Investment styles -- The growth-value conundrum

A. Srikanth

ONLY out of chaos does clarity emerge. Anyone who has closely tracked the equity market post-liberalisation would surely agree that the last two years were the most chaotic, in terms of major developments (capital market, economic and political) and frequent shifts in business cycles and investment trends.

Though analysts have observed the market's performance from different angles, a close scrutiny of gainers and losers from the point of view of investment style makes things clearer.

A review of the losers and gainers in the BL-250 index portfolio over the last two years shows that the market followed varying investment styles. While an analysis of these styles can help identify a method in the madness, the early spotting of shifts in style could be the key to profitable investments.

A marked feature of the market over the last two years was its frequent shifts in equity investment styles -- between value and growth stocks, on the one hand, and between small and large market-capitalisation stocks, on the other.

A study of the BL-250 portfolio shows that, except at certain times, the market prefers growth to value stocks. Similarly, the study reveals, the market increasingly tends to favour large market-cap to small market-cap stocks.

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Growth vs. value

Analysis shows that except when the economy is on a revival path, growth stocks generate higher returns than value stocks. Thus between April 1998 and March 1999, when the economy was sluggish, the growth stocks outperformed the value stocks by a huge margin. But between April and September 1999, when the economy witnessed healthy GDP growth rates, the value stocks outperformed the growth stocks.

Similarly, between February and May 2000, when the broad market fell 22 per cent, the value stocks posted lower declines than the growth stocks. But between September 1999 and February 2000, despite the economic uptrend, value stocks underperformed the growth stocks. This could be an aberration, as the Nasdaq bull-run may have overwhelmed all other domestic signals.

Though GDP growth rates reportedly slowed in the first two months of 2000-2001, concrete signals of a permanent decline in growth rates are yet to be seen. This could be why value stocks declined by a lower percentage between February and May 2000.

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But how does one explain the shift in investment styles from growth stocks to value stocks. The outperformance of value stocks during the economic recovery reflects the mispricing of financial assets at either end of the spectrum. Investors overvalue the prospects of stocks they consider the best, and undervalue those they rate the worst.

There is also the tendency to project the positive or negative developments of the past into the future. As a result, prices are pushed too far in one direction, though there is ultimately a reversion to the mean, as investors' perceptions change. The reversion could be quite rapid, because while the overvalued growth stocks tend to underperform, the undervalued value stocks tend to deliver superior returns.

However, a closer look at the returns shows that when value stocks outperformed growth stocks, they had smaller spreads than when the latter outperformed the former. In the growth stocks sample, in general, the large-cap growth stocks performed far better than their small-cap counterparts.

Further division of the sample into four sets of 15 companies each showed that mid-cap growth stocks performed better than their large- and small-cap counterparts. However, no such trends were observed when the value stocks sample was segregated into large- and small-cap stocks. Thus, overall, it can be said that the market, in general, favours growth stocks to value stocks.

This phenomenon is true of mutual fund portfolios too. Most MF portfolios perform along a median as they track one of the major indices. This is why most MF schemes find it difficult to significantly outperform one another. And even if they do deviate from the median, they tend to favour a growth-stock-oriented portfolio rather than a value-stock-oriented one.

Several reasons can be cited to support the preference for growth stocks. For one, as growth stocks have a good track record, they tend to be safe havens for investors. This is true even for mutual funds, which aim to keep their NAVs steady. To the extent that funds tend to herd (as indicated by the similar portfolio profiles), selecting stocks that have traditionally done well makes sense. Another possibility is the perception that value strategies take long to become profitable, while growth stocks have price momentum working in their favour in the intermediate term.

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Big is beautiful

Small-cap stocks outperformed the large-cap ones between April 1998 and March 1999. The former posted a return of 31.50 per cent, and the latter 24.70 per cent. But this was when the economy was witnessing sluggish growth rates. In other words, small-cap stocks generate better returns than their large-cap counterparts when there is an economic slowdown. And the former underperform the latter during an economic revival. This is contradictory to the long-term trend witnessed so far in the Indian market; it is also at variance with the trend observed for long in other mature markets abroad.

An important reason for such a serious deviation could be the superior performance of the growth stocks over the value stocks in the small-stocks sample. To test this, the small-cap stocks sample was divided into growth and value. As anticipated, the growth stocks outperformed the value stocks by a huge margin in the period when the serious contradiction was noticed.

Thus, between April and October 1998, while the small-cap growth stocks recorded average return of 28 per cent, the small-cap value stocks returned a negative 28 per cent. Similarly, between October 1998 and March 1999, while the former returned 97.65 per cent, the latter returned just 28.40 per cent.

The further segregation of the sample into four groups of 15 companies each offered additional insights. The stocks comprising the second and the third sets (the middle 30 stocks), classified as mid-cap stocks, tend to generate better returns than either the first group (the top 15 large market-cap) or the fourth group (the lowest 15). Even during downturns (April to October 1998 and February to May 2000), the mid-cap stocks performed better. The stocks in these categories were predominantly from FMCG, MNC pharma, automobile, electrical and power equipment companies.

However, except between April 1998 and March 1999, large-cap stocks generated better returns than the small-cap stocks for all other periods. Thus, overall, the market was generally more favourable towards mid-cap and large-cap stocks. Why are large-cap and mid-cap companies favoured more? If it is assumed that a company's equity base will remain constant in the medium term, the increase in market capitalisation is nothing but an increase in the company's share price.

A larger market capitalisation gives companies an edge in acquiring other companies and capturing global growth opportunities, while protecting themselves from takeover threats. Their sheer size positions them to shape, rather than react to, the evolution of global markets. On the other hand, low market capitalisation renders a company vulnerable, particularly when global equity markets integrate.

The market capitalisation of a company can be split into book value (BV) and the market value to book value ratio (MV/BV). Empirical research (See ``The market capitalisation drive,'' Business Line, May 30, 1999), revealed that the rapid growth in the latter ratio (MV/BV) contributed the most to the increase in the overall market capitalisation.

But companies with a high MV/BV ratio also had the highest growth in return on net worth. So, it was the high growth in return on net worth which drove the increase in market capitalisation. As the research reveals, the average growth in the return on net worth of the large- and mid-cap companies was higher than that of the small market-cap ones.

Moreover, the large- and mid-cap companies are less risky (in terms of market and business risks) than the small-cap ones. With increasing market volatility, the market has been assuming a defensive stance. This rationale has been the key factor driving the market towards large market-cap companies.

Though it may be too early to come to any conclusion on investment styles, the signals over the last two years show that `growth' was the predominant theme, with large-cap stocks generally outperforming small-cap companies.

For the investors, the rules could be:

During periods of economic revival, it is better to get into large-cap value stocks. However, it pays to make sure that the economic revival is well in place before taking such a position. Even slight doubts of a slack in growth rates should prompt investors to switch to growth stocks.

During periods of economic downturn, it is better to get into large-cap growth stocks.