With equity markets still depressed despite positive global economic data, investors face a difficult decision as to when to shift assets from value companies to those offering growth
Woody Allen once said: 'If only God would give me some clear sign ' like make a large deposit in my name at a Swiss bank.'
Although a divine signal or a large deposit into a Swiss bank account is unlikely, investors are clearly looking at the recent improvement in global economic data in search of an indication as to when equity markets will break out of their current banana-shaped recovery.
The evidence of the recovery has resulted in steepening yield curves, especially in the US, although inflation in Europe and across the Atlantic remains relatively benign. Low inflation and steep yield curves is good news for equities but the performance of the markets has been dull since the beginning of the year, to say the least.
This poor performance, particularly in Europe, can partly be blamed on the declining fortunes of the telecoms sector, where excess capacity and concerns over high levels of debt continue to provoke concern. Investors also have doubts over the accounting practices of many high-growth companies.
We are probably still slightly short of a scenario that will deliver a sustained market rally, particularly given that valuations are not at compellingly cheap levels. However, an improving earnings outlook provides some justification for optimism later in the year.
The problem for investors is that the present disconnection between economic recovery and equity market performance is making it difficult to ascertain whether they should remain fans of value-oriented equity investment styles or move towards growth-biased styles in order to outperform when markets break out of the current doldrums.
Over the past two years, value strategies have been the clear winners, a trend that remains strong, with the largest contribution to performance since September 2001 in the US, UK and Continental Europe coming from banks.
Value has gained the upper hand over growth styles because accounting scandals, unjustifiably high valuations and falling earnings have hit many high-growth sectors. Put simply, investors do not trust companies that have speculative and optimistic business plans.
Instead, they have reverted to using traditional valuation techniques that focus on what a company is worth now, such as asset growth, turnover, dividend yield, price/sales and other measures best exemplified by value companies.
Investors are willing to pay a premium for companies with a dependable revenue stream and the market therefore remains focused on low valuation strategies such as price/sales and dividend yield.
Paul Slovic, a distinguished cognitive researcher, summed up this attitude in his 1993 publication Perceived Risk, Trust and Democracy by stating that when it comes to winning trust, the playing field is not level, it is tilted towards distrust.
Given the recent divergence in performance between growth and value, choosing the right investment style has clearly never been so important. For example, the MSCI Europe Value Index has now outperformed the Growth Index by 58% since the peak in equity markets in March 2000.
Given the outperformance of value stocks over the past two years and the fact investors typically stick with investment styles that have been successful in the past, it is no surprise many have switched assets to value-oriented styles and away from aggressive growth-oriented funds.
Another lesson for investors in European mutual funds since March 2000 has been the importance of being clear exactly what they are buying. Many European equity funds have a style bias and understanding the fund managers' definition of style and their bias can be tricky.
Defining value and growth is a notoriously difficult task as opinions differ widely as to what constitutes the appropriate criteria. Some funds also experience style drift, where the fund manager buys stocks from the opposite style to what they are focused on when his/her style is underperforming. The way to avoid this problem is to pick a fund with a clearly specified and defined process.
Style is highly important when making investment choices and the question now is whether this is the right time in the cycle to move away from value-oriented investing strategies.
Style timing is a notoriously difficult area of fund management. For long-term investors, a balanced strategy of growth and value styles is the best formula for weathering changing economic conditions and reducing portfolio volatility. However, in the short term, the distrust of accounting practices and the continued fears over technology earnings growth should continue to support value-oriented strategies.
Meanwhile, the impact on equity markets of short-term interest rate changes by the Federal Reserve remains unclear. Historically, an interest rate hike typically leads to a rotation from cyclicals back into defensives.
We might, therefore, see a rally in technology-related stocks because they are seen as late cycle stocks. However, this might be short-lived given that technology earnings forecasts do not justify a sustained rally. Just look at the high level of indebtedness of telecom stocks and the disappointing recovery in tech capex. These concerns should provide a cap to any rally in the tech sectors.
In his book Style Investing ' Unique Insights into Equity Management (1995), Richard Bernstein found that for US equities, value will outperform growth as the slope of the yield curve moves from extremely steep to flat, typically when short-term interest rates are raised.
The reason for this, according to Bernstein, is that 'investors will believe the Fed is reacting to the strength within the economy and is trying to slow the economic expansion'.
With this in mind, the value rally may have some distance left so our broad European portfolios remain biased to value cyclicals.
It is, of course, too early to tell if we have entered a value-dominated decade similar to the 1980s. But we suspect total returns for equity markets will remain relatively low, at 7%-8% per year, and that dividends will probably make up a larger percentage of that return than in the 1990s.
The ability of companies to pay dividends safely and securely will, therefore, once again become an important criteria for stock pickers and it is possible companies that arbitrarily cut their dividends, and/or use money intended for dividends as a simple free cashflow item, will be punished by the markets. Again, this trend will support value investment styles, making the journey ahead full of value opportunities for growth investors.
Problems stem from the present disconnection between economic recovery and equity market performance.
Value has gained the upper hand over growth because accounting scandals, high valuations and falling earnings have all hit high-growth sectors.
The ability of companies to pay dividends safely will become an important criterion for stockpickers.
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