Out of Style
By Jeremy Held

Death, taxes and style investing. Given its ubiquity in both asset allocation models and mutual fund offerings, it is not surprising that some would view style investing as an inevitability rather than simply another investment option. Growth and value benchmarks have increasingly become the new yardsticks by which investment manager performance is measured. In fact, nearly 80 percent of all domestic equity mutual funds can be identified as having some sort of style bias.

The goal of style investing is to describe and define a unique group of stocks based on certain market factors, such as relative valuation, dividend yield and earnings per share growth rate. Once stocks have been identified as either growth or value, these categories can be used to customize a portfolio or as part of an asset allocation program.

Illustration by Russell Thurston

In theory, making the distinction between growth stocks and value stocks gives investors and financial advisors another asset class to work with.

Accordingly, the differences between growth and value stocks should provide investors with increased diversification and the ability to create unique portfolios designed for a variety of investment objectives.

The main problem with the widespread acceptance of style investing is that it rarely delivers on its promise as an asset class. In practice, style indexes have proven to be both imprecise and inconsistent. In comparison with other asset classes, such as international stocks, bonds, cash and real estate, the distinction between growth and value stocks appears to be surprisingly vague. Asset classes should be distinguished by concrete, meaningful criteria that allow for a consistent divergence in returns over time. This divergence can be created by a variety of differences, such as capital structure (equity vs. debt securities) or issuer (government bonds vs. corporate bonds). Fo reign securities have also proven to be a legitimate stand-alone asset class, due to the large variation in economic infrastructure and political stability that exists between different countries (although this variation has diminished in recent years).

Style indexes, on the other hand, use a limited number of simple financial ratios to distinguish between a growth stock and a value stock. The simplicity of this approach limits its ability to capture other important contributors to a stock's performance, including current economic conditions and industry-specific factors. The correlations between value and growth stocks have been high in recent years, especially among large-capitalization stocks, diminishing the ability of style indexes to provide adequate diversification. In addition, much of the discrepancy that does exist between growth and value stocks can be attributed to underlying differences in sector allocations between the two groups .

This is not to say that the emperor has no clothes, merely that he is poorly dressed. The information provided by style investment categories can be very useful, and when used in conjunction with other economic and company-specific data, can assist in the investment analysis process. When used qualitatively, style can also be a useful way to describe an investment manager's philosophy. When used in isolation, however, making the distinction between growth stocks and value stocks has little utility in either constructing an asset allocation model or managing a portfolio. A closer analysis of style investing in its current form reveals that much of its appeal is based on myth rather than reality.

Style Myth #1: Growth And Value Exist

For starters, the underlying premise behind style investing is flawed. Style investing seeks to identify and distinguish between "growth" and "value" companies. But not only are earnings growth and inexpensive valuation both attractive qualities for individual stocks, they are not mutually exclusive. While one could argue that certain companies exhibit more "value" characteristics than "growth" characteristics, and vice versa, prudent investment management incorporates both value and growth analysis into an assessment of intrinsic value. Warren Buffet, in his 1992 letter to Berkshire Hathaway shareholders, echoed this sentiment when referring to the distinction between growth and value:

The two approaches are joined at the hip. Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. To illustrate this point further, follow the logic behind the alleged distinction between value and growth stocks. Value stocks are stocks which appear "cheap" based on a variety of market measures, such as price-to-book ratio (P/B), price-to-earnings ratio (P/E) and dividend yield.The market, however, has already discounted these ratios into the stock price. Value stocks are truly undervalued only if their expected return exceeds what is currently being priced by the market. For this to occur, one of two things must happen: Earnings must grow faster than expected, or the market must demand a higher earnings multiple for the stock. Multiple expansion often occurs when the market expects-you guessed it-faster earnings growth in the future. In other words, for a value stock to be a good investment, it must grow.

The same is true for growth stocks. Growth stocks can loosely be defined as companies who are expected to grow faster than the market, as measured by earnings, cash flow, revenue and book value. Earnings growth, however, is only relevant when compared to the price paid for the initial investment. Unless any of the aforementioned growth rates exceed the rate that is already being priced into the stock, the investment should not be selected. In other words, the growth stock must be a good value.

Simply stated, if the expected return on an investment exceeds its cost of capital, the investment should be made, nothing more and nothing less. This is not to insinuate that investing is easy. In fact, on the contrary, sound investing is a very difficult process that requires experience and expertise. Style investing, however, is simple. And as is often the case, if it sounds to good to be true, it is.