It's All About Style:
Growth and Value Investing in Institutional Portfolios

By Dorian Andritoiu
J.P. Morgan Investment Analytics and Consulting
dorian.g.andritoiu@jpmorgan.com

According to Russell Investments, the two large-cap style indices – the Russell 1000 Growth Index and Russell 1000 Value Index – account for more than $1 trillion combined, and each has more assets benchmarked to it than the Russell 2000 does. Style investing continues to be an important part of portfolio construction for U.S. institutional investors.

This article provides a brief overview of style investing, and analyzes the recent and past performance of these investment styles to determine how they perform in varied market environments. The article also examines how style indices are constructed, their correlation to one another, and whether style investing benefits institutional investors.

Background on Growth & Value Investing

In the current market, shares have traded at lows that investors have not seen in over five years. As a result, much attention has recently been attributed to value investors. This should come as no surprise. With P/E ratios at multi-year lows, one would expect value managers to be eager to participate in today’s market. Value investors are generally concerned with the price in the P/E ratio. The value manager believes that overreaction to adverse news will lead good companies to exhibit a temporarily depressed Price to Earnings (“P/E”) ratio. This will be the manager’s opportunity to pick up the stock at a price that is not indicative of its actual value.

In contrast, growth investors are primarily concerned with the earnings or bottom number in the P/E ratio. To growth investors, a company with better than average growth prospects should command a higher price for its shares.

As with all other investment strategies, there are possible downsides for both value and growth managers. For example, a value manager might believe that the market has overreacted and that a company’s stock is priced below its actual value. But what if that is not the case? What if the stock of that company was fairly priced? We recently observed financial stocks, which had experienced huge price depreciations, being purchased by investors who believed that the market had overreacted to the adverse news. Such investors in the shares of firms such as WaMu, Lehman, or Bear Stearns were wiped out as these companies were either taken over at deep discounts or allowed to fail. These investors were stuck in a value trap – they believed that the stock was undervalued and would experience price appreciation once the market’s overreaction was over. This is one of the major problems of value investing: two investors can analyze the same information and reach a different conclusion regarding the intrinsic value of the company.

Problems also exist within the growth investment camp. The growth strategy is based on expectations of earnings growth, but what if these expectations fail to materialize? This was most evident when the Tech Bubble burst. Growth managers had been paying too much money for the stocks of growth companies whose earnings failed to materialize – for example, think of Pets.com. It is also possible that the price of the stock will remain the same or decline even with an increase in earnings.

In addition to the risks specific to each style, there are also risks that apply to style investing in general. Due to the nature of style investing, there is a possibility of concentration or lack of diversification in the portfolio. Also, investors need to become accustomed to long stretches of over- and under-performance.

Strategies for Growth & Value Investing

Having looked at the rationale behind and potential risks of growth and value investing, we can now dig deeper and consider the different types of growth and value investing.

Performance Results

Through September Year-to-Date, value investors have enjoyed slightly better performance than their growth peers. This comes as no surprise because value investors tend to perform better than growth investors in down markets. What does come as a surprise, though, is that small-cap stocks have out-performed large-cap stocks. One would think that, with all the turmoil in the financial markets, investors would flee to the relative safety of large-cap stocks. Exhibit 1 illustrates September YTD total returns, including dividends.

If we were to examine performance for the past ten years, we would see that growth stocks performed extremely well during 1998 and 1999 regardless of market cap. During the same period, value stocks were either flat or slightly higher. Growth stocks sustained heavy losses across all market caps from 2000 to 2002. Returns for value stocks during the same period were higher for small- and mid-cap and flat for large-cap stocks. This illustrates one of the risks of style investing. The investor should be prepared for periods of under- and over-performance.

As Exhibit 2 shows, since the market low of October 2002, value investments reflecting total return, including dividends, have handsomely out-performed both growth and blend investments. Also, small-cap value stocks have performed better than mid- and large-cap value stocks. It seems that in the bear market following the Tech Bubble, value investors were able to pick up stocks at a significant discount to their true value. This in turn fueled their performance over the following years. Could something similar be happening now?

Index Constituents

We analyzed the constituents within the Russell Growth and Value indices. All companies held by the Russell 1000 Growth and Russell 1000 Value are held by the Russell 1000, although in different proportions. Of the 646 companies held in the Russell 1000 Growth and the 661 companies held in the Russell 1000 Value, 310 are held in both. In other words, 50% of the companies held by one index are also held by the other. We must keep in mind that the weights assigned to these 310 companies will be different in the growth and value indices. For example, one index will be under-weight one company while the other will be over-weight the same company. Institutional investors that assign an equal amount of money to both strategies (growth and value) could end up with average weights in those 310 stocks that are almost identical to their average weights in the Russell 1000. The investor will effectively be holding 1/3 (i.e., 300+ securities that overlap for Growth and Value) of the Russell 1000 and will be under- or over-weight in the remaining 2/3 (i.e., 300+ Growth and 300+ Value securities) of the Russell 1000 on a company-by-company basis.

Diversification Benefits

Growth and value managers may tend to focus on the same stock, but at different points in time. For example, let us consider a stock that is currently out of favor because the company had some recent adverse news that brought down its share price. Value investors will buy the stock if they believe that it is now undervalued. As the company begins to restructure and improve its performance, its earnings and growth prospects may improve. The stock price may now rise and could potentially become overvalued by the value investor’s standard. At this point, the growth manager may believe that the growth prospects of the firm warrant the higher price and that the stock price will continue to climb as earnings increase. This cycle will repeat once another shock hits the firm.

This supports the conventional wisdom that growth and value investments are not highly correlated and that when growth is out-performing, value is under-performing and vice-versa. Exhibit 3 outlines the correlation between the performance of different investment styles since 1979.

A value of one would indicate perfect correlation, meaning that the investments have performed exactly the same in that time period. By looking at the Russell 1000 Growth and Russell 1000 Value, we can see that the two have a correlation of 0.83. The Russell 2000 Growth and the Russell 2000 Value have a correlation of 0.87. This tells us that, contrary to conventional wisdom, the performance of these two investment styles is highly correlated over the long run.

Interestingly, the correlation between growth and value investing decreased significantly in the period from 1998-2003. In Exhibit 4, we illustrate the correlation of Russell Growth and Value indices in five-year intervals for the past 20 years.

Exhibit 4: Correlation—Growth vs. Value
Source: J.P. Morgan Investment Analytics & Consulting estimates, Russell, Bloomberg.

As indicated by Exhibit 4, the correlation of value and growth indices declined during the period 1998-2003. This was the period of the Technology Bubble, during which growth investors enjoyed unprecedented returns and value investors were shunned.

Conclusion

Considering all the risks associated with style investing, it is understandable for institutional investors to attempt to minimize these risks. Style investing leads to lack of diversification, so in order to minimize this risk, investors will hold both value and growth managers. However, as we have demonstrated, allocating equal amounts to both strategies produced minimal added benefits over the past ten years. In addition, the performance of growth and value investments is highly correlated, so holding both investment styles offers no significant diversification benefits.

Over the past ten years, value has out-performed growth and there are strong arguments supporting value as a winning strategy over the long run. In our view, if value managers take advantage of the current market environment and avoid the value trap, they could continue to out-perform their growth peers.

Growth Minus Value Performance - Rolling 12 Month Returns
The unstable third quarter ended with value stocks outgaining growth by 1.3%; however, on a rolling twelve month basis, growth stocks have still out-performed value by 11.7%.	With the expectation of continued U.S. economic slowdown and volatility in the markets, value stocksmay benefit relative to growth, given the premium on the quality of their earnings and their dividend growth.
Source: J.P. Morgan Investment Analytics & Consulting, Rimes.