The year 2003 proved to be a roller-coaster one for European equities.
The early months were dominated by headlines such as the war in Iraq,
terrorist fears and the Sars virus. In the period to 12 March 2003, the
MSCI Europe index gave up nearly 20 per cent of its value. What many
saw as an initial bear market rally has since blossomed into a more
robust bull market, with the index rising by 60 per cent as at end
February 2004.
As a result, those equity investors who not surprisingly adopted a
cautious approach during 2003 have missed out on many of the gains seen
in European stock markets. Some lost out by retaining positions in more
defensively orientated stocks, instead of switching into higher beta
companies. Today, others may have missed out on the potential for
future stock market rises in 2004 by taking profits from equity gains
and re-allocating into other asset classes. This uncertainty over the
pattern of future equity market advances, plus the dilemma of
“identifying the winners and avoiding the losers” offers no answers to
the question: “What should investors do right now?”
Popularity
Solutions do exist and one such example is a “style investing”
strategy. This involves fund managers swapping from “value” to “growth”
companies depending on market conditions, and they are gaining in
popularity due to investor uncertainty about future trends. Many
investors are actively using strategies that offer the potential to
benefit from either of these investment styles, in-line with prevailing
market momentum.
Trends in European economies and equity markets make long-term
investment in European stocks increasingly attractive. Favourable
macro-economic factors such as widespread structural reform of
institutions and the job market, coupled with the creation of private
pension plans in the European Union, are underpinning stock market
gains. In terms of market capitalisation, the European equity market is
the second biggest in the world, giving investors a broad investment
universe by region and sector. Europe’s low equity ratio, compared with
the US, is also advantageous to equity investing in the region.
To
benefit from these current upbeat trends in European stock markets,
products that take advantage of style investing could provide a useful
way into the market at this
point of the cycle where uncertainty is still present. It is important
for banks and other distributors to understand how these products work
and how useful they can potentially be for their clients’ portfolios.
Sub-markets
A wide range of academic research suggests that distinct segments or
sub-markets exist within the overall equity market. Furthermore,
companies from different segments have different characteristics and
appear to generate different risk-adjusted average returns for extended
periods of time. In response to this research, investment professionals
have devised strategies designed to exploit these so-called market
anomalies. The implementation of such strategies has become known as
style investing and is currently a major focus of interest amongst
asset managers and investors.
Style investment strategies took off in the 1990s largely as a result
of the work of William Sharpe, a Nobel Prize winner, who put forward
the view that up to 90 per cent of performance in a US equity fund
could be due to the style investment approach of the manager. Today,
investors recognise two primary styles: value and growth. Some also
believe that momentum is a distinct style, but others consider it a
sub-style of value and growth.
Yin and Yang
For argument’s sake, value and growth – the yin and yang of the equity
investment world – are the two most popular styles of investment.
Value and growth investing typically look at stocks with the characteristics shown in Chart 1.
Growth stocks will typically have certain key characteristics in
common. These include high revenue and earnings growth, high
price/earnings ratios and high price/book ratios.
By contrast, value securities will have low revenue and earnings growth, low price/earning ratios and low price/book ratios.
However, no stock is always either a growth or value stock. Growth
stocks could become value stocks over a period of time and vice versa.
Stocks can also be simultaneously classified as both value and growth
companies, depending on the sector and position in the life-cycle of
the company, allowing for characteristics to be differently pronounced.
The creation of a product that takes advantage of upside performance in
both value and growth stocks should, if rigorously managed, have the
potential to outperform an index over all periods. So, how can such a
vehicle be constructed?
The first step is to create two portfolios, one of growth stocks and
the other of value stocks. In Europe, each model style portfolio would
be looking to pick stocks from European companies with a market
capitalisation of at least €500m.
The growth portfolio would comprise 50–100 growth stocks selected using
strict quantitative criteria such as industry sector, long-term price
momentum and high earnings growth over recent years. The portfolio
would be rebalanced every three months, with stocks added and discarded
depending on their adherence to the growth style.
The second portfolio of 50–100 value stocks would be selected on the
basis of high dividend yield, low price to book ratios and long-term
price momentum. For a value portfolio, a rebalancing every six months
is sufficient.
The next step is to determine the balance between growth and value
portfolios within the product. By using a quantitative model, the STAR
(style allocation rotation) oscillator model, it is possible to adjust
the relative weighting so as to reflect the different risk preferences
of investors.
This oscillator model is a function of expected economic growth, market
sentiment (risk appetite) and the momentum of spreads between the
return of value and growth stocks. The advantages of a quantitative
investment strategy in such a style-based approach to investing are
that it allows for:
- systematic detection and appraisal of market anomalies;
- structured and disciplined investment process with integrated risk management;
- evaluation of a large investment universe;
- rapid shifts of focus as well as the immediate exploitation of opportunities; and
- independence from human emotions, with no bias towards sell-side research recommendations.
The weighting of either portfolio can be zero, one-third or two-thirds. A neutral weighting is not permitted so as to ensure the portfolio always has an active bias towards either one of the two styles. This disciplined investment process is shown in Chart 2.
Investors likely to be interested in a value/growth style fund in European equities will be seeking diversified investment in European equities with an active investment strategy. Such a product would provide active portfolio management that enables significant divergence from benchmark returns to be achieved.
Typically, such a product takes the pain out of investor decisions as to which investment style they prefer at any one time, and when they should switch, and leaves that up to a proven investment process that can demonstrate positive results over recent years.
Discipline
The downside of style investing is when a portfolio manager does not apply this strategy in a disciplined fashion. Historically, some managers may not have been as rigorous with their investment style as they needed to be. This results in style drift, with managers either moving away from their primary focus or becoming heavily biased towards it.
In a value/growth fund, the importance of applying rigorous quantitative methods is key to successful investing. A robust application of these methods provides the potential for significant outperformance of an index over all time periods.
Key benefits
The following benefits feature in a product specialising in style investing:
- offers a compelling strategy for investors seeking attractive returns from an actively managed equity product;
- enables investors to benefit from the relative merits of either value or growth investing; and
- the portfolio’s overall bias is automatically adjusted by professional asset managers according to prevailing market conditions.
Martin Schlatter, portfolio manager, Credit Suisse Equity Fund (Lux) Style Invest Europe
