Optimize 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, 2005
I view equity style strategies as one of the most powerful and
profitable elements of our Absolute Return Portfolios
THE TWO AXES OF EQUITY STYLES
In Equity Style vernacular, stocks can be grouped along two
axes: 1) Market Capitalization and 2) Fundamental Valuation
MARKET CAPITALIZATION
Market 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 VALUATION
The 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 MATRIX
Really, 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 Growth Mid-Cap Growth Large-Cap Growth Small-Cap Value
Mid-Cap Value Large-Cap Value
RELATIVE PERFORMANCE – MARKET CAPITALIZATION
This 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 SP 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 Return SP 500
(Large-Cap):22066% 2620% Russell 2000 (Small-Cap): 5771%
950%
Period of Small-Cap dominance (March 30, 1999 – June 30, 2005)
Index Total Return Annualized Return SP 500 (Large-Cap):
170% 027% Russell 2000 (Small-Cap): 6087% 792%
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 950% annualized Things get more interesting
in the second period which encompassed a massive bear market
decline Over this past 625 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 VALUATION
Let’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 Return Growth: 12798% 4423%
Value: 1028% 445%
Period of Value Style dominance (March 31, 2000- June 30, 2005)
Index Total Return Annualized Return Growth: -5501% -1375%
Value: 5416% 834%
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 Valuation
As 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: 15650% Morningstar Mid-Cap Value:
11370% Morningstar Smal-lCap All Style: 11063% Morningstar
Mid-Cap All Style: 7521% Morningstar US All-Cap Value: 5136%
Morningstar Small-Cap Growth: 3189% Morningstar Large-Cap
Value: 3133% Morningstar Mid-Cap Growth: 2394% SP 500 Index:
334% Morningstar Large-Cap All Style: -754% NASDAQ Composite
Index: -1323% Morningstar US All-Cap Growth -3349% Morningstar
Large-Cap Growth -4744%
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 PERFOMANCE
There 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 TRENDS
A picture is worth a thousand words I recommend using charting
software or a service such as BigChartscom or Stockchartscom
(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 VEHICLES
There 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 TRENDS
Our 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
DISCLAIMER
These 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 Management ALL RIGHTS RESERVED

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