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Another choice

16 November 2004 Angelo Coppola

The recent introduction of style indices by the JSE has been a welcome addition to the arsenal of risk-analysis tools available to investors, says Brendan Howie, quantitative manager at Investment Solutions.

In South Africa market factors often have a greater influence on investment decisions than style investing alone, where the style investment approach is widely accepted.

“At times, style will certainly be a dominant factor in determining investment performance and these published style indices enable investors to effectively manage style risk in portfolios,” says Howie.

“The criteria used by the JSE for classifying style are also globally recognised and this gives investors further confidence that style risk and style tools can be consistently applied to investment portfolios in South Africa as they are in other markets.”

Style investing attempts to define the philosophy employed by investment managers in managing assets by using Growth style and Value categories.

A value-style share is typically characterised by a low price-to-book value, price-to-earnings and price-to-cashflow ratios, and high dividend yields. As a result of their seemingly unfavourable prospects, Value shares are often neglected by market participants, according to Howie.

He believes that style investing can diminish investment risk by achieving reasonable diversification quickly by allocating assets to different styles.

“The reason for this is that the different styles have been shown to exhibit meaningful differences in performance for extended periods, so splitting assets by style makes sense,” says Howie.

“However,” he says, “investors realise value and growth styles are not always opposite investment concepts. For instance, an investor may favour a share with a high dividend yield (characteristic of a value share) and high expected earnings growth (characteristic of a growth share).

Attempts to divide a market where these characteristics are not generally opposites can lead to confusion and may not achieve optimal diversification.”

South Africa may be such a market.

Since value investors believe the intrinsic value of the business is well above the current market price, they buy these shares for the protection of a strong dividend flow and in the hope that other market participants will eventually recognise the intrinsic value the Value investor has identified in that share and re-price the share upwards.

Growth-style shares are typically characterised by strong expected growth in earnings, return on equity and growth in sales. They often trade on high price-to-earnings ratios, as the share price reflects the expected future growth in earnings. They may also be characterised by a high level of investor attention and the related market turnover this brings.

The investable universe is little more than 100 shares - which may have stronger common factors than Value and Growth that determine their relative performance.

Also, the dominance of effects market factors such as currency, industry and size on the market may mean that focusing on these factors may be more appropriate, and more meaningful for investors at certain points in the cycle, than a focus solely on style.

“For this reason, it may be inappropriate to benchmark investment managers against style benchmarks,” says Howie, “as it may limit their ability to add to investment returns across different market cycles.

In such a small market of shares, any restrictions imposed at the benchmark level run the risk of eliminating sources of value-add the manager may possess that are not correctly identified as traditional style characteristics.”

Howie says investors need to continue to focus on all aspects of risk, including style, and evaluate which factors are significantly adding to risk and which are less significant at that point in the cycle.

“It is only when these factors are stable and significant over all market cycles that they are suitable to use as benchmarks,” he says.

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