Mood Ring
By Rodney Alldredge

Growth and value investment styles have emerged over recent years as distinct asset classes in the invest-ment world, particularly among pension plans and other fiduciary institutional investors. Yet, if you ask five professional investors or analysts for a definition of either growth stocks or value stocks, you likely will get five different answers.  William F. Sharpe once wrote: ' Much has been written about both the small-stock and the value/growth phenomena. While the  terms ´value' and  'growth' reflect common usage in the investment profession, they serve only as convenient names for stocks that tend to be similar in several respects. As is well-known, across securities there is sig-nificant positive correlation among: book/price, earnings/price, low earnings growth, dividend yield and low return on equity.

.... Those concerned with these distinc-tions have focused most of their research on long-run average return differences; that is, they have asked whether small stocks or value stocks 'do better than they should' in the long-run. Less attention has been paid to likely sources of short-run variability in returns among such groups. For present purposes it suffices that such variability is substantial. ¹

Interestingly, in the same article, Dr. Sharpe' s analysis utilized benchmarks that delineated the two styles using only the rela-tionship of book value (also known as share-holders' equity) and market price. Stocks with ' high' P/B ratios were growth, and stocks with ' low' P/B were value. As Dr. Sharpe indicated, delineating the two styles by a single factor may begin to define them but does not neces-sarily go far enough to allow investors to see clearly the volatile short-term impact of style swings. The more reliable the distinction, the more capability we have to choose proper benchmarks and then to allocate investments according to the expectations of those index-es. The net result is that we achieve greater control of the expected performance of that portfolio. If we must define a style through delin-eation, we should, when available, use all factors that contribute to that  delineation. One way to begin building definitions for the two styles is to ask what things are general-ly held to be true regarding growth and value. What characteristics of a stock (and the company that issued it) would make it universally perceived among investors as a growth or value security? Growth and value generally can be seen as a security' s expected performance under given market conditions based on the influence of the fundamental data of the company that issued it. Expanding on Dr. Sharpe' s com-ments, if  Security A has: a high historic price to earnings ratio (P/E) and a high expected P/E high historic earnings growth and high expected earnings growth high price to book ratio (P/B) low dividend yield, it starts looking undeniably like a growth stock from a growth-oriented company.

Conversely, if Security B has:

• low P/B ratio
• high dividend yield
• low positive historic P/E and low positive expected P/E
• low positive earnings growth and low but positive expected earnings growth it clearly is a value stock.

These fundamentals reflect the assertion of many investors that 'earnings drive prices'. Given a market in which earnings are rising and/or are expected to rise, it is logical to assume that Security A would be seen as appealing and, in attracting investment capital, would experience price appreciation. Given a market wherein earnings are expected to remain flat or fall, Security B would be seen as attractive in the marketplace, and its price would be expected to go up. Growth and value in this context can be likened to the colors of the market' s mood ring.

A Circular Relationship
The key word is 'expectation'. It is true that a company' s profit expectations normally don' t fluctuate significantly from month to month. But it is also true that market sentiment imposes its own interpretations of both individual company performance and the collec-tive profit outlook. Moreover, in many ways, the relationship between market mood and corporate earnings is circular. Many corporate capital structures nowadays consist of diversi-fied investments across many industries, or are leveraged based on their stock prices.

A corporate pension plan is a good example. If a defined benefit plan currently has less expected value than is necessary to cover projected pension liabilities, the plan sponsor is required to adjust its income by the amount of the contribution needed to boost the plan' s value. If the expected value of the plan' s assets exceeds liabilities, the company is required to show the excess value as income. In other words, the plan assets affect the com-pany' s bottom line as much as widget sales. 

A market downturn reduces the value of equities held by the pension plan and thus negatively impacts earnings. Similarly, a bull market bolsters corporate profits. In a different vein, when interest rates fall significantly, cor-porations not only borrow more freely for new projects, but they also may refinance existing debt at more attractive rates, which improves their capital models and cash flows. Thus, just as corporate earnings can drive the market, the market can influence the earnings of companies whose stocks are in it. It is my theory that this interdependence of market temperament and earnings trends can lead to expectation cycles of much shorter duration than is typically supposed.

The Illusion Of Trends
In grouping and measuring growth  and value stocks, index purveyors employ a variety of definitions. Yet, one can see that across those  ariedmethodologies, theleadership rotatesback and forthbetween growth andvalue on a monthlyand even dailybasis. This condi-tionimplies that thelong-term growthand value cycles wesee discussed regu-larlyin Wall Streetresearch and in themedia are really thegreater sum ofshort-term fluctuations of growth-to-value andvalue-to-growth performance differencesover periods of the observers' choosing.Rather than viewing growth and value aslong-term style trends, it may be more help-fulto envision the market as a large multifac-etedenvironment- think pinball machine ormaze puzzle- in which market sentimentcontinually bounces around like a steel ball.If half of the room is designated growth andhalf is designated value, longish-term markettrends would then be the side of the roomwith the most bounces over whatever period.

Figure 1 shows the monthly differentialreturn of a capitalization-weighted combina-tionof the Dow Jones U.S. Growth indexes (large cap, mid cap and small cap) and acap-weighted combination of Dow JonesU.S. Value indexes for each month fromAugust 1997 through May 2001. A chart plotpoint above the zero line indicates that valueoutperformed growth, and the number onthe Y axis represents the percentage points of outperformance. Plot points below the zero line indicate growth outperformingvalue, and again the numbers represent thepercentage points.

Much of this 46-month period is widely regarded by the investment community to have been a 'growth market'. Indeed, growth prevailed in two stretches of con-secutivemonths, six from September 1998 through January 1999 and seven from June 1999 through December 1999. However, further analysis reveals that growth' s domination was a thin 52% (24 of 46 months) in that period. In fact the arith-metic average difference in monthly returns was only 0.17%, with a standard deviation of the differences being 7.3%. Further, the annualized total return of the Dow Jones Value index (9.14%) was greater than that of growth (6.12%). If one were to have been able to move from growth to value with perfect timing in that period, one would have achieved an a n n u a l i z ed  return of about 51%, disre-g a r d i n g turnover costs. For investors who practice tactical asset allocation, this characteristic of short-term lead-ership fluctua-tion means low c o r r e l a t i o n between growth and value (as measured by the indexes), which of course is very desir-able because it means greater opportunity to reduce risk and maximize return. If an investor could even marginally predict short-term growth or value leadership and had access to efficient investment vehicles, he/she should be able to enhance portfolio total return.

Strategic Applications
Daydreams aside, let' s look at a more con-servative asset allocation strategy to approxi-mate what a pension fund might actually be able to do. Using the same 46 months, assume an investment that began with a 60% Dow Jones Total Market Growth index fund allocation and a 40% Dow Jones Total Market Value index fund allocation on Aug. 1, 1997. This allocation would approximate a cap-weighted growth and value portfolio. Assume that a difference of two standard deviations, or approximately 15 percentage points in month-ly total return  between the two indexes, is a signal to allocate 60% of the portfolio to the index fund with the lower return in the previous month and 40% to the index fund with the higher return. Except for this single  condition, no other tactical changes may be made to the allocations.

Conclusion
While growth and value trends do stretch over several consecutive months from time to time, the fluctuation of leadership or domi-nance is much more frequent than is general-ly realized. The vicissi-tudes of market mood seem to play a role in shifting investor expec-tations, which in turn influence the relative perceived appeal of growth and value. As a result, while the overar-ching trend may be either growth or value, the market more often than not reacts aggres-sively in opposite ways over the short term. Perhaps some investors could  enhance their returns by placing less emphasis in their strategies on riding long-term growth or value trends and more emphasis on understanding the conditions under which the market tends to rebalance growth tilts with value reactions and value tilts with growth reactions.

Footnotes

1. Sharpe, William F., ' Asset Allocation: Management Style and Performance Measurement, An asset class factor model can help make order out of chaos,' Journal of Portfolio Management, Winter 1992, pp. 7-19.
2. Dow Jones uses a six-factor cluster-analysis methodology to determine style. The factors are trailing p/e, forward p/e, trailing earnings growth, forward growth, dividend yield and price/book. Russell uses two factors, price/book and I/B/E/S projected growth rate, in a proprietary weighting scheme to determine style. S&P/Barra delineates half the market cap of the universe in question as growth and half as value when sort-ed solely by price/book. These methodological differences ren-der direct comparisons of the indexes meaningless, which is why direction of index performance is chosen as the unit of measurement in determining style dominance.