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​Understanding Investment Styles – Part 2

By Shawn Phillips, 16 February 2018

“A leopard can’t change its spots” is a saying entrenched in the belief that a person’s core character doesn’t change over time. The same cannot be said of the markets or investment strategies.

After the lessons of the 2008 Global Financial Crisis, investors have moved away from the traditional approach of investing that focusses on specific investment styles, such as value, quality, momentum, growth and low volatility. As the nature of market risk evolves and new assets emerge, investors need to be familiar with the available risk methods as well as an understanding of the prevailing market regime in order to exploit profitable market conditions (Kolanovic and Wei, 2013: 59). There has been a transition from investing in one specific investment style to a multifactor approach that controls for the risk, return and correlation of the respective styles in a portfolio in order to yield better results for an investor. This article will address four investment styles, namely value, momentum, growth and quality. An emphasis will be placed on understanding how each investment style is constructed. It is important to realise that these investment styles are based on various accounting measures as well as share price movements (in the case of momentum), whereby the application of approximating a specific investment style is subjective as one investment manager could define a style very differently than another.

Style investing is defined as a disciplined and systematic method of investing that produces long-term positive returns (Asness et al., 2015: 28). It aims to achieve an intuitive and cost-effective manner using liquid securities. Style investing has been widely studied, with the classic example being the work of Eugene Fama and Kenneth French. For the purposes of this article, the FTSE/JSE value and growth style indices will be used as well as the S&P South Africa quality and momentum indices. The general idea is not to fixate on the returns of each respective style, but more so to understand each investment style.

Describing investment styles

Value

Value is probably the most well-known investment style, which dates back to the British-born American economist and professional investor, Benjamin Graham. A value investor buys assets that are undervalued and sells assets that are overvalued according to some valuation metric (Kolanovic and Wei, 2013: 39). Despite the fact that this approach appears straightforward, a great deal of uncertainty remains with regards to determining the fair value of a security (Jensen-Gaard, 2013: 27). Value stocks are considered to be cheap as investors underestimate their growth prospects (Ang, 2014: 233), whereby value is captured by various accounting measures such as: price to book, earnings to price, sales, book value, cash earnings, net profit and dividends (Bender et al, 2013: 5). Furthermore, a value strategy aims to capitalise on the mean-reversion of a securities price to its ‘fair value’, where value relies on the premise that prices are temporarily driven away from their ‘fair value’ by either behavioural or liquidity effects (Kolanovic and Wei, 2013: 39).

Momentum

Momentum can be characterized as the tendency of securities, in every market and asset class to exhibit persistence in terms of their performance (Asness et al., 2015: 31). In addition, momentum investors buy stocks that have performed well and sell stocks that have performed poorly. The momentum effect relies on the phenomenon that stocks that have done well previously, will continue to do well, while stocks that have done poorly, will continue to perform poorly (Ang, 2014: 235). The existence of a price momentum effect goes against the efficient market hypothesis which states that past prices alone cannot predict future returns (Kolanovic and Wei, 2013: 34). The theory underlying the premium attributed to momentum is very much undecided, where there is no satisfactory efficient based market theory to explain why a momentum premium exists (Bender et al., 2013: 25). The most widely cited theories are all behavioural, where investors either over-react or under-react to market news which leads to price momentum (Bender et al., 2013: 25).

Growth

Growth investors look for stocks which they believe have the ability to outgrow the market. Contrary to value investing, which focusses on observed facts, growth investors focus on the future prospects of a company. Growth can typically be described by the following accounting measures: asset growth, growth in earnings per share and sales growth. Advocates for growth investing argue that companies with high growth rates will be able to sustain or even improve their growth rate in the future, and in so doing continue to outperform the market going forward.

Quality

“Quality, unlike value, has no universally accepted definition” (Novy-Marx, 2012: 1). The main challenge in terms of selecting quality stocks is how to define the quality factor objectively and consistently (Bender et al., 2013: 27). Quality investors typically look for stocks that are characterized by low debt, stable earnings growth and other ‘quality’ metrics such as: high return on equity, dividend growth stability, strength of a company’s balance sheet, financial leverage, cash flows, strength of management, and accounting policies (Bender et al., 2013: 5). These quality metrics provide a measure of strength in terms of the underlying business, a competitive advantage from an industry perspective and management’s ability to efficiently allocate capital. Investors who advocate for following a quality strategy believe that the market undervalues firms with a high and sustainable profit profile (Jensen-Gaard, 2013: 13).

Graphical representation and discussion

Below are three graphs, which depict the respective investment styles over different time periods. It is evident from the respective graphs that not one investment style dominates over each of the respective time periods.

In graph 1 below, over the period January 2010 to July 2017, we see that quality has narrowly outperformed momentum, while value was the worst performer over the respective period.

Graph 1: Performance since 2010

Morningstar and Glacier Research

In graph 2 below, over the period January 2015 to July 2017, we see that growth was the top performer, followed by value, while momentum was the worst performer over the respective period.

Graph 2: Performance since 2015

Morningstar and Glacier Research

Furthermore, in graph 3 below, over the period January 2016 to July 2017, we see that value was the top performer, followed by quality, while momentum was the worst performer over the respective period.

Graph 3: Performance since 2016

Morningstar and Glacier Research

Conclusion

As seen above, it is clear from the respective graphs that not one investment style dominated over each of the respective time periods. This highlights the need for investor education in terms of understanding investment styles, how they are constructed and how they perform under different market regimes. Due to the fact that investment styles perform differently over different time periods and during different market regimes, there has been a transition from investing in one specific investment style to a multifactor approach that controls for the risk, return and correlation of the respective investment styles in a portfolio in order to yield better results for an investor.

In the third article segment, we will put this into practice by blending investment styles to create a multifactor portfolio.

Bibliography

Ang, A. 2014. Asset Management: A Systematic Approach to Factor Investing. Oxford University Press.
Asness, C., Ilmanen, A., Israel, R., and Moskowitz, T., 2015. Invest with Style. Journal of Investment Management, Vol. 13, No. 1, pp. 27-63.
Bender, J., Briand, R., Melas, D. and Subramanian, R. 2013. Foundations of Factor Investing. MSCI Index Research.
Jensen-Gaard, C., 2013. Equity Investment Styles: Recent evidence on the existence and cyclicality of investment styles. Copenhagen Business School.
Kolanovic, M., and Wei, Z. 2013. Systematic Strategies Across Asset Classes: Risk Factor Approach to Investing and Portfolio Management. J.P. Morgan Global Quantitative and Derivate Strategy, pp. 1-205.
Novy-Marx, R., 2012. Quality Investing. Simon Business School, University of Rochester.
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