A Mutual Fund’s style should inform the retail investors about what type of mutual fund product they have bought. This is also useful for the portfolio managers, as they can choose to specialize in particulars segment of the stock market, so that the manager becomes an expert in that niche area. Furthermore, if funds are categorized with style labels, then it is possible for the funds to be ranked against other funds with similar styles. This is useful for individual investors and for fund-of-fund managers, who can select the best performing funds based on the peer group rankings produced by agencies like Morning Star and Fitch.
There are many styles which can be used to classify and select portfolios. This article concentrates on the three styles which are used in building Global and European mutual funds, namely: Value; Growth; and Momentum.
THE VALUE STYLE
In choosing the value factors to use in ranking the stocks in the investment universe, a three-legged-stool approach was adopted. Each factor used in the selection process had to be either: a) proven by academic literature to have delivered outperformance historically (meaning no back-test was necessary); b) commonly used as a selection factor in the financial industry; or c) logical or economic sensible. If the factor satisfied all three criteria, then this was even better.
a) Ranking of PEG Ratios (Price Ratio relative to growth)
The PEG ratio is a simple tool which is well explained in Jim Slater’s Book “The Zulu Principle”. Essentially it is a tool to insure that a reasonable price is paid for a growth stock. Academic studies show however that, although the PEG can perform well over certain periods of time, it is not a consistent long term outperformer.
b) Ranking of the Dividend Yield (D/P)
The dividend yield is one of the most commonly used investment selection criteria. It is not a consistent outperformer over the long-term, but it does very well in Bear Market phases and is often more stable than the PE as earnings can fall or disappear for cyclical stocks during a recession.
c) Ranking of Dividend Cover
The dividend cover is defined as the earning divided by the dividend. It is included in the screening process to act as a control on the dividend yield. If a stock has a high dividend yield, due to a low price, but the dividend cover is high then the chances are better that the dividend will be maintained. If however the dividend cover is low then a cut in the dividend payout is more likely. Therefore the model controls for this possibility and assigns a low rank to stocks which have an inadequate dividend cover.
d) Ranking of Earnings Yield E/P (or Inverse Price Earnings Ratio)
The PE ratio is the most widely used tool by the fundamental investor. Academic studies by Basu; Lakonishok; and Fama & French, among others, have shown that the stocks with low PE ratios have consistently outperformed those stocks with high PE ratios since 1926. These studies in the late 1970s and 1980s came as no surprise to the original Value investors like Benjamin Graham who was explaining the virtues of these fundamental tools over 30 years earlier.
e) Ranking of Book/ Price ratio B/P (asset backing)
The screening model has been developed to favour those stocks with a high asset backing, as measured by the Book/Price ratio. As with the PE ratio above, the low B/P ratio has been shown by academics, such as Fama & French; and Lakonishok and Chan, to be one of the most powerful long-term and consistent predictors of future outperformance. There has been some academic debate as to whether the low B/P ratio is a proxy for some other unknown risk, but the fact remains that it works.
One advantage of the B/P over the E/P ratio is that the later measure sometimes will not work at times when the earnings (E) are contracting, or become negative, as a result of a recession. This anomaly is known as the Molodovsky Effect and is something that needs to be considered in building a quantitative screening process, if cyclical stocks are to be included in the investable universe.
f) Ranking of Return on Equity (ROE)
The high ROE has also been shown by the academic studies to be a consistent long-term predictor of price outperformance. However, it is interesting that the ROE includes neither the market price nor the payout ratio, which makes it a very interesting factor in stock price prediction.
Finally, all ranks for the factors (a) to (f) are summed and the total scores are then themselves ranked.
THE MOMENTUM STYLE
The screening process includes two types of momentum: Earnings Momentum and Price Momentum. Academic studies by Latane and Jones (1979) find that firms reporting unexpectedly high earnings outperform firms reporting unexpectedly poor earnings. This outperformance persists for about six months. Givoly and Lakonishok (1979) similarly report that prices react slowly to revisions in analysts’ forecasts of earnings.
To capture these earnings momentum anomalies the screening model incorporated the following:
a) Ranking of One-month breath;
b) Ranking of Three-month breath, where the “earnings breath” is defined as the number of brokers earnings upgrades minus downgrades, divided by the total;
c) Ranking of month-on-month Earnings Revisions Momentum; and
d) Ranking of three month Earnings Revision Momentum, where the simple percentage change in the brokers’ earnings estimates is measured.
These are followed by the two Price Momentum screening factors:
e) Ranking of three month Price Momentum; and
f) Ranking of six month Price Momentum.
Academic studies show that simple price momentum strategies, where you buy stocks simply because the price has risen in the past, do work. For example, in the article “The Profitability of Momentum Strategies”, by Chan and Lakonishok (1999), they found that such strategies proved profitable for intermediate horizons. There is however one health warning here and that is that stock prices which have risen in the previous month tend to reverse in the following month. This is why the screening model has incorporated a 3-month “price-formation” period and not a 1-month period .
The price formation period can be up to 12 months. So if a stock has risen over the previous year then the chances are good that it will continue to rise. However, if the stock price has been rising for more than a year then it becomes dangerous to buy it, due to what is called “Mean-Reversion”, which is the reversal of prices to normal values after a long period of time. Just as stock prices under-react for the medium term, there can also be longer-term phases where they over-react and they eventually need to correct themselves. The model therefore chooses a safer price formation period of just 6 months.
Finally, all momentum rankings are summed to give a composite momentum which is in turn ranked.
THE GROWTH STYLE
a) Ranking of the Re-Investment Growth Rate
The re-investment growth rate was defined as the Return on Equity multiplied by “1 minus the Payout Ratio” and is an attempt to guess the future growth rate of the firm based on the existing rate of return on equity capital and how much of the earnings are retained to earn more in the future. It is one of the criteria chosen for logical reasons. This Reinvested ROE factor was tested by the Quantitative Department of Citibank in London and was found to achieve outperformance.
b) Ranking of the 5-Year EPS Growth Rate
This was a simple attempt to select the companies with the best historical earnings growth rate.
c) Ranking of the 5-Year EPS Standard Deviation
The use of 5 year EPS stability was an additional control on the growth rate and was chosen because studies were showing that those companies who grew their earnings with the least volatility in earnings were the ones who had the best long term share price performance.
Once again the rankings of the three Growth measures above are summed to give a composite number which is also ranked.
BALANCED STYLE PORTFOLIOS
The funds managed are given equal weights to each of the three styles to achieve a “balanced portfolio”, which essentially is one that takes no bet on the individual style. If you actually want to bet on the relative performance of the individual styles then a Style Switching Concept has to be developed.
To achieve the goal of having a balanced portfolio, the rankings of the Value, Momentum and Growth Styles are added and a final ranking is calculated which is used as the basis for a new model portfolio each month.
CONCLUSION
A Mutual Fund’s style is the label it carries to let the retail customer know how the fund manager makes his stock selection. This article has attempted to give an insight into the criteria which are used in building a style-based mutual fund. The most popular investment styles: Value, Growth and Momentum have been addressed, but there are many other types of funds, such as Size, Eco-friendly, Country and Theme funds, which also exist. The issue of Style Switching has been mentioned, but there are many who believe that it is not worth the risk in trying to gain added value through style selection. Such investors prefer to use a “balanced” style as has been done in this article.