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Style Counsel

There is a significant source of investment return that is still relatively poorly understood within the UK.

Traditionally, the method of diversification has been to spread clients&#39 investments between cash, bonds and equities across geographic markets. A core model for a growth investor is to have 60 per cent invested in the UK and possibly 10 to 20 per cent in UK bonds, with the balance in international equity markets.

This approach has doubtless served well but there is an additional source of risk diversification and return enhancement – style. Stocks can be classified using their key ratios (price/earnings, price/book and so on) in one of two investment styles – value or growth.

Value stocks will typically be those which appear to be undervalued by the market. They may be high-quality stocks in an unloved sector or may have been through significant change that has not yet been priced in by the market. These stocks typically have a low price/earnings ratio.

Growth stocks, on the other hand, may be companies in sectors showing dramatic growth overall. The technology, media and telecoms stocks which performed so well in the latter part of the 1990s are good examples. There was little evidence of short-term earnings but market sentiment put a significant value on these companies because of the way in which the internet was changing business both in the business-to-consumer and business-to-business markets.

Economies tend to behave in a recognisable cyclical pattern. In periods of recovery, with interest rates easing and demand picking up, different types of company will tend to perform better than in those periods when growth has peaked and the economy is beginning to cool down.

In most of the major equity markets, the early part of the last decade was characterised by value stocks outperforming the market. However, in the latter part of the 1990s, growth stocks dramatically outperformed, led by the TMTs.

In the US in 1992/93, value stocks outperformed growth stocks by an average of nearly 10 per cent a year. However, most people&#39s perceptions would be that the US market is now a growth market based on the fact that, over the last six years, growth stocks have outperformed value stocks by an average 11 per cent a year. This trend is unlikely to continue indefinitely.

The picture has been very different in Japan, where value stocks have outperformed growth stocks by an average 8.5 per cent in seven of the last 10 years.

A natural consequence of these trends for retail investors is obvious. Fund managers tend to have a preferred style of investing. A fund may have a brief to invest broadly within the FT All Share index but a value manager will err towards buying stocks with low price/earnings ratios whereas a growth manager will look more to momentum factors.

Stocks such as Boots and Rolls-Royce are classic value stocks with price/earnings ratios of 11 and 13 whereas stocks such as AstraZeneca and Cable & Wireless are typical growth stocks with ratios of 47 and 54 respectively.

Consequently, managers with a value bias will have performed well in the early 1990s where those with a growth bias will have performed well in the latter part of the decade.

European funds have grown significantly in popularity over recent years. Those funds that have tended to take significant flows of business over this time have had a strong growth bias. It may be that clients have invested in these leading funds believing they have got their European exposure covered.

On a traditional asset allocation model, this would achieve the objective. However, additional style analysis would determine there is a major growth bias to the portfolio. As long as growth stocks perform strongly, this will be a very profitable structure. However, if key TMT sectors see a shake-out and the economy looks as if it is heading for a material slowdown, then a more value-oriented style may be more appropriate as growth stocks lose some of their attraction.

If this happens, it will take three to five years for performance figures to reflect this change in market sentiment and relative style performance, by which time it will be too late. Buying and selling funds purely on their historical competitive performance can be a bit l
ike jumping from sinking ship to sinking ship.

Many investors do not particularly care about technical matters but style is a material driver behind investment returns. Most funds achieve maximum positive cash flows when they can demonstrate top three- to five-year competitive performance and, conversely, maximum negative cash flows when competitive performance suffers. If advisers and clients do not take notice of style, then they will continue to chase performance rather than seek to pre-empt it.


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