Achieving a decent level of performance from an investment has become difficult since the end of the bull market so finding the right balance between growth and value investing is essential
As the high-octane returns of the 1990s have given way to an environment of more subdued long-term investment returns, achieving significant levels of performance has become a real challenge for investors and their advisers.
One way in which we believe investors can increase their probability of performance is through style investing, in particular by combining two styles: growth and value.
However, to be successful, it is important to have a clear definition of these two terms.
When assessing a value stock, we are essentially looking for cheap, fundamentally sound but out-of-fashion stocks. There are a number of reasons a stock may be unfashionable: poor company management, a relatively unfavourable economic environment for the company or simply the fact the sector is out of the limelight. For example, the majority of old economy brick-and-mortar stocks were shunned by the market during the tech, media and telecoms bubble of late 1999 and early 2000 despite being fundamentally sound and good value.
These companies need a catalyst to release their value, be it a management change, expansion into new markets or simply for the stock to come back into fashion. The key to value investing is to ensure the company is not cheap for a good reason. This means looking for stocks that are cheap via an objective measure but still fundamentally sound.
Research on the US market shows that on average over the past 50 years, the cheapest decile of stocks has outperformed the most expensive decile by more than 10% per year. Growth investing entails looking for companies that are growing their earnings faster than the market and are supported by positive newsflow. US research once again shows that on average over the past 50 years, the 10% of stocks with the strongest price momentum, a proxy for market sentiment, have outperformed the 10% of stocks with the poorest price momentum by more than 10% per year.
The key to growth investing is to ensure the fast-growing company is also supported by positive newsflow. As soon as a growth stock disappoints the market, it tends to suffer from adverse price performance.
For many years, investment professionals have known that fear and greed influence the markets. However, it wasn't until recently that academics formally recognised market sentiment is an important factor in driving market returns, evidenced by the decision to award Daniel Kahneman the latest Nobel Prize for Economics for developing the field of behavioural finance.
The principal reason for the success of the growth and value approach is that it exploits the cognitive biases inherent in humans that lead human behaviour to be systematically irrational. Contrary to what the efficient market hypothesis and modern portfolio theory assume, investors are not rational, they are irrational, and systematically irrational at that. This allows us to exploit the market anomalies arising from human behavioural biases. Examples of these biases include:
l Overconfidence in own investment ideas. Investors are generally overconfident about the accuracy of their own predictions without giving enough regard for the impact of external factors and chance on their investment decision.
l Loss aversion (regret aversion). Investors are reluctant to admit their mistakes. When faced with losses, investors are reluctant to sell stock and crystallise the loss, and may even buy more stock. Conversely, investors like the pride effect associated with selling stocks that have gone up in value. Empirical evidence shows investors are three times more likely to sell a winner than sell a loser due to regret aversion bias, even though common sense tells us that we should do the exact opposite.
l Anchoring. Investors irrationally anchor themselves to historic information. For example, by anchoring their price level expectations on what some technology stocks were trading at at the peak of the technology bubble, investors may believe stocks that have fallen in value are cheap, regardless of what has happened to fundamentals and hence valuation parameters.
To take advantage of these biases, we have a rigorous and disciplined investment approach to capture style returns that also allows us to ensure we do not become subject to the same behaviour. By assessing stocks initially on strictly objective measures, subjective judgements about stocks are minimised.
While over the long term both value and growth strategies outperform the market, there will clearly be short-term periods when one style is out of favour with the market. However, analysis shows that over the longer term, value has outperformed 60% of the time and growth has outperformed 60% of the time. When we combine these styles in our other European portfolios, we are able to outperform 80% of the time.
We adopt an extreme growth extreme value approach on the JPMF Premier Equity Growth fund. However, for investors looking for style separately we also have 'pure' style funds such as JPMF UK Strategic Value, which was launched three years ago expressly to provide long-term capital growth through a value-biased portfolio of UK companies.
JPMF UK Strategic Value only invests in the cheapest stocks within its investable universe and holds a high number of stocks, between 100 and 150, which reduces stock-specific risk and ensures we are able to take advantage of the sampling effect. The fund's disciplined process ensures there is no deviation from its stated value style and means expensive stocks are excluded from the portfolio. This enables the fund to maintain its style purity.
Style funds allow investors to diversify away risk, thereby enabling them to invest more efficiently. For instance, an investor currently invested in a UK core fund with a growth bias can invest in a value fund to diversify away risk and boost risk-adjusted returns.
Style funds therefore provide investors with the opportunity to balance their portfolios so they are not caught out by a change in stock-market fashion. In this way, style investing offers investors an ideal way to maximise their opportunities for outperformance in today's difficult stock markets.
Michael Baratios, fund manager of JPMF UK Strategic Value fund
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