There are many reasons why a fund outperforms others, such as the ability of the fund manager to select and sell stocks and asset allocate, the timing of buy and sell decisions and the size of the fund, the investment style of the fund and whether that style is in favour with stock markets. Because of this, there are many different ways for managers to select stocks and run their funds.

Broad value
Value investors buy stocks that they believe have undervalued share prices against measures of their fundamental value. Typically, value stocks have low price-to-book (p/b) and price-to-earnings (p/e) ratios and high dividend yields, says Ashok Shah, chief investment officer of London and Capital.

Value companies have traditionally been seen as defensive stocks and are usually found in mature and stable industries such as utilities, foods and tobacco.  Value stocks are often expected to deliver low earnings growth but are regarded as value stocks because they have been overlooked by the market or are in an out-of-favour sector or a turnaround situation. A turnaround may be driven by new management or the launch of new products.

Tim Price, director of investment at PFP Wealth Management, points out that if a growth stock suffers a large share price fall it can turn into a value stock, but investors must beware ‘value traps’. These are cheap for good reason and may be in terminal decline.

Alternative approaches
There are two sub-styles of value investing: equity income and contrarian – their investment approaches varying significantly. Equity income fund managers buy companies paying a high dividend yield or whose dividend is growing. A dividend yield
is a measure of distributions to shareholders as a percentage of the share price. 

According to the website www.fundfact.com, if equity income funds are ranked on years of dividend growth, the top four are Credit Suisse Income, Liontrust First Income, Merrill Lynch UK Income and Rathbone Income.

If ranked according to three-year total returns, the top two are Invesco Perpetual High Income and Invesco Perpetual Income.

Contrarian investors buy stocks that have performed badly in the past that could return to favour or for which a catalyst will produce an upturn in the share price.

Turning to growth
Growth investors are looking for companies that grow their earnings and profits faster than the market average. These stocks tend to have high p/e and p/b ratios, with investors often expecting them to deliver growth in earnings of 20 per cent or more for a number of years. Consequently, growth investors seek significant appreciation.

The growth at a reasonable price (GARP) approach combines both growth and value styles. GARP managers look for undervalued stocks that can deliver sustainable earnings and profits growth.

Some fund managers take an agnostic approach to investment style, says Ashok Shah. This means they have no bias towards selecting value or growth stocks.

It is argued that, over the long term, value stocks outperform growth companies. In his book Stocks for the Long Run, Jeremy Siegel says that between 1963 and 2000, small-cap value stocks delivered a compound annual return of 23.26 per cent, compared with 6.41 per cent from small-cap growth stocks.

The differentiation was less for large-caps. Value stocks returned a compound annual return of 13.59 per cent over the same period, against 10.28 per cent from large-cap growth companies.

Does value outperform?
This is supported by comparing the performance of the Dow Jones USA Growth Large-Cap and the Dow Jones USA Value Large-Cap indices. www.morningstar.com
says that between 1 January 1993 and 1 January 2008, the value index returned 301.44 per cent compared with 103.96 per cent by the growth index.

Of course, there are also periods when growth stocks have outperformed value companies. Between 1 January 1998 and 1 January 1999, the Dow Jones USA Growth Large-Cap index returned 44.15 per cent while the Dow Jones USA Value Large-Cap index returned 14.13 per cent. From 1 January 1999 to 3 January 2000, the growth index returned 40.78 per cent and the value index returned 4.63 per cent.

Tim Price says this shows that when the economy grows strongly and confidence in future growth is high, growth stocks tend to outperform value stocks.

Andrew Wilson, head of investment at Towry Law, says growth stocks also do well when markets slow, as people seek real and sustainable growth wherever they can find it. He adds that value companies do well when economies enter recession or a sharp slowdown, as people take refuge in defensive stocks.

At this stage, investors generally look for stocks with below-average p/e ratios and above-average dividend yields. They take comfort in the fact that as value stocks
are fundamentally cheap, they should have less far to fall as stock markets tumble. 

Divided opinions
Adrian Shandley, managing director of Premier Wealth Management, believes it has become harder to relate value and growth to cycles in the market. ‘There are many more factors that impact on stock market cycles now,’ he says. ‘These include mergers and acquisitions, the growing economic strength of China and the rise of sovereign wealth funds.’ 

Mark Dampier, head of research at Hargreaves Lansdown, argues that it is more difficult to find companies that can grow their earnings and profits by more than 20 per cent a year over a sustained period than undervalued stocks.

‘If companies are enjoying 20 to 25 per cent earnings growth, other businesses try to capture some of this growth,’ explains Dampier. ‘If companies do not meet their growth expectations, share prices can fall quickly.’

Sandy Black, head of equities at Insight Investments, says value investing is more of a buy-and-hold strategy than growth investing. He says growth managers tend to have a higher turnover of their portfolios.

Going with the momentum
Momentum investing is where investors buy stocks that have already delivered strong returns over a relatively short period of time, such as the past three, six or 12 months. Momentum investors buy those stocks they believe will continue to enjoy a rise in their share price.

The momentum style is popular among hedge fund managers. It is also used occasionally by value and growth fund managers. Andrew Wilson, for example, says some value fund managers use momentum strategies to try to generate capital growth.
‘The problem for value managers is that they can hold undervalued stocks for some time before the market recognises they are cheap or the catalyst to raise their share price kicks in,’ says Wilson. ‘Managers like some share price growth in the meantime, which can come from momentum plays.’

Tim Price says that ‘stop-loss points’ can be used within momentum strategies in order to reduce risk. For example, fund managers may buy gold at US$920 an ounce with a stop-loss point of $890. ‘If the gold price rises to $960 an ounce, then managers can make another purchase and raise the stop-loss point to $930. This can continue in the same way as the gold price rises and ensure strong risk management while, at the same time, benefiting from price momentum.’

Economies of scale
Another style distinction is between the capitalisation of stocks. While some fund managers invest in stocks of any size, others focus on small-, mid- or large-cap stocks.
Small-cap stocks are considered to be the highest-risk investments because they are generally younger companies in a faster growth phase than large-caps, which are usually mature companies that have less scope to grow rapidly.

Small-cap stocks may be more vulnerable to cyclical downturns by having less capital, a focus on fewer markets and possibly only one or two products. It can be more difficult to redeem from small-cap stocks than large-caps when demand for shares is low.

Nevertheless, small- and mid-caps offer the potential for higher returns than large-caps over the long-term because of their ability to grow earnings and profits. Small-caps are generally less well researched than large-caps. This means that there is the potential for greater mispricing and thus investment opportunities.

Another consideration is the degree to which a portfolio is concentrated or diversified. In theory, a concentrated portfolio of 40 to 50 stocks is likely to lead to greater volatility than a diversified portfolio of more than 100 stocks, says Wilson.

With a more concentrated portfolio, each stock’s share price movement will have a greater impact than a more diversified fund. But with the greater concentration can
come higher returns because of higher conviction.