SAN DIEGO - Does splitting the U.S. stock market between growth and value stocks still make sense?
Lawrence S. Speidell and John Graves, researchers at Nicholas-Applegate Capital Management, San Diego, contend the growth vs. value paradigm - embraced by U.S. institutional investors for more than 30 years - needs a major overhaul.
In an article in the Winter issue of the Journal of Investing, they argue institutional investors have done themselves a disservice by putting growth and value into opposite camps. "Growth is not the opposite of value, but rather an important element of it," they wrote in "Are Growth and Value Dead? A New Framework."
Winning investment strategies will rely on opportunistically switching in and out of a variety of strategies, they say. Their message comes with an implicit bias for growth-oriented strategies, which is Nicholas-Applegate's primary investment style.
The article comes at a time when executives at many institutions are starting to question whether they have created too many style boxes and have hemmed managers into tighter and tighter corners by tying them to narrow benchmarks. Some investment experts, such as Richard Ennis, principal at Ennis Knupp & Associates, Chicago, argue pension funds should adopt "whole-stock" portfolios that give managers flexibility to move in and out of different styles and capitalization weightings.
However, no one foresees a sweeping move toward broad-based mandates. "I'm not seeing plan sponsors going back," said Jeffrey B. Saef, senior vice president and co-head of Boston-based Putnam Investments' strategic relationship team. For example, while many pension executives are intrigued with the concept of adopting a global equity approach and abandoning the division between domestic and international stocks, perhaps only six or seven have implemented something in the area, he said.
The article by Messrs. Speidell and Graves questions whether current definitions of growth and value themselves still make sense. "I'm not saying that value and growth are dead. But I am saying maybe the labels are inappropriate," Mr. Speidell said in an interview.
The debate over whether growth or value stocks provide better returns goes back decades. Academics tend to describe value stocks as those with low price-to-book value, while growth stocks have a high ratio, according to the paper.
Part of the problem lies with the various benchmarks used to define growth and value, which oversimplify managers' investment styles, the authors wrote.
While Standard & Poor's/ BARRA, Frank Russell Co., Wilshire Associates Inc. and Morgan Stanley Capital International Inc. "rely heavily on price-to-book as a discriminator, Russell also uses estimated growth; Wilshire and Prudential (Securities Inc.) use earnings-to-price; and Salomon (Smith Barney Inc.) uses three growth and four value measures," according to the paper.
Most benchmarks rely heavily on price-to-book, which simply draws the line between expensive and cheap stocks. But managers don't look solely at the relative cost of a stock; they "must make judgments about management, strategy, new products R&D ... and growth," they wrote. In other words, they must analyze the quality of a stock, not just its relative price.
Messrs. Speidell and Graves assert the stock market and economy have changed dramatically since Benjamin Graham and David L. Dodd first published "Security Analysis: Principles and Techniques" in 1934.
Past their prime
Taking a page out of the New Economy book, the Nicholas-Applegate researchers wrote that many old-line U.S. manufacturing companies that provided the basis for value investing "may be past their prime." Instead, knowledge-based companies in technology, health care and financial services have replaced many old-line firms in economic importance.
The problem, they added, is that traditional investment tools do not capture New Economy companies well. Historical cost accounting is geared toward manufacturing and production companies, but tends to understate assets of knowledge-based companies. What's more, New Economy companies do not encounter the same capacity limitations of Old Economy companies: instead, higher production reduces costs and lowers prices, encouraging demand.
As a result, managers have adopted a wide assortment of techniques for valuing companies, ranging from traditional tools such as yield and earnings-to-price and book-to-price ratios to newer-fangled economic value-added and EBITDA techniques. In addition, investment styles have proliferated: instead of the simple value/ growth split, managers now employ such specialized strategies as deep value, relative value, growth at a reasonable price, and earnings momentum.
Messrs. Speidell and Graves arrayed the various tools and investment styles on an oval "style map." At the left end of the x-axis are the "skeptics" - value-oriented managers that the authors say have shorter time horizons.
The "believers" - managers with higher growth strategies and a long-term perspective - cluster at the opposite end of the x-axis.
"What really separates investors today is not a difference in their commitment to finding good values, it is the difference in their willingness to look out into the future, to accept growth. If they are doubters, they will be skeptical about future growth," they wrote.
In addition, at the top of the y-axis are momentum-driven strategies, while contrarian strategies are at the bottom. And littering the middle are such tools as dividend discount models, cash flow return on investment and EVA.
While value managers no doubt would dispute being called skeptics, Messrs. Speidell and Graves adopt a more holistic approach toward investing. While saying "value and growth are not dead," they argue that a new nomenclature may be in order.
What's more, "successful investors will lie in all quadrants of the style map," they conclude. "Rewards will go to those investors who adapt to changing conditions and learn where the opportunities lie more quickly than the market does."
The article drew mixed reactions.
"The opposite of growth is not value, and that's real valuable for people to think in those terms," said Kevin Johnson, a partner in Aronson + Partners, Philadelphia. Displaying its own bias, the value-oriented money manager refers to stocks as being "value" or "anti-value."
Ronald J. Surz, managing director of Roxbury Capital Management, San Clemente, Calif., questioned how one would measure a manager's performance using the authors' style map.
In response, Mr. Speidell said he was inclined to agree with Mr. Ennis' approach of using the whole stock market, and not narrow style boxes.
Other experts argued the distinction between value and growth still holds up. Peter L. Bernstein, president and founder of the eponymous economic consulting firm, said the paper only serves to muddy the waters. "They're adding complexity to a useful idea that everybody knows has fuzzy edges," he said.
Josef Lakonishok, principal and chief executive officer of LSV Asset Management, Chicago, a deep-value player, thinks the distinction between value and growth remains valid. And he points to superior returns provided by value stocks over long-term periods.
From 1979 through 2001, the Russell 1000 Value index returned 15.4% annually, compared with 14% for the Russell 1000 Growth index, Mr. Lakonishok noted. (Deep value stocks returned 20.4% annually during that period, compared with 7.9% for the most growth-oriented decile of U.S. large-cap stocks, he pointed out.)
"If those measures were as lousy as Larry Speidell claims, you would not see a big difference in returns," said Mr. Lakonishok, who also is William G. Karnes Professor of Finance at the University of Illinois at Urbana-Champaign.