ANCHORAGE, Alaska -- International equity managers will achieve better returns by splitting allocations into growth and value mandates, according to a new study that challenges conventional theories about international investing.
"A Case for International Growth Investing: A Separate Asset Class?" by Robert A. Gillam, manager of international and global equities at growth equity manager McKinley Capital Management Inc., Anchorage, points out problems with the conventional tendency to ignore growth and value distinctions in international investing.
Until recently, most international investing has not been based on style differences, Mr. Gillam said. "Few managers in international equities will tell you if they're growth- or value-oriented," he said.
Mr. Gillam argues that the Morgan Stanley Capital International Europe Australasia Far East Growth and Value indexes - which use the price-to-book-value ratio to determine whether a stock is growth or value - are flawed.
"While relatively low p/b ratios may be a reasonable indicator of value, a high p/b is not necessarily a good criterion for selecting growth stocks," the study states. "An alternative measure for selecting growth stocks is the earnings-per-share growth rate. This is ... intuitively more acceptable ... because it cannot necessarily be stated that more expensive stocks (high p/b) are consistently stocks that are growth-oriented."
Selecting stocks based on an EPS growth rate "could provide a distinguishable alternative group of securities to one that focuses solely on p/b," according to the report. So stocks that are by the more traditional p/b-based definition "value" stocks may be considered to be growth stocks.
McKinley, with $5 billion in assets under management, manages $1 billion in international equities. Between Sept. 30, 1995, and Sept. 30, 2000, McKinley's international growth fund climbed a cumulative 132% compared to a 38% increase for the MSCI All Country World index ex-U.S.
Mr. Gillam said that most international growth stock managers are not correlated to the MSCI EAFE growth stock index because they "calculate growth differently," generally by using EPS.
"We have started to see plan sponsors differentiate between growth and value" in international investing, said Mr. Gillam, although this has been slower to catch on in emerging markets, he said.
As more plan sponsors look to differentiate growth and value stocks in their international portfolios "the net beneficiaries will be growth managers," said Mr. Gillam, "because there are not many specific growth allocations now."
Mr. Gillam predicts that more than $5 trillion will flow from general non-U.S. equities into non-U.S. growth stocks over the next few years. He bases that figure on the Pensions & Investments/Watson Wyatt 500 largest worldwide money managers, which handle about $33.6 trillion in assets. Of that amount, 55.4% is in invested outside the United States, and 25% of those assets are indexed. If 40% of the remaining assets flow into growth stocks, that would be more than $5 trillion.
"Fund flows follow performance. As growth performs, more money will flow into it," said Mr. Gillam.
It's also possible for international investors to lower the risk profile of their investments by dividing their international holdings between growth and value stocks, Mr. Gillam said.
The report says the performance of international value vs. international growth is more related to the effects of inflation and strong economic and earnings growth than it is to one style always being superior to another. During periods of global economic recession, growth strategies tend to underperform value strategies, and vice versa in the opposite economic cycle.
"This is one of the strongest reasons for allocating to both the growth and value styles in domestic markets. It is logical that this should apply to international markets as well," according to the report.
Mr. Gillam said international growth strategies have outperformed value strategies in the recent past (1997-1999), which has been a time of unprecedented economic expansion.
This leads to the report's conclusion that "the best international investment strategy, like the best domestic investment strategy, is not focused on discovering the superior investment style. The focus should be on mixing good active managers from both international growth and international value to create the best risk/return tradeoff for the specific client in question."