In a previous article I discussed the rational for style investing in Europe and some preliminary findings using the Morningstar European Style Indices. In this article, I present the background of style investing and some additional findings.
The Academic Origin of Style Investing
The academic theory that has had the most influence on investment practice is the Capital Asset Pricing Model (CAPM). Developed in the 1960s, the CAPM is the intellectual origin of the practice of using indices for measuring systematic risk (“beta”), for separating manager skill from exposure to the market (“alpha”), and for forming the basis for passive investment products.
However, academic research done in the late 1970s and early 1980s showed that one of the main predications of the CAPM fails empirically; namely, that over the long run, the only factor that should predict the relative performance of stocks is beta. However, research on the U.S. equity market showed that over long periods of time, portfolios of the stocks of small companies, as measured by market capitalisation, tend to outperform portfolios of the stocks of large companies within the same equity markets, even after controlling for beta.
Similarly, research on the U.S. market concluded that in addition to a small-cap effect, there is also a value effect. In other words, over long periods of time, portfolios of stocks with relatively favourable valuation ratios (low price-to-book, low price-to-earnings, high dividend yields, etc.) tend to outperform portfolios of stocks with relatively unfavourable valuation ratios, even after controlling for beta. Stocks with favourable ratios became known as “value” stocks and those with unfavourable ratios became known as “growth” stocks.
These “CAPM anomalies” led to the practice of dividing the U.S. stock market into groups of stocks on the basis of market capitalisation and valuation ratios. At Morningstar, we divide both the U.S. stock market and the aggregation of European stock markets into nine groups as follows:
Some Interesting Findings
Figure 1 shows how the value/growth effects evolved over time within each size band by plotting the ratio of each Morningstar European growth index to its value counterpart. Large-cap and mid-cap stocks followed the same pattern of favouring value stocks until September 2008, which is when the global financial crisis started. At that point, for large-cap stocks there was a substantial lurch in favour of growth stocks relative to value stocks, which did not occur for mid-cap stocks. The patterns for large-cap and mid-cap stocks became similar, but in 2010, the large-cap growth stocks overtook their value counterparts to a much higher degree than happened with mid-cap stocks. So for the period as a whole, the value/growth effects for the large-cap and mid-cap bands played out in opposite directions.
The story for small-cap stocks is completely different. Here, growth stocks outperformed value stocks by a large margin until a reversal started in June 2008. From that point forward, value stocks tended to outperform growth stocks (with some notable exceptions along the way). By June 2010, the cumulative advantage had been cut from a high of 54% in June 2008 down to 36% two years later. However, this still left growth stocks substantially ahead for the overall period.
These results again demonstrate that even over a period of less than a decade, style effects should matter to investors in European stocks and they could benefit by looking at equity portfolio construction through the prism of style.
Paul D. Kaplan, Ph.D., CFA, A version of this article first appeared in Investment Adviser on March 28, 2011.
