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Value makes a comeback and having no style's a winner

Friday 6th April 2001

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By David van Schaardenburg

A year ago, at the annual Ipac investment conference, Paul Bagnoli, partner at the US-based value-based investment firm Sanford Bernstein, pointed out at that time two technology firms, Cisco and Yahoo!, were worth the same as the entire Bernstein Value portfolio that consisted of 40 industrial firms (NBR, Mar 3, 2000).

No big deal except the Value portfolio had 45 times the revenue, 18 times the book value and 12 times the profitability of the two technology stocks. No wonder therefore Bernstein's models indicated the "value opportunity" was then at an all-time high.

In financial bubbles of the last 20 years - oil in 1980, gold in 1980, Japanese shares in 1990 and US biotechnology in 1992 - subsequent asset prices declines from the high point averaged near 60%. So if one believes the internet euphoria was merely a bubble, it should come as no surprise the Nasdaq currently trades 62% below its peak.

Combine the demise of the tech sector with renewed investor interest in "old economy" industrials and a year down the track value investor's have every reason to smile. Value investment firms such as Bernstein are substantially avoiding the market slump that has seen a 26 % slide in the S&P500 in 12 months.

It's a similar story for investors in "value" markets such as New Zealand, which performed badly in 1998-2000. So why the startling turnaround?

The decline in tech prices and the rise in many value stocks can be rationalised as simply a logical economic outcome from the sustained disparities in relative industry and stock valuations in the period 1998-2000. These disparities reached their zenith in March, 2000. So what are the lessons for investors?

Extremes in relative asset valuations inevitably revert to the mean. Over-valuations attract excess capital, which in time increases competition, drives down business margins and subsequently asset prices.

Conversely, prolonged low asset prices squeeze the supply of capital, forcing industries, especially capital-intensive ones, to ration capital expenditure. Over time, this creates supply shortages, higher prices and improved industry profitability.

These key lessons may appear somewhat confusing.

But stock and market trends over the last year still show economic fundamentals will ultimately lead to mean reversion of industry and corporate profitability directly leading to stock price increases or declines.

The tremendous dispersion in returns between differing industries and their stocks over the last three years has had a marked impact on the relative performances between the two main professional investment styles.

A recent US study indicated industry allocations in equity portfolios accounted for 83% of the performance variance between the value and growth investors.

Value managers, like Bernstein, will typically gravitate toward asset-intensive industries while growth managers such as Alliance Capital will tend toward service- or brand-based-industries.

When the economics of the respective industries in these general categories are trending favourably, so too will the relative performance of either the value or growth-style investment managers.

Style purity, however, has led to material under or overperformances by managers for prolonged periods - something their clients typically wish to avoid.

As a consequence some asset management groups have sought to better manage style risk, and therefore business risk, either by becoming a multi-style business or developing "style neutral" equity portfolios.

It is therefore ironic through 1998-2001, when growth managers outperformed and then value managers made a strong comeback, the investment firms that grew the fastest were often those that espoused either no strong investment style or had a multiplicity of investment styles.

David van Schaardenburg is director of Ipac, the investment strategy and funds management research company

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