Investment style is one of the most important considerations both when understanding the dynamics of equity markets, and when assessing the performance of funds. Much of a fund’s performance may be attributable to its investment style. The two main styles are the value style and the growth style.
Value investors look for bargains. They like to buy shares cheaply, believing they will recover from their low price. A value style can be simulated by selecting shares with a low price to book ratio. The book value is the company’s equity according to its balance sheet. The price to book ratio is the share price divided by the book value per share: when that ratio is low it is an indication that the share is cheap.
Another method of simulating a value style is to use the price earnings ratio, which is share price divided by the company’s earnings per share. Again, the aim is to find a basket of shares whose price is relatively low.
Growth investors look for companies growing faster than average. They like to buy stocks in companies with innovative or superior products that are in high demand. They tend not mind so much that the shares may be expensive when measured by the value metrics mentioned above.
A growth style may be simulated by selecting shares in companies that have higher than average growth in revenues, for example, or higher than average growth in earnings per share.
Neither a value nor a growth style does well in all market conditions. We believe that a value style tends to do better in risk on environments, but less well in risk off. So fund managers with a pronounced persistent style can fall into the pitfall of style bias. Many investors are familiar with the unfortunate results: funds that perform well for a time, but subsequently underperform.
We try to avoid style bias by flexing our style depending on the market environment. We do this especially through our Dynamic Value stock selection component, which blends a sophisticated valuation model with measures of stock quality, and adjusts the blend based on our measurement of the market environment. The simulated performance of this component, compared to a value style based on the price to book ratio, is shown in the chart below.
DYNAMIC VALUATION: AVOIDING THE PITFALL OF VALUE STYLE BIAS
Source: OMGI. Performance of market neutral quintile value portfolio in North America from August 1981 to December 2016. This is a simulation for illustrative purposes only. Past performance is not a guide to future performance. The value of investments can go down as well as up and is not guaranteed.
You can see that a pure value style (the light green line) suffers badly during periods when the market environment is one of high risk aversion (grey bars). By taking our foot off the value pedal in such environments, we aim to outperform a pure value style. And our Dynamic Value stock selection component is just one of five we use in our funds, as we seek diversification.
Neither a value style nor a growth style works in all seasons. We believe that consistency in return structure is crucial in controlling portfolio volatility, and that the ability to remain nimble and fluid when deploying stock selection techniques is vital.