The Canadian Source Of Employee Pension Fund Investment And Benefits Plan Management

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September 2007

Manager Style Report: Differentiating Growth And Value

By: Lawrence Lim

Plan sponsors don’t typically decide which individual securities will be invested in their plans. They do, however, decide which investment managers they will hire for that purpose. With so many active managers to choose from, the key differentiating factor often becomes management style, ‘growth’ and ‘value’ being the most recognizable.

Value investing refers to the search for bargains or stocks that have been overlooked by the market and subsequently underpriced. Growth investing, on the other hand, is the search for stocks with aboveaverage sustainable growth potential that justifies their above-average market price.

Generally, history has shown that one style of investing is in favour at the expense of the other, causing many plans to diversify the management of their assets through the use of different style managers in an effort to smooth out results and reduce overall volatility. Today, however, telling the difference between a growth and value stock is not as clear-cut as it once was. As a result, growth and value managers are frequently holding similar securities and maintaining similar industry weights.

In order to ensure diversification benefits, plans must constantly evaluate whether their managers are operating as advertised. Along with monitoring the individual manager, the plan should also look at how its entire stable of managers fits together at both the asset class and plan level. Markets have evolved and manager styles have become less distinct over the years due to this challenge of differentiating between a growth and value security.

manager style report

The Past And Present

Looking back to 1999 and 2000, it was easy to tell whether a manager adopted a growth or value approach. The technology sector was the darling industry at the time and stocks, such as Nortel, were trading at incredible multiples to their current and historical earnings. The expectation of future earnings growth for those securities overcame any traditional notions of what was over-valued. It was common to see growth managers with annual returns of 60 per cent prior to the collapse.

Value managers, on the other hand, were not enjoying themselves at all during that time period. Contrary to growth managers, they did not see the tech sector as a bargain and tended toward other industries that were not in favour. And while it might be hard to remember now, the price of oil was below $20 per barrel in 2000, with little expectation of change. Well-known value managers were drastically underperforming the TSX and having to justify their approach to clients.

At the height of the growth market in Canada, we witnessed more than half of the active large cap Canadian equity funds posting annual returns of more than 45 per cent. These were staggering figures, yet they were still underperforming the index. Investment restrictions prevented them from overweighting high-flyers like Nortel, which was dominating the cap weighted index (hence the creation of the TSE 300 Capped Index).

After the tech bubble burst and investors returned to focusing more on actual valuations, there was a dramatic shift away from growth and back to value. Canadian and U.S. growth managers who were accustomed to ranking in the first quartile of their peer group samples found themselves in the fourth quartile just a year later. Value managers did the opposite and demonstrated less volatile long-term returns as markets corrected.

One of the lessons learned from those times is that performance of a style can change quickly and dramatically. What was in favour for approximately two years, suddenly spun into a downward spiral in the second of half of 2000 and marked the beginning of a shift into value investing. During that period, the difference between a growth and value security was quite clear. If your portfolio was overloaded with growth stocks, you would have experienced incredible highs and lows in returns, while a portfolio heavily weighted in value stocks would have been much more stable.

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