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Understanding Investment Styles
John Henry Low
THE SAVVY INVESTOR
As a Matter of Style
BY CONSTANZA ERDOES AND JOHN HENRY LOW
We are often asked our opinion of the investment market, and always hesitate to answer. Not that we do not like to share our views (we most certainly do) but on which market should we focus our answer? When it comes to reporting investment news, the media tends to do investors a great disservice. When we listen to an investment news report, we are usually quoted how the Dow Jones Industrials performed, and if we are lucky, maybe a reference to the S&P 500. Are these two indexes the best way to keep track of the market and by association, our own individual investment portfolios? Are these even accurate measures of the market?
The answer, of course, is no. Remember, the Dow Jones Industrial Average is composed of only 30 "industrial company" stocks (well actually 26, with a couple of financials and retailers thrown in), and is hardly representative of the stock market, which consists of over 7,000 stocks. Even the S&P 500 is limited, as it only represents 500 of the largest stocks in the market, and completely ignores over 6,500 smaller stocks.
We would suggest an alternate view of the investing world. One that holds that there is no such thing as "the market," but rather, that there are many markets in which to invest. These markets by defini
Erdoes and Low are partners at Knickerbocker Advisors Inc., an investment management firm based in New York. The information contained in this article is intended for general information only and should not be acted upon without professional advice.
tion, share risk and return characteristics, and tend to move as a group. Most of us already segment the investment market, in the broadest sense by thinking of stocks and bonds as two distinct investment categories or asset classes (and rightly so). But let us take that market segmentation a little further, into something that investment professionals call style analysis.
First, let us categorize the entire stock market into three company sizes: large, medium and small. For this article, we will use the same size definitions as does Morningstar, the mutual fund rating service. Consider large (or large cap) companies as those with market capitalizations of $5 billion or more. (Another way to understand market capitalization is to consider that it would take more than $17.2 billion, its market capitalization, to purchase every share of stock of Sprint.) Medium-size stocks or mid caps range from $1 billion to $5 billion in market capitalization, and small caps are $1 billion or less.
Now let us further divide the stock market into two broad investment styles: growth and value. These represent two basic reasons to buy a stock. We buy growth stocks because of their high-growth prospects. These are companies whose annual rate of sales growth might exceed 20, 30, 40 or even 50 percent. We might purchase a high-tech computer company stock because it has released an innovative software package that we expect everyone will want to buy. Similarly, we may buy a medical compa-
THE SAVVY INVESTOR
ny stock because they have developed a new medical device for which we expect high demand. High-growth companies are often small in size, have a product that is innovative and new, and can easily be found in the technology and medical sectors.
Value stocks, on the other hand, are bargains or stocks that are "on sale." Think of a large financial stock such as the Chase Manhattan Bank. We would not buy Chase because we think it is going to grow by 50 percent this year, but because analysts have given it a fair valuation of, let us say, $130 and it is currently selling at $90. We buy value companies because we think their fundamentals are solid, and the market has undervalued and/or overlooked them for some reason. Some stocks do not fall clearly in either the growth or value category, but in fact are in between or some combination of both. For them, we will add a third category, a blend between growth and value.
So now we have divided the equity market by company size and investment style. We put these concepts together in Figure 1:
Figure 1. Equity "Style" Box
Consider each box in Figure 1 as its own market or asset class, with distinct risk and return characteristics. The Large
Value market, fu11 of well-established, large companies, tends to be the most conservative and least volatile. The Small Growth market, full of new, high-tech stocks, is the most volatile and aggressive. We saw a perfect example of this risk/return relationship in July 1996 when the large cap blend market lost 5 percent of its value and recovered within four weeks, whereas the small growth market lost between 15 percent to 20 percent of its value and has yet to fully recover.
Each market will tend to move together and be affected by similar economic factors. For example, let us look at how a rise in interest rates might affect large value stocks (such as Citicorp, Gannett, and Exxon) and small growth stocks (such as Oakley, Barra and Respironics). The larger, well-established companies tend to be stable and have tremendous access to financing on a global scale. Chances are that a small rise in U.S. interest rates is not likely to have much effect on them or their stock price. A young, small-growth company, on the other hand, may be much more dependent on a limited source of financing. Even a small rise in U.S. interest rates could adversely affect such a company's access and/or cost of capital, and send its stock price plummeting.
The bond market can be similarly categorized. First, let us segment the bond market by maturity or duration-long being greater than 10 years, intermediate being between 4 and 10 years, and short being under four years. Then let us further divide the market by credit quality-high comprises those bonds rated AA or higher, medium comprises bonds rated BBB through A, and low are bonds rated BB or lower.
We can clearly see in Figure 2, that for bonds, the longer the maturity and the lower the credit quality, the higher the risk of the bond. (Interested readers may want to refer to our previous two articles on fixed income.)
Figure 2. Bond "Style" Box
In addition to these stock and bond markets or asset classes, we would include other markets, such as the inter-national markets (developed countries), which can be categorized similarly to the style box in Figure 1. We would also examine markets that are not as easily categorized by market capitalization and/or style, such as the emerging country stock markets and real estate securities, such as REITs, which nevertheless, are important markets in their own right and play a significant role in a well-diversified portfolio.
For the individual investor, style analysis is most useful in three important ways:
First, by thinking of many investment markets or asset classes (as opposed to one all-encompassing market), it is easier to understand that markets move differently and at different times. For example, we all have been hearing about the tremendous bull market of the 1990s. True, for large blend and large value stocks. Although the S&P 500 Index has performed admirably and would be located in the upper quarter of the large blend box in Figure 1, at the same time, one segment of the market is currently in the midst of a major bear market and small-growth stocks have been decimated since June 1996. So you see that the answer to how the market is doing depends com
pletely on where your focus lies.
This type of information is crucial to every investor, especially when it comes time to make a selling decision. Let us say that you own some small-cap growth investments that have not been performing well. You can now put their lackluster performance into perspective (i.e., it may not be the individual investments that are underperforming but the whole small growth market or asset class). If, on the other hand, the small-growth market was returning more than 20 percent per year and your particular small-cap growth investments were underperforming, you may have a legitimate reason to sell them.
Second, style analysis helps you put together a portfolio that fits your person-al risk tolerance. We maintain that most investors should take advantage of almost every market or asset class as we have defined them in this article. In other words, have a percentage of your investments in stocks and bonds, large and small caps, in value and growth stocks, in domestic and international stocks, and so forth. How much to put in each category or market is called asset allocation. Your individual "mix" of categories should depend on your investment time horizon and your individual return requirements and risk tolerance. Look at your investment portfolio and try to categorize it among the different style boxes. At a glance, these style boxes give you a quick overview of which segments of the market are more volatile and relatively riskier and which segments of the market you are missing out on.
Third, each stock and/or mutual fund in each of these markets or boxes tends to move together. In two academic studies published in the Financial Analysts Journal, Gary Brinson, Brian Singer and Gilbert Beebower proved that stock selection is not as important as asset class selection. In fact, their studies went fur
(Please see Savvy Investor, page 45)
THE SAVVY INVESTOR
(Continued from page 31)
ther, noting that 91 percent of investment performance is determined by the asset class you are invested in, and not by the stock you selected, or the timing of your purchase or sale. This means that for the average investor, whether you pick IBM over AT&T as a stock to invest in is not nearly as important as picking a large cap blend stock, as they tend to move upward and downward in price together. If you have held a diversified portfolio of large cap stocks and/or mutual funds in your portfolio over the past two years, you will have participated in that market's great run up just by having held a diversified portfolio of large cap stocks/mutual funds. If your portfolio was concentrated in bonds and/or smaller stocks or mutual funds, your portfolio will not have performed as well.
You might wonder which "style box" or market has historically outperformed all others. The answer may surprise you: it is the small value companies. Value stocks in general, outperform growth stocks over long time periods. While counterintuitive, this is due to unrealistic expectations of growth stocks that make them more volatile. Expectations of a growth stock can be so high that if a company grows by an astounding 40 percent per year, but forecasts had been 45 percent, expectations are dashed and the stock can actually fall in price, despite an extraordinary rate of growth. Value stocks, by contrast, do not carry such high expectations and tend to react much less to negative earnings surprises.
So why not just invest all of your money in this asset class and ignore the rest? For three reasons. First, while this class has outperformed over the past 70 years, there is no guarantee it will do so in the future. Second, by ignoring the rest of the markets, you will be missing out on some great returns in other asset classes. Third, performance is cyclical among all asset classes. One year, large cap blend is the hottest market (as was true in 1995). Another year emerging markets are the clear winners and in another long-term bonds are the winners. No one has been able to predict with any certainty which market or asset class will be the winner next year. Thus it is far more prudent to allocate your investments over a wide range of asset classes or markets and take advantage of them all. (By the way, lest you are tempted, last year's winning asset class tends to underperform the following year, so do not invest in a stock, mutual fund or market just because it performed well last year.)
So now, when asked how the market is, the savvy investor will, too, get that gleam in his or her eye and ask "and just which investment market are you refer-ring to?," all the while smiling happily as his or her portfolio is well allocated among many different markets. Until next time, happy investing. n
Have questions or comments? Contact the authors at Knickerbocker Advisors Inc., P.O. Box 312, Pine Plains, NY 12567 or E-mail: jhlowt2knick.com.
Reprinted with permission from Experience, published by the Senior Lawyers Division of the American Bar Association. Copyright © 1997 by Knickerbocker Advisors Inc. All rights reserved. No copies or reproductions may be made without the express permission of Knickerbocker Advisors Inc. Information contained herein is solely for informational purposes and was obtained from a variety of recognized sources believed to be reliable. However, we do not make any representations as to its accuracy or completeness. Questions and comments may be sent to Knickerbocker Advisors Inc., Post Office Box 312, Pine Plains, NY 12567. (518) 398-9000 Fax (518) 398-9800.