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Value managers find it hard to compete with growth investors

Friday 3rd March 2000

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By David van Schaardenburg

Investing philosophy within the professional investment management world is broadly split between growth investing and value investing.

Historically, returns from investing in growth shares have been near those from value investing, but a marked divergence in the last five years has been accentuated by the considerable gap in returns between value and growth investors during 1999. This has created debate as to whether value investing is outdated and if investors should increasingly bias toward growth investing.

Broadly speaking, value investors buy stocks that are disliked by the market and are relatively "cheap" by most fundamental measures. Growth investors are less concerned with relative pricing today and are more focused on the long-term superior earnings growth of a company.

In certain periods when growth companies or industries have been highly fashionable, growth investors have performed relatively well. But in each instance value stocks have staged a renaissance. Will this happen again?

Sanford Bernstein, a high profile US value manager, has supplied US sharemarket analyses to indicate just how far divergences in the US market have presently reached. The return from the cheapest half of value stocks in 1999 was 0.4% versus 10.2% for the expensive half. Across the market enormous valuation differentials exist.

Sanford Bernstein has modelled the relative price of the cheapest 100 stocks against the most expensive stocks since 1971, covering a wide range of market environments. At the end of 1999, their model indicated the value opportunity in US stocks was at its most attractive in 30 years.

Sanford Bernstein puts much of the blame for the disconnection in recent returns and valuations on the prices paid for internet and technology stocks. It predicts the internet stock bubble will burst.

It also demonstrates the mathematics of high- versus low-priced stocks: the earnings catch-up required for the expensive high-growth stocks over that of the average cheap stock (19 years at an excess earnings growth rate of 14% a year).

The argument and the mathematics are convincing, yet in 2000 to date the value investing approach has continued to underperform the market. Why is this?

It appears nothing more than the average US investor still being prepared to buy into yesterday's better performing stocks by pumping more than 90% of their new investments into technology or aggressive growth share funds. This has led to continued relative price momentum as fund managers seek out growth stocks and shun value stocks.

Growth proponents naturally paint a positive picture for technology stocks as well as indicating their higher earnings quality in terms of free cash flow and the higher margins typical of businesses built on human knowledge rather than machines.

They also point out the rapidly changing business environment will threaten the existence of many traditional businesses such that "old" businesses should be priced down as this uncertainty exists.

Time will be the arbiter but investors can be sure good stock selection will be the inevitable winner irrespective of whether one falls into the value or growth universe or, as we prefer, has a foot in both camps.

David van Schaardenburg is general manager of IPAC, the investment strategy and funds management research company

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