Optimizing Portfolio Performance with Equity Styles

1) Equities can be grouped into six “equity styles”2) Returns of each equity style can vary significantly with trends persisting for months and years.3) By dynamically altering a portfolio’s exposure to various equity styles, investors can attempt to add performance over a static allocation.4) Relatively simple strategies can be employed to signal rotational decisions among various equity styles.September, 2005I view equity style strategies as one of the most powerful and profitable elements of our Absolute Return Portfolios.THE TWO AXES OF EQUITY STYLESIn Equity Style vernacular, stocks can be grouped along two axes: 1) Market Capitalization and 2) Fundamental Valuation.MARKET CAPITALIZATIONMarket capitalization is simply the outstanding number of shares multiplied by share price. That product represents the total value, or market capitalization, of a publicly traded company. If a firm had 1 million shares outstanding and traded at $50 per share, the market capitalization would be $50 million, for example.FUNDAMENTAL VALUATIONThe second axis on which a company can be compared is fundamental valuation. Stocks are characterized as either “growth” or “value” firms. This categorization is dynamic in that growth companies can become value companies and vice versa. The approaches used to characterize companies into one of these two categories are quite varied and can run from the utterly simplistic to esoteric multi-factor models.All categorization techniques seek to use one or more fundamental variables to categorize a company as either a “growth stock” or “value stock”. Initial approaches were based on ranking companies of the basis of price-to-book value (P/B ratio). Those companies with the highest P/B ratio were categorized as “growth” while those with the lowest P/B ratio were considered “value stocks”. Since that time, models that use an assortment of fundamental ratios (Price/Earnings, Price/Sales, Gross Margin Percentages, EPS and Sales Growth etc.) have been developed to better categorize stocks into their respective camps.THE EQUITY STYLE MATRIXReally, the categorizations are nothing more than combining one group from each of the two axes that cover capitalization and fundamental valuation. Since we have three capitalization groups (small, mid, and large) and two fundamental valuation groups (growth and value) our matrix is comprised of the six equity styles below:Small-Cap GrowthMid-Cap GrowthLarge-Cap GrowthSmall-Cap ValueMid-Cap ValueLarge-Cap ValueRELATIVE PERFORMANCE – MARKET CAPITALIZATIONThis exercise wouldn’t be very interesting if it weren’t for the fact that significant variability occurs among the returns of these six equity styles. Let’s start with just the Market Capitalization axis and review the performance of Small-Cap versus Large-Cap stocks over two recent periods. I will be using the S&P 500 as a proxy for large-cap stocks and the Russell 2000 as a proxy for small-cap stocks.Period of Large-Cap dominance (March 30, 1994 – March 30, 1999)Index Total Return & Annualized ReturnS&P 500 (Large-Cap):220.66% & 26.20%Russell 2000 (Small-Cap): 57.71% & 9.50%Period of Small-Cap dominance (March 30, 1999 – June 30, 2005)Index Total Return & Annualized ReturnS&P 500 (Large-Cap): 1.70% & 0.27%Russell 2000 (Small-Cap): 60.87% & 7.92%This first period coincided with a powerful bull market. Large-cap stocks delivered incredible returns of over 26% annually! Even though the large-cap stocks trounced their small-cap brethren, the small-caps still had a respectable showing returning 9.50% annualized. Things get more interesting in the second period which encompassed a massive bear market decline. Over this past 6.25 year period large-cap stocks haven’t even provided money market rates of return. Small-cap stocks have provided a respectable result considering that many indexes suffered declines of over 50% within this time period.RELATIVE PERFORMANCE – FUNDAMENTAL VALUATIONLet’s now turn our attention to the other axis of Fundamental Valuation and review performance trends among growth and value equity styles. In this case, I will use the Morningstar indices as proxies for the growth and value equity styles.Period of Growth Style dominance (December 31, 1997 – March 31, 2000)Index Total Return & Annualized ReturnGrowth: 127.98% & 44.23%Value: 10.28% & 4.45%Period of Value Style dominance (March 31, 2000- June 30, 2005)Index Total Return & Annualized ReturnGrowth: -55.01% & -13.75%Value: 54.16% & 8.34%The difference in performance over both of these periods is staggering. During the first period ending March 2000, Growth stocks out-performed valued stocks by nearly 40% per annum. Their period of relative strength ended coincident with the top in Technology stocks and since then value stocks have taken the lead. Since March 2000, growth equities have depreciated by over half whilst Value equities have appreciated over 50%! That’s better than a 20% annual difference between growth and value.COMBINING THE BEST EQUITY STYLES – Market Capitalization and Fundamental ValuationAs I’ve shown, recently small-cap stocks have been performing significantly better than large-cap stocks. Similarly, Value stocks have been doing relatively better than growth stocks. Initially, we looked at each of these factors in isolation but the real performance boost comes from combining the best of both worlds. In recent history, this has meant Small-Cap Value has been among the very best places to invest.Using the Morningstar style boxes below, I have ranked them by performance since the Value outperformance cycle began in the spring of 2000.Index Return 03/30/1999-08/31/2005:Morningstar Small-Cap Value: 156.50%Morningstar Mid-Cap Value: 113.70%Morningstar Smal-lCap All Style: 110.63%Morningstar Mid-Cap All Style: 75.21%Morningstar US All-Cap Value: 51.36%Morningstar Small-Cap Growth: 31.89%Morningstar Large-Cap Value: 31.33%Morningstar Mid-Cap Growth: 23.94%S&P 500 Index: 3.34%Morningstar Large-Cap All Style: -7.54%NASDAQ Composite Index: -13.23%Morningstar US All-Cap Growth -33.49%Morningstar Large-Cap Growth -47.44%The performance differences among the various equity styles are extraordinary. From the very best performance from Small-Cap Value to the very worst performance from Large-Cap Growth there is over a 200% difference over the 6+ year period evaluated! Annualized, that amounts to over 19% from Small-Cap Value as compared to over a -16% loss from Large-Cap Growth. That’s greater than a 35% difference in annual returns.DRIVERS OF EQUITY STYLE PERFOMANCEThere are many drivers of relative performance among various equity styles. The factors effecting each of the Market Capitalization and Fundamental Valuation cycles have overlapping as well as unique drivers and catalysts both economic and political. The topic is complex and beyond the scope of this article. As a generalization, relative valuation drives the performance along the Market Capitalization axis (large-cap vs. small-cap). Macroeconomic factors drive performance along the Fundamental Valuation axis (growth vs. value).TRACKING EQUITY STYLE RELATIVE PERFORMANCE TRENDSA picture is worth a thousand words. I recommend using charting software or a service such as BigCharts.com or Stockcharts.com (with whom I have no affiliation) that will allow you to compare the performance of the various equity styles graphically. The type of analysis is referred as Relative Strength or Relative Performance. A Relative Performance line is calculated by simply divided the price one index by another for each period and then plotting those resulting ratios.An upward trend in the Relative Performance line indicates that the index in the numerator of our comparison is performing better than the index in the denominator. Likewise, a downtrend in the Relative Performance line indicates that the index in the numerator is performing more poorly than the index in the denominator.By tracking these Relative Performance trends, investors can determine which “equity style box” they should concentrate upon. This is true whether you buy individual stocks, mutual funds, variable annuities, or ETFs. Smaller investors have a tremendous advantage over billion dollar mutual funds and registered investment advisors that can pursue only one equity style.EQUITY STYLE INVESTMENT VEHICLESThere are now a large number of ways to take advantage of equity style trends. For ETF-based strategies the Yahoo Finance site is an excellent resource for searching for ETFs. For mutual fund investors, Rydex and ProFunds both offer all of the various equity styles. The large mutual fund houses also offer many of the equity style funds but aren’t as friendly to mutual fund switchers as Rydex and ProFunds.STAYING ON TOP OF EQUITY STYLE TRENDSOur FREE managed account publication, The Absolute Return Strategist, covers equity style trends each week. Those that are not as technically proficient can get our regular updates on equity style trends and how we are positioning our Absolute Return Portfolios. Additionally, our site provides the unabridged version of this article complete with charts and tables.DISCLAIMERThese reports express our opinions and suggestions, provided only as a supplement to your own further research and decisions. We take care to assure accuracy of contents but accuracy is not guaranteed. Past performance does not imply future results. The publisher shall have no liability of whatever nature in respect of any claim, damages, loss or expense arising out of or in connection with the reliance by you on the contents of our web site, any promotion, published material, alert or update.©2005 Absolute Return Portfolio ManagementALL RIGHTS RESERVED

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