Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Investment Styles Part II

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Every few months the financial press publish articles lauding the best performing equity fund managers over the previous 12 month period; generally accompanied by a picture of the manager looking responsible in an expensive suit and a post-match account of which stocks they held that caused them to outperform their peers and win on the day. Underlying these articles is the assumption that all equity funds are managed using the same principles and that a manager's outperformance is solely due to their skill. In reality the underlying investment philosophy or style is normally a major factor in determining performance. Last week's piece looked at the four basic investment styles (index, growth, value and quality) and in this second piece we are going to look at the market conditions under which each style tends to outperform.

Investment-styles-part-2.PNG

No one single investment style outperforms in all markets, though for obvious reasons an index fund should deliver to investors the return of the underlying index less a small management fee.

Generally growth-style managers along with momentum-based quantitative funds tend to outperform during market rallies. Investor exuberance leads to excessive optimism about the future prospects of new and exciting companies, which increases investor appetite for risk. Similar to growth-funds, quantitative funds relying on momentum signals perform well in strongly rising markets. This style of quantitative fund will tend to buy companies whose share prices have performed well over the last 12 months, as this is determined by the underlying mathematical or quantitative computer models as the best signal for future outperformance. This can be a self-fulfilling prophesy and can work very well driving certain stock prices higher, until a break or fundamental change occurs such as an unforeseen banking liquidity crisis.

The above table shows that prior to the bursting of the Dot.Com bubble in 2001 and the onset of the GFC, growth as a style outperformed. In August 2000 investors were willing to buy growth companies such as NewsCorp on 85 times earnings, ultimately overestimating the potential impact of the company's investments in digital technology. Similarly in 2006 the price of ABC Learning and Centro Properties were bid up to an extent that their share prices represented 20 and 24 years of current earnings respectively. Whilst neither of these two companies fulfilled their debt-fuelled promise of conquering the vast US childcare and retail mall markets, growth style fund managers who held these stocks in their portfolios would have outperformed between 2005 and 2007.

Value funds tend to outperform during the first stages of a recovery. During this time, value fund managers will own a portfolio of cheap stocks that face some issues or the market has taken an overtly pessimistic view of the outlook for these companies. Over the period 1999 to 2000 value funds would have generally avoided internet and telecom companies such as One.Tel and eCorp and invested in "tired old economy" companies such as BHP and Westfield and thus would have underperformed.

Value-style funds are often rewarded during the early periods of economic recovery as earnings recover and companies priced on a low price to equity (PE) ratio enjoy an expanding multiple. Over the period 2003 to 2004 typical value stocks like BlueScope, Caltex, Origin Energy and Orica all outperformed the market by greater than 30%. Value funds must be careful to avoid companies that are "value traps", or companies that look cheap as they trade on a low multiple of earnings or are priced below the book value of their assets. Often these companies are cheap for a reason, due to some negative structural factors impacting their industry such as Fairfax, Qantas or the domestic steel companies.

Similar to value, quality as a style tends to underperform in markets being driven by increasing investor appetite for risk. Quality investing seeks to avoid risky stocks and focus on owning companies with high quality earnings, strong governance and sound balance sheets. In equity bull markets these companies tend to underperform as investors chase stocks that represent a new industry with vast potential.

Quality funds tend to outperform the overall market during a downturn or periods of increasing volatility or uncertainty. Here investors' risk appetites reduce sharply and companies that were previously perceived to be "boring" become favoured by investors for their stable earnings, dividends and conservative balance sheets. During the GFC from 2007 to 2009 stable high quality companies such as Woolworths, Coca-Cola and CSL delivered positive returns in a market that declined by -25%, as unlike many stocks on the ASX these companies delivered rising dividends without having to make dilutive equity raisings.

At Philo Capital we manage the Core Equity Portfolio as a quality style equity portfolio. We view that through the cycle, a portfolio of good quality stocks with lower volatility and higher yield will outperform the market, especially during periods of market corrections. Further we see that after a long period of global quantitative easing, investors are facing an investment environment with structurally lower growth rates and overall higher levels of government debt. Arguably this will result in a greater degree of equity market volatility, which should allow quality as a style to outperform and give our investors smoother returns.

No one single investment style outperforms in all markets and most fund managers will argue that their style is superior. Arguably individuals should invest with managers whose style most closely represents their own investing personality and most importantly their risk profile. Clients with high risk tolerances and a desire for "sizzle" in their portfolios could find value and quality style managers too staid. Alternatively the volatility of returns delivered by even the best growth managers could give conservative investors too many sleepless nights.

Disclaimer
This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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