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Smart moves

The UK investor has been able to choose between regional funds for decades, with Japanese, US and European funds offering a well established method of diversification for fund investors.

During the 1990s, sector funds developed, culminating recently in a wave of technology-related launches that ref-lected strong retail demand in late 1999, early 2000. More recently, investors have had a new range of funds from which to choose.

Since their launch in February 2000, the Fleming European strategics growth fund has grown to E47.5m while the Fleming strategic value fund is worth E217m. Last October, we introduced similar growth and value funds which focused on the US stockmarket.

The demand for these funds has been fuelled by the recent rise and subsequent bursting of the TMT bubble. A stampede into growth-oriented funds was prompted by TMT stocks massively outperforming old-economy value stocks. Since the autumn of 2000, the opposite has been true. Investors are now finding solace in value stocks that offer earnings transparency and stability. But we believe we are only seeing the tip of the iceberg of potential demand.

In the US, mutual funds which concentrate on particular investment styles are well established. However, style investing is a fairly new concept to European retail investors. Let us be clear about one thing – style, in investment jargon, does not have anything to do with aesthetics or taste.

The rationale behind style investing is that, over time, markets clearly and consistently reward certain attributes or styles. Comprehensive research has shown that the most consistently rewarded stocks over the longer term have been companies with stylistic attributes that can be best categorised as belonging to either the extreme growth or extreme value end of the market. At the same time, it is also clear that different styles come in and out of fashion at different times.

For example, there have been prominent periods in history when small capitalisation stocks have outperformed bigger capitalisation stocks or when value-oriented companies have outperformed growth-oriented companies and vice versa.

Style investing is a recognition of this fact. It accepts that stockmarkets are segmented and that all stocks do not behave identically.

Typically, every stock goes through a growth and a value phase during its life cycle. Growth stocks are companies whose earnings have the potential to grow rapidly and therefore, increase the value of their shares over time.

Usually, these companies are young and vibrant, expanding quickly into new markets or developing highly sought after new products. Value stocks, on the other hand, are companies whose share price is depressed for one reason or another but which investors believe will eventually rise, with the help of a catalyst, to reflect its intrinsic value. Such companies are usually more mature, operating in developed markets with less room to grow organically.

But why do these stocks at the extreme ends of the value/growth spectrum tend to outperform over the long term? In the case of value stocks, there may be a psychological explanation. When buying value stocks, investors like to feel they have bought a bargain that everyone else has missed.

They expect that others will eventually recognise the true value of the stock, causing its price to rise. However, low prices alone do not indicate an undervalued asset. The key to identifying the best-value companies is to recognise when a stock is cheap for a good reason, avoiding those companies that are potentially bankrupt. If supported by strong fundamentals, a catalyst will enable the market to unlock their intrinsic value. This catalyst could be a change in the company&#39s management or a beneficial change in the economic environment.

Good style investors will look for inefficiencies in the market to maximise growth potential. For example, in the case of value stocks, investors may be able, through close analysis, to identify and buy a company whose shares have been oversold.

This may be because it is perceived that its earnings will remain depressed for longer than is the case. If a catalyst can be spotted early, these stocks can experience dramatic re-ratings against the stockmarket as a whole, hence the outperformance.

Investors buy growth stocks on good news, such as earnings upgrades, in the expectation that, over time, the price of the stock will rise to reflect its improved future earnings potential. This appeals to their basic human desire for comfort. The inefficiency this time is that the market tends, at first, to underestimate the full effects of good news.

Our research shows that when a growth company first starts to report good news, it is usually a sign that there is further good news to come. This creates a window of opportunity to buy a stock as soon as news turns positive, as the market will not at first price in the full potential of the news.

The key is to sell growth companies as soon as news turns bad and therefore avoid those stocks that are failing to sustain their earnings growth, thuslosing their momentum. This is because, as with good news, the first sign of bad news tends to be a signal of bad things to come.

Given that extreme growth stocks have much higher ratings than the market as a whole, any continuation of bad news flow that leads to an earnings downgrade can rapidly lead to a steep fall in share price. Therefore, it is through the use of a disciplined and research-driven investment approach that these extreme value and extreme growth opportunities can best be identified and exploited.

Style funds concentrating on growth or value are particularly useful to investors because stockmarkets often experience sectoral rotations that result in a change of leadership between growth and value stocks. For example, technology stocks considerably outperformed the wider market in the six-month period between October 1999 and March 2000.

Their rise resulted in many stockmarket indices becoming bloated with technology and many portfolios that use these indices as a benchmark were compelled to become particularly growth-oriented.

Consequently, many investment portfolios became highly dependent on growth stocks, leaving little room for exposure to value companies. However, there has since been a re-evaluation of the old-economy value stocks that had been ignored in the rush for technology.

A major sectoral shift from growth to value had occurred in the spring of 1999, resulting in considerable outperformance for value-oriented investors. This was reversed at the end of 1999 but the cycle has come round again and value stocks have outperformed growth over the last six months.

Clearly, a single focus on growth or value stocks will not provide outperformance all the time. However, with the help of growthand value-style funds, investors have the opportunity to balance their portfolios so that they are not caught out by a change in stockmarket fashion. Research also shows that over the long term both, extreme growth and extreme value stocks outperform.

Style funds are viable long-term investments in their own right.

Alternatively, investors can use them to follow the style that is in vogue with the market at any one particular point. Whatever the choice, style funds are an excellent addition to the investment armoury of any serious stockmarket investor.


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