its prospects for future growth.
Analysts working for growth managers generally like companies with proven management who are grabbing market share in a growing market. While there are growth companies that operate in mature industries (eg Dell in the PC industry), growth managers tend to buy stocks in industries that are themselves still developing — such as pharmaceuticals and medical technology.
As growth stocks generally concentrate on growth strategies, they will typically plough the profits back into the company in order to continue their rapid rise. For that reason, growth stocks tend to pay smaller dividends to investors than other types of stocks. Instead, they hope to reward investors with rapid growth in their share price.
Examples of growth companies: Cochlear Billabong Microsoft Examples of growth investment managers:
Marvin & Palmer Associates, Inc. Alliance Capital
And because these stocks offer the promise of rapid growth over the long-term, they are often regarded as ‘expensive’ by other types of investors due to their high price compared to the amount of profit they generate. When these investors refer to an expensive stock, they are referring to a stock with a high price to earnings ratio (P/E ratio), which is the company’s share price divided by its last stated earnings per share.
Cochlear, the Australian medical implant company, is a classic growth stock. Over the three years to 2003 it has met its internal targets of averaging 20% annual sales growth. In the 2002 financial year it increased unit sales by 21%, after tax profit by 29% and earnings per share by 27%. Cochlear’s management is well regarded within its industry and the company is currently the world leader in its field. In 2003 Cochlear’s stated aim is to again grow unit sales by 20% and to deliver earnings per share growth of at least 25%.
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1_This article first appeared in The Sydney Morning Herald and is reproduced with the permission of John Fairfax Holdings Limited. All rights reserved, the article may not be published, broadcast or redistributed in any form.
The growth style —
talent spotting
“The wide range of returns witnessed in the year to September 2002 has reinforced the need for investors to study thoroughly the different styles of investing in equities.”
Jan Eakin, The Sydney Morning Herald, 22 March 20031
Value managers believe the best way to achieve consistent long-term returns is to invest in companies that offer the best value for money. These companies are commonly referred to as ‘value stocks’.
Where growth managers spend a great deal of time estimating future profit growth of a company, value managers concentrate on establishing an opinion on companies that are out of favour with the market. The idea is that, sooner or later, the market will wake up to the hidden value and push these stocks higher. Value managers want to buy low and sell high — that is buy shares in a company when it is cheap and sell them when they are expensive.
So how do value managers determine if a company is cheap or expensive? There are a number of valuation techniques that form part of the value manager’s armoury. Quantitative financial reports such as profit and loss statements and balance sheets can be sliced and diced to provide valuable information to the value manager. For instance, a balance sheet will calculate the company’s view of the value of its assets. Comparing this book value of the company to its current share price is one popular valuation tool for value managers (known as the price to book ratio). Value managers will look for companies with a low price to book ratio to consider for their portfolio.
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The value style —
bargain hunting
Nobody wants to pay more for an item than it is really worth. Every-one likes a bargain. Investment managers who follow the value style (value managers) apply this sentiment to investment.
“Combining managers with complementary styles offers the potential to reduce risk at a total portfolio level while still capturing positive returns.”
InTech Financial Services, December 2002
Examples of value companies Qantas Orica ANZ Examples of value investment managers
BIAM Australia Pty Ltd GMO Australia Limited
Once a company has been identified as offering attractive valuation
characteristics, the analysts take over to dissect the company to understand whether its share price is likely to rise over the long term. To reach this opinion, analysts diagnose the company’s strategy, its management and the health of the industry it operates in.
What sort of companies are these? Value stocks are sometimes companies whose share price has been battered by short-term woes. Value managers try to buy shares in these rough gems in the belief that the company will recover in the long term and its share price will rebound.
Value stocks are also commonly found in mature industries. As the industry is only growing slightly, these companies are unlikely to shoot the lights out in terms of profit growth but are likely to provide reliable profits year after year. As they often produce steady profit streams and are less likely to invest substantially into research and development, value stocks tend to pay higher dividends than their growth counterparts.
A good example of a value stock in the Australian market over the past 18 months has been Orica. Orica specialises in explosives, generally considered a mature market. Its share price had been battered during 2000 due to market concerns over its high cost structure and struggling revenue stream. Following the appointment of a new chief executive in 2001, the company reduced its costs by half and thereby doubled its profits. Orica’s share price more than doubled over the eight months to July 2002.
Core managers rely on the talents of their team of analysts to choose individual stocks that they believe will perform better then the overall market, no matter whether these stocks are characterised as value or growth stocks.
Due to this deep analysis of individual companies, a core manager’s portfolio may at times display growth or value characteristics depending on
circumstances in the market. The important thing to remember is that this growth or value bias is an outcome of the core investment process rather than an intentional philosophical leaning towards either style.
This is how the core investment style differs from what is often referred to as a ‘style neutral’ investment philosophy. Style neutral managers actively try to neutralise any bias towards growth or value. On the other hand, core managers simply ignore any bias an individual stock shows towards growth or value — their focus is solely on the quality of the stock.
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The core style —
ignoring style
Core managers consciously choose to ignore style in their quest to perform better than the overall sharemarket over the long term. Instead, they focus on deep fundamental analysis of individual companies to come to conclusions about their long-term worth.
“Style is knowing who you are, what you want to say and not giving a damn.” Gore Vidal, US author
Like their growth and value counterparts, core analysts spend their working hours examining financial records in detail, visiting companies (referred to as ‘kicking the tyres’ by analysts), speaking to management, customers, suppliers, stock brokers and competitors to get a complete understanding of each company they are responsible for examining.
Each company is then assigned a long-term value by the analysts. If the current share price places the stock below this value, then it is considered a buying opportunity. Conversely, if the share price is above the valuation level, it would not be considered.
Core managers will typically hold the stock in their portfolio until the share price rises above their valuation. Once this price is struck, the manager will generally sell the stock and hunt for other opportunities.
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Examples of core investment managers
BT Financial Group Putnam Investments
Which style is best? While individual investment managers may crow about the superiority of their own style, no one style has been proven to provide consistently better returns. In fact, over the very long term (20 years), it appears returns from value and growth styles are about the same.
However, over the relatively short term, one style may perform vastly better than another. The chart opposite compares two indices measuring the performance of US growth stocks and US value stocks. As you can see, growth shares vastly outperformed value shares during the peak of the technology boom in the late 1990s. Since the boom ended, value shares have been a much more rewarding place to be.
The different styles don’t only thrive at different times — they can also swap places very quickly. In the US market in 1999, growth shares outperformed value shares by 15.5%. A year later value beat growth by 28%.
Even the most seasoned experts have difficulty predicting which style will be the best performer over a given time period. So, rather than trying to pick which style will outperform at any given time, allocating a portion of your share investments in each of the three styles will tend to smooth out your returns over the long term.
We call this allocation to different styles blending. As the graphs on the following page demonstrate, the blending of different styles will tend to produce more consistent returns — giving you an extra level of diversification for your investment portfolio.
Investment academics have been studying the effects of style on investment returns for more than 30 years. Style investing theory (shown overleaf in figure 1) shows the differences in investment returns achieved by two different styles, in this case value and growth.
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How style can work
for you
Okay, so you know the ins and outs of the different styles. Now you have to put that knowledge to good use — to make style investing work for you.
This model assumes that the value and growth styles are perfectly inversely correlated — that is, as one style falls the other rises in exact proportions. Of course, nothing is perfect in reality. But the same principle applies. Figure 2 shows the investment returns of international funds managed by US-based growth manager Marvin & Palmer Associates, Inc and Irish-based value manager Bank of Ireland Asset Management. It also shows the effect of combining the two in equal proportions at the start of the period.
As you can see, growth managers tend to perform better in different markets to value managers. But rather than being a problem, it is an opportunity. As the blue line shows, by combining two managers (and therefore the two styles), you can reduce the volatility of your investment and still achieve performance above the relevant benchmark.
Excess returns (% pa)
14 1_Source: Datastream. Dec 75 Dec 78 Dec 81 Dec 84 Dec 87 Dec 90 Dec 93 Dec 96 Dec 99 Dec 02 30 20 0 10 -10 -20 -30 MSCI Growth MSCI Value
How style can work
for you
15 1_Source: Intech. 30 20 10 0 -10 Mar 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 100 80 60 40 20 0 -20 Bank of Ireland Asset Management 50/50 blend Marvin & Palmer Associates, Inc. Combination Manager 1 Manager 2 1_Style diversification in theory1 2_Style diversification in practice1
There are two major ways of blending the different styles. Firstly, you can select funds from high quality investment managers in each investment style and invest a proportion of your money in each. This requires a solid knowledge of the various fund managers available to you plus an understanding of each manager’s style — your financial adviser is probably the best source of this knowledge. Each fund manager should also be able to tell you the style that guides their investment decisions.
The second way is to let experts pick and monitor these funds for you by using what is called a multi-manager fund. As their name suggests, multi-manager funds are a mixture of a number of different investment managers. The investment managers are generally selected, monitored and blended by specialist investment research companies, such as asset consultants. It is the job of these specialists to comb the world in search of the best investment managers in each particular style. Once they have found these managers, they blend the managers to try to counteract the style bias of each manager. It is also the job of asset consultants to monitor each investment manager to ensure their performance hasn’t deteriorated or they haven’t deviated from their stated style.
Sound advice You now know the basics of style investing and how it can be used to smooth out investment returns. However, putting this knowledge into action can be fraught with difficulties. That is where the services of a professional financial planner really come into their own. Your financial planner can not only help you invest with style but can also help you decide whether a particular portfolio of share funds (or a multi-manager portfolio) suits your investment approach and risk tolerance.
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To make style investing really work for you, you need to spread your investment dollars among different investment styles. As we saw on the previous page, the secret to style investing lies in the way the various styles are blended in a portfolio.
How to blend
investment styles
The information in this document does not account for your investment objectives, particular needs or financial situation. These should be considered before investing and we recommend you consult a financial adviser.
