Style wars

Time and again dispiriting reports are published claiming that, on average, stockpickers fail to beat the market. Fortunately for fans of active investing, there is a number of funds that have consistently outperformed over the long term, and in some cases spectacularly so. 

There are many ways fund managers try to beat their benchmarks, but approaches can broadly be broken down into four styles: growth, quality, value and momentum. The interpretation of these styles is subjective and will vary among managers, but generally growth investors look for companies with high earnings growth rates, quality investors seek growth with strong balance sheets, value investors are attracted to low valuation ratios and momentum investors follow stock price trends.

An analysis of stocks over the past century reveals, you might be surprised to learn, that value has outperformed growth, but since 2007 growth stocks have done far better. As this trend has gone on for so long, many now question if value investing lives up to its name, while its proponents argue that the underperformance of value relative to growth has gone on for so long it is due a reversal. A value rally in November following positive vaccine news sparked speculation that this might be the start of a rotation from expensive tech stocks to cheaper cyclicals, but growth stocks performed better in the final month of the year. 

The chart below shows the performance of MSCI’s world indices across growth, value, momentum and quality over the past five years. The way the factor-based indices are calculated is complicated, but you can see a clear outperformance of growth and momentum over value and quality.

Although overall performance has been weaker in the UK, the chart below shows a similar trend with the underperformance of value stocks. 

The question now is: will growth stocks continue to outperform? Part of the reason they have done so well is because interest rates have been so low since the financial crisis, leading to a greater tolerance of high valuations. There is little reason to believe that interest rates will rise significantly any time soon.  

Growth stocks also cluster in the technology or tech-enabled sectors, which have seen a spike in demand this year that in many places looks set to continue. While the valuations are generally high by historic standards, no one knows how long this growth might continue. And history suggests any rotation could happen quite quickly – as at the turn of the century when the dot-com bubble burst. 

Some investment managers are optimistic about the outlook for value stocks, as they tend to be more sensitive to the economy, which should rebound as vaccines are rolled out (even if the outlook until then is very difficult). The Brexit deal has also removed some of the uncertainty that has weighed on the economy, and the UK might gradually attract more investment as a result. 

To cover different outcomes, it is a good idea to have a blend of styles in your portfolio. “Time after time we see people with huge style biases that they don’t know exist,” says Ryan Hughes, head of active portfolios at AJ Bell. In November MSCI UK IMI Value increased 17 per cent, compared with 6 per cent for MSCI UK IMI Growth, giving a flavour of how sentiment can change. 

Most fund managers’ styles will be laid out in their annual report, on their websites and on factsheets. While it can be difficult and sometimes unhelpful to classify them in terms of rigid criteria, the most popular investment platforms have portfolio analysis tools to help you analyse style blend. 

Below we detail the distinct styles of some of the UK’s most prominent fund managers. They all share the goal of trying to grow investors’ money over the long term, but their approaches differ significantly. 

Growth

Growth investors look for the fastest growing companies, often in industries being transformed by technology. Generally they invest in companies that reinvest most of their earnings to grow the businesses, so dividends tend to be low. 

Baillie Gifford is the UK’s leading asset manager with a distinct ‘growth’ style. Scottish Mortgage Investment Trust (SMT), its flagship fund, tries to find the world’s most attractive growth companies, and own them over their life cycle. The managers’ philosophy centres on their belief that long-term investment performance is concentrated in very few stocks, and these are the companies they look to own. 

According to research by Hendrik Bessembinder of Arizona State University, with whom Baillie Gifford has partnered, between 1926 and 2016 just 90 out of a total of more than 25,000 companies generated half the excess returns from the US stock market over government securities.

By their nature, growth investments can be risky, and James Anderson, co-manager of Scottish Mortgage, expects that many if not most of the companies in the portfolio will deliver lacklustre returns. But they are focused on trying to make sure they own the companies that will deliver extreme returns, which they hope will far outweigh the investments that go wrong.

A classic example of a ‘growth’ company is Tesla (US:TSLA), held across many of Baillie Gifford’s funds. If you believe that a company is the present value of its future cash flows the valuation of Tesla is daunting. But Mr Anderson views it as a symbol of the revolution in energy; and, on its current trajectory, one of the outliers driving stock market returns.  

Most of Baillie Gifford’s funds follow its philosophy of long-term growth. Roddy Snell, who co-manages four of the firm’s Asia funds, says they look to invest in companies that will at least double in market capitalisation over a five-year period. For a more cautious growth strategy, Monks Investment Trust (MKS) is a large global portfolio with half its assets invested in rapid growth companies, and half in cyclical sectors or companies closer to reaching maturity.   

Beyond Baillie Gifford, most technology and healthcare funds also have a ‘growth’ style bias. This is because these industries are growing at a phenomenal rate. The Biotech Growth Trust's (BIOG) net assets have grown by 769 per cent over the past decade, making it the best performing investment trust over the past 10 years in terms of net assets, with Scottish Mortgage a close second.  

Small-caps also tend to have a growth bias, as it can be easier to rapidly grow profits when starting from a lower base. They are also often younger companies in faster-growing industries. Adrian Lowcock, head of personal investing at Willis Owen, recommends Merian UK Smaller Companies Fund (GB00B1XG9599) as a UK option. It has invested in companies such as Boohoo (BOO) and Just Eat (JET) which have grown quickly in a market with little growth. However, Boohoo is a good example of how fast-growing companies can contain hidden risks, in Boohoo's case its working practices.

While growth strategies have delivered the best returns over the past decade, Ben Yearsley, director at Shore Financial Planning, says we could enter a period where highly rated stocks take years to grow into their highly priced valuations, as happened in the 1970s. And Mr Anderson says he expects there to be years when all of his portfolio holdings perform poorly, but he is looking to own them for a decade or longer.

Quality

Quality investors look for companies with strong earnings growth at reasonable valuations. They typically favour companies with strong cash positions and below-average debt-to-equity ratios. 

Terry Smith is a notable self-styled ‘quality’ investor. He invests in companies with a sustainably high cash rate of return, mainly in consumer sectors where repeat business is consistent. He likes businesses with significant intangible assets, such as brand names, patents or client relationships, as these can be difficult to replicate, helping them stave off competition. 

Mr Smith also expects his holdings to grow, and only invests in companies that reinvest at least a portion of their excess cash flow back into the business. Over time, this should compound shareholders’ wealth by generating more than a pound of stock market value for each pound reinvested. His investors' manual says: “Good businesses of the sort we seek to invest in produce cash flows on their capital invested which are better than the average, and they can sustain those returns and even replicate them on newly invested capital.”

This simple no-nonsense approach has served investors very well. Fundsmith Equity (GB00B41YBW71) has had an annualised rate of return of 18 per cent since inception in November 2010 to the end of November 2020, with performance more than double that of the MSCI World Index over five years.

Rival Nick Train also has a ‘quality’ approach, as he aims to have big holdings in predictable, low-risk companies. Like Mr Smith, he takes a long-term view and has low portfolio turnover, making just one new investment in Lindsell Train Global Equity (IE00BJSPMJ28) in 2020 – and not exiting any. 

In a recent interview with Investors’ Chronicle Mr Train shared his three rules of thumb for investing: 1) if a company owns or manufactures products that taste good it's likely to be an excellent company; 2) people will never get bored of being entertained or informed; and 3) professional investors are too pessimistic. All of these feed into his search for resilient companies with growth potential. 

Interestingly, Mr Train’s UK and global funds have relatively high exposure to financial companies. He believes over the long term markets will rise, and holdings such as the London Stock Exchange (LSE), Schroders (SDR) and Hargreaves Lansdown (HL) will rise too. 

Like growth investors, Mr Train is looking for companies that are transforming their sector with digital technology, with UK companies RELX (REL) and Experian (EXPN) meeting this criterion. He also emphasises the importance of strong brand names, which he thinks are broadly undervalued by investors, particularly in the UK. 

Because quality investors have high conviction in their ideas, the best funds tend to have concentrated portfolios. Both Mr Train and Mr Smith argue that having too many stocks leads to "diworsification" and leaves managers closet index tracking and generally underperforming over the long term. 

This differs from the Baillie Gifford approach, of having a large number of small holdings with the hope that some will see outstanding growth – while the rest will not have a significant impact if they do badly. 

Value 

Value investing can be traced back to legendary investor Ben Graham, Warren Buffett’s mentor and author of The Intelligent Investor. For Mr Graham, value investing meant buying a stock below its intrinsic value and then waiting for the share price to catch up.

In modern terms, it is more often thought of as buying shares with low price/earnings ratios, or in beaten-up parts of the market. As Terry Smith points out in his new book, Investing for Growth, buying stocks on low valuations does not necessarily mean they are lower than their intrinsic value, so investors need to be very wary of so-called ‘value traps’.

Value stocks span a range of industries, some of which face clear structural headwinds, including oil and tobacco. However other more cyclical sectors, such as housebuilders, travel companies, commercial property and banks, that may have more attractive long-term prospects, are on relatively low valuations, as are some mined materials, which could benefit from investment in the ‘green industrial revolution’.

Schroder Global Recovery Fund (GB00BYRJXP30) has a reputation for being a committed value fund. Its managers, Nick Kirrage and Kevin Murphy, invest in out-of-favour companies that they deem significantly undervalued relative to their long-term earnings potential. The managers use quantitative screens to highlight companies that have underperformed and are attractive on a variety of valuation measures. 

Their approach of investing in out-of-favour companies has seen the fund underperform the MSCI World Index over one, three and five years. However, it did see a significant jump last autumn when positive vaccine news sparked a worldwide value rally. The fund increased 21 per cent in November 2020, compared with a 10 per cent rise for Scottish Mortgage. But the outperformance of value stocks didn’t last long and growth performed better in December as the new virus strain caused the pandemic to escalate. 

The fund is overweight the banking sector, with financial institutions making up 19 per cent at the end of September. While these companies have had poor performance in recent years, the managers stand firm in their belief that the valuation of banks such as Standard Chartered (STAN) and Natwest Group (NWG) are at odds with their economic future – even if central bank rates are not increased. As at the end of November, 21 per cent of the fund was invested in the UK, 12 per cent in the US, 9 per cent in Japan and 6 per cent in Italy. 

For a UK focus, Fidelity Special Values (FSV) has had an effective value-based approach. Alex Wright, manager of the fund since 2012, looks for unloved companies where he believes market perception may soon shift owing to changes in the company’s competitors or market, a new product line or an expansion into new business areas. He also imposes a strict sell discipline once the recovery has taken place.    

Mr Wright thinks there is currently an unusually broad choice of attractively valued stocks in the UK, with scope to make significant gains once a mass vaccine programme has been rolled out. However, investors in value stocks must be aware of the difficulties they face. As the digital age replaces the industrial age, the intrinsic worth of businesses may not be well captured by old-style valuation methods, according to a recent essay by Michael Mauboussin and Dan Callahan of Morgan Stanley Investment Management. They argue that earnings are less relevant for value today than in the past, because of the rise of intangible assets and the increase in non-recurring, or ancillary, items.

Momentum

Momentum is a more rules-based way of investing, where investors buy stocks that have done well recently, perhaps over three to 12 months, and sell those that have performed poorly. The strategy holds that trends can persist for some time, and it's possible to profit by staying with a trend until its conclusion, no matter how long that may be. It has certainly served its supporters well over the past decade. 

It is not a style employed by many active fund managers, as it follows technical indicators rather than active stock selection. But it was coined by Chicago’s veteran investor Richard Driehaus, who made a fortune by letting his winners run and cutting his losers. 

Mr Driehaus challenged a lot of conventional investing wisdom. Rather than buy low, sell high, he advocates buying high and selling higher. And he doesn’t believe investors should have a rigid value-based process, because he doesn’t think there is any universal way of valuing a company as the world is more complex.  

Momentum investing can be an expensive strategy with high portfolio turnover in crowded trades. A rules-based approach could also leave you selling at or near the bottom of a bear market, and then missing much of the upside when shares recover. 

There are a handful of Momentum Factor ETFs available in the UK. iShares MSCI World Momentum Factor ETF (IWMO) is available on the major investment platforms and has considerably outperformed its counterpart without the Momentum bias over the past three years, as shown in the chart below. 

Blending styles

These categories can help an investor get a feeling for how managers approach their tasks, but they should not be interpreted too rigidly. Managers share a common goal – to make money for their clients – and conditions change. Across styles they generally aim to take advantage of the gap between expectations and fundamentals, which should lead to share price growth. 

Many investors currently believe that companies at the forefront of technological innovation will continue to deliver the best long-term growth, but, as after the dot-com boom 20 years ago, value stocks could rally if a bubble in the hottest parts of the market were to burst. 

Some managers have a deliberately opportunistic style: Jeremy Podger of Fidelity Global Special Situations (GB00B8HT7153) might be an example. Nobody can define the perfect portfolio, but a consideration of different styles should help diversification so long as you remember the importance of adapting to a changing world.