Plan sponsors and their consultants have a clear responsibility to identify and monitor a large universe of managers with a high probability of outperforming in a consistent manner. This begs the need for a classification standard: encouraging convenient "style" categories such as growth and value.
Growth managers buy growth stocks, which are expected to generate excellent cashflow in the future. Value managers are meant to be different because they identify current value, not future rewards. They buy stocks trading below their assessed value in anticipation that the price will increase when the market recognizes the disparity. Other familiar "styles" are those of market capitalization: large-, medium- and small-cap.
Instead of differentiating managers by portfolio characteristics, our industry might consider focusing on the investment formula that produces those characteristics. Style ought to have nothing to do with the kind or size of stock a manager buys. Rather, it should describe the manager's particular formula or process. Coca-Cola Corp., for example, is best know for its Coke product, yet this is simply the result of the company's formula for concentrate and the process used to produce and distribute it. It's the formula that counts.
Semantics can be confusing
A closer look at the terms "value" and "growth" reveals how confusing style terminology can be. Ask major investors to define value and most will reply that it is an assessment of cashflow and risk. As to cashflow, most would agree that sooner is better than later and more is better than less. Are there any managers who do not ultimately expect to generate cashflow, yet factor risk into the price they are willing to pay?
True "value" managers who consistently outperform use a process to determine the present value of future cashflows in light of comparative risks. The approach is similar to valuing a bond, where a growth assumption is necessary to set the discount rate on future cashflows. In effect, growth is just one element in determining value. Is it really a style, or simply a means to an end?
In today's buoyant markets, so-called growth managers become momentum players as their stocks rise along with the market. The term "value," meanwhile, has been relegated to the "buy assets and buy them cheaply" definition expounded by Benjamin Graham, the father of security analysis.
The reality is that every manager is looking for a bargain, stocks that either display multiples enhancement over time, or consistently enhance shareholder value by re-investing tax-paid cash at a healthy rate.
Defining styles by market capitalization is equally problematic. What is a supposedly "small-cap" domestic manager to do when one of its holdings becomes a midcap stock - sell it? How can a global manager label its style as large-cap, if emerging market stocks in that category become small- to midcap stocks in more mature markets? If a global manager adopted a large-cap style, it effectively would eliminate the vast majority of emerging market companies from the universe of investment opportunity.
Surely, the process used to arrive at asset and security selection is more important than labels attached to portfolio characteristics. How does the manager combine human resources, information and technology to produce its results? Does it follow a disciplined approach while fostering independent thinking in its research? Successful managers recognize there is no single solution to the task of building superior investment returns.
Style doesn't travel well
Attempts to apply style labels to international investing can be even more confusing. Foreign markets are often driven by their own particular traditions and culture and local investor psychology differs from one country to the next. Whereas "growth" is usually associated with Asian markets, investors in the United Kingdom tend to look for "value" in stock selection. In France and Germany, where the cult of equity is still in its infancy, neither term has familiar meaning for domestic investors.
As for capitalization labels, the wide variations in size of foreign equity markets make these categories at best ambiguous. This is particularly true of emerging markets, where, for example, a large-cap stock in Venezuela would equate to small-cap stock in Japan. Further, significant long-term currency movements require market "cap" classification changes when measured in U.S. dollars.
Regardless of nationality, weak corporate managers use weak accounting to report weak results. To add further challenges, international accounting differences create major problems for would-be style seekers. Germany and Switzerland are just two countries where accounting standards are less transparent than a North American investor would expect.
These differences can severely distort international earnings comparisons. In our experience, varying depreciation schedules adopted by companies - a reflection of different tax codes and therefore different political philosophies - have a particularly significant impact on earnings. This is why international managers should focus on cashflow rather then earnings ratios when comparing companies on a global sector basis.
Another impediment to "stylization" in international markets is the frequent lack of independent thinking in local research. Domestic U.S. managers use readily available independent earnings predictions for "value" and "growth" categorizations. But international mangers may be confronted with consensus forecasts based on little real research. In some European markets, word-of-mouth recommendations by local brokers may be the only "research" available.
It's the formula that counts
Whatever the market, plan sponsors and consultants would benefit by analyzing the manager's formula for asset and security selection rather than the portfolio characteristics. In reality, if you examined six different "growth" or "value" managers, you probably would find six different processes. With international managers, the basic approach should first be determined; is it driven by macroeconomics (top down) or stock selection (bottom up)? Does the manager take an integrated view, using both approaches?
What else to look for in the process? Here are some pointers:
The process should match the philosophy. If a manager's "mission" is to add long-term value for clients while communicating effectively with them, how does the process fulfill the promise?
What is driving an international manager's country allocation decision as well as the sector and security selection? Is the process rational and well defined?
Discipline is essential. A manager may have the most talented and independent-thinking people, the best sources of information and the latest technology, but are these resources being used effectively?
Being opportunistic helps. A structure and process that encourage individuals to take advantage of opportunities - within the parameters laid down - is critical to the decision-making process.
Ideas should be self-generated. While "Street" research can be helpful, managers should be generating research in-house. Understanding companies, unraveling accounting conventions and speaking with management is more important than searching for data or talking to brokers.
Watch the "star manager." One or two managers in a firm may capture the headlines with unusually good performance. But how firmly wedded are they to the firm? If they left, what depth of talent would they leave behind?
Style classification for managers and companies has become all the rage in our industry and it does have the merit of convenience. However, it also can cause serious confusion, and investors would be much better served by examining a manager's process, layer by layer.
All of us know we are out looking for bargains, or "value" in its simplest sense. How we find them is what counts. John McDonald is president and chief investment officer of McDonald Investment Management Inc., Toronto
