Investing with Style: A Primer
Successful equity style timing can considerably add to investment performance. So what is style investing? In this article, learn how it can be a source of added value, as well as which styles work best in various economic phases.Style investing is concerned about investing in equity market segments that are driven by common risk factors and tries to select the appropriate style at the right stage of the business cycle. The most popular equity investment styles are: value vs. growth stocks, large caps vs. small caps, and defensive companies vs. cyclical companies. While academics have long neglected style investing, practitioners have been using these classifications for a long time. Value investing, for instance, goes as far back as Benjamin Graham and David Dodd and their investment classic “Security Analysis” (1934). Warren Buffett is probably the most famous proponent of the value approach to investing.
Why Should Investors Be Interested in Style Investing?
Styles are among the most important return drivers in active equity portfolio management. Getting the style timing right can lead to significant outperformance relative to the overall market and could be a substantial potential source of added value. When a style is in favor, all managers of that particular style usually benefit from the tailwind, whereas the other styles languish. The figure shows our Cycle Clock framework, which indicates the styles that work best in certain phases. Obviously, this is a simplified view and need not hold at all times. However, it is a good starting point for an equity style strategy.
Varying Performance in Different Phases
Style performance can vary substantially over time. During the technology bubble in the late nineties, for instance, growth strongly outperformed value for several years. While the fortunes eventually reversed, pure value managers suffered in the meantime and saw significant outflows of client money. The relative performance of large cap stocks relative to smaller companies was also subject to dramatic swings at times. Although over the entire period shown in the chart, small caps outperformed their larger counterparts, there were substantial reversals in between. This illustrates the danger of adopting strategies that rely on simple observations such as “small caps outperform large caps in the long run”. The long run might simply be too long.
How To Select Between Different Styles
As certain styles work best in a specific phase of the business cycle, a natural starting point for determining which style works best at a certain point in time is our Global Cycle Clock. Based on a measure of the global output gap, the Cycle Clock divides the business cycle into four distinct phases: recovery, overheating, slowdown and contraction. Cyclical companies and small caps, for instance, usually outperform during recovery phases, while large caps and high-quality stocks outperform during slowdown and contraction phases.
While getting the phase in the business cycle right goes a long way in explaining a style’s performance over time, there are times when factors other than the cycle dominate. During the technology bubble or the European sovereign debt crisis, some styles did not perform as the Cycle Clock had predicted. As it is only one factor, it is unlikely to catch all the relevant dimensions of a particular style’s performance. In order to refine the signals of the Cycle Clock, we incorporate three additional variables into our framework: relative valuations, momentum and investors’ risk appetite. By doing so, we are able to improve the accuracy of the signals (hit ratio) relative to using the Cycle Clock alone by between 1.6 and 6.6 percentage points and the average (annualized) monthly performance by between 4.5 and 16 percentage points.
An overview of the most popular equity investment styles is provided below.
Is Big Really Beautiful? Large Caps Versus Small Caps
An equity style that is based on size is usually determined by the market capitalization of the constituents. As noted, historically, small caps tended to outperform large caps. Still, there were long stretches of small cap underperformance. Often, the stocks of larger companies outperformed in more difficult market environments and when investors are more risk averse, as larger companies are, on average, more resilient to withstand economic headwinds and have easier access to financing sources than smaller companies. On the other hand, when economic growth is strong and stocks rise, small caps often outperform the overall market.
There are many reasons why small cap stocks offer better returns than larger companies. One reason could be institutional policies that prohibit money managers from investing in stocks with a market capitalization below a certain threshold, due to a lack of liquidity. As a consequence, companies that fall below that limit get less analyst coverage and hence mispricings tend to be more pronounced, giving rise to the “smallcap- effect”. Also, smaller companies usually grow faster than larger ones that often operate in saturated markets. Furthermore, smaller companies often get taken over by bigger ones trying to gain access to crucial technology or new markets, resulting in handsome gains to investors in these small cap stocks.
A further distinction of the equity market could be made in terms of cyclical and defensive companies. Cyclical companies are highly sensitive to the business cycle. When times are good and economic growth is strong, cyclical companies benefit disproportionately from the expansion. When the tide turns and times get tougher, however, these companies tend to suffer more than others. Companies in the materials, industrials and consumer discretionary sectors are cyclical in nature. Financial services and energy companies also exhibit cyclical traits.Defensive companies, on the other hand, operate in sectors and industries that are less dependent on the economic cycle. Demand for their products is largely unaffected by the ups and downs of the economy. Defensive sectors are consumer staples, healthcare, telecom and utilities. The choice between cyclical and defensive sectors depends to a large extent on the stage in the business cycle. As soon as there are signs that a recession is on the verge of ending and an upswing is setting in, cyclical companies start to outperform the more defensive companies. The reverse pattern is observed when economic activity is rolling over.
Several studies have demonstrated that a value strategy performs better than a growth strategy in the long run. Often, this outperformance is ascribed to the value style’s greater riskiness. Probably closer to the truth is the explanation that investors simply overpay for growth. If expectations (and prices) for future growth are running high, even small disappointments could lead to painful losses as the margin of safety is small. Value investors, on the other hand, are very skeptical about the value of growth due to the difficulty of its estimation. Usually, growth investing performs better during more challenging market environments, when growth is scarce. In these situations, companies that offer growth opportunities command an above-average valuation premium. Value, on the other hand, normally outperforms during upswings, when growth opportunities are abundant.
Quality Stocks – Good Company = Good Investment?
While investors often talk about “quality stocks”, there is no clear-cut definition of what exactly a quality company is. However, few people would disagree that quality stocks have low leverage, show high and persistent profitability and have low sales and earnings volatility. But other factors need to be taken into consideration too, including transparent information vis-à-vis the investment community and the participation of key employees in the success of the company. Such companies are often large conglomerates that manufacture recognized brands and/or have an outstanding position in their markets. Whereas stocks of lower quality tend to outperform in an economic upturn, quality stocks on average outperform the market over an entire economic cycle, as they hold their value much better during cyclical downturns. Of course, even these companies cannot escape the waves of selling pressure that affect the financial markets, but their stronger balance sheets enable them to weather storms better, and in some cases to even emerge stronger from a crisis, as their weaker competitors are often driven out of the market in such situations.
Income Generators or High-Dividend-Yielding Stocks
This style refers to investing in companies with a tradition of paying above-average dividends and which are expected to continue to do so in the future. We thus look for well established companies generating steady revenues which translate into regular cash inflows for their shareholders. Even though many investors think of dividends as unexciting, over time their impact on performance could be rather dramatic. Whereas 100 US dollars invested in the MSCI World Index in 1973 would have grown to about 1,200 US dollars today, an equal amount invested in the same index with the dividends reinvested would have grown to almost 4,200 US dollars over the same time horizon. Including dividends, the total return would have been 3.5 times bigger. Often, the “income generators” operate in more defensive industries and produce goods and services that are needed irrespective of the prevailing business cycle. Thus, the stocks are less volatile and achieve more stable profits which allow them to pay out regular dividends. The stocks of such companies are likely to outperform the overall market in periods of economic slowdown or contraction. However, they tend to lag during recoveries.
Momentum investors invest in the most popular stocks. Their strategy is to take short- to medium-term positions in stocks which exhibit positive price performance and where earnings and growth expectations are positive and rising. The best entry point for this style would be near a stock market trough, just at the beginning of a major rally. In reality, a momentum investor would have to wait until a trend is well established before investing. Ideally, investors exit the strategy at the peak of a stock market rally. Empirical research indicates that the best returns are usually achieved over a period of 6–12 months. However, momentum strategies tend to underperform over periods longer than one year as mean reversion sets in.Why should a simple strategy such as momentum outperform? Traditional finance says high returns are justified by the style’s riskiness. Behavioral finance argues that people become overly pessimistic about companies that have done badly and become overly optimistic about past winners. As these trends continue for some time, prices start to deviate from fundamentals and the losers become under- and the winners become overvalued. This mispricing, however, tends to correct itself eventually, as contrarian investors become interested. As the name implies, contrarian investors select companies which most other investors do not wish to own. Companies with the lowest momentum scores belong to the contrarian style. Thus, contrarian investors select businesses which are underpriced and show negative price momentum. In the words of John Maynard Keynes, contrarians believe that a “central principle of investment is to go contrary to general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”