Sunday, July 08, 2007

How Much in Value versus Growth Stocks- Good Beta versus Bad Beta?

In today's New York Times, there is an article by Mark Hulbert (in the business section p28) that addresses the issue of equity allocation between value stocks and growth stocks. How many times do financial planners get asked about the allocation of a 401 (k) or an RRSP as to what portion should be invested in growth versus value? How many times do individual investors wonder about which box to tick?

Last week, I warned about the homogeneity of thinking that many value investors harbor. Hulbert, of Hulbert Financial Digest fame, points out the Ibbotson research that since 1969, value stocks have outperformed growth by an average of 2.5% a year. Typically, value stocks were about 15% less volatile than growth stocks as well. Sounds like value stocks win under most circumstances, right?

Not exactly. So why even think about a growth stock? First of all, Buffett insists that growth and value are joined at the hip...i.e. it is feasible to buy a growth stock that is undervalued. A value buyer does not disdain owning a stock that exhibits success and is highly profitable...all that matters is that it comes at an appropriately cheap price.

More subtly however, is a different proportion of a flavor of risk that growth stocks contain as compared to value stocks. Hulbert refers to an article by John Campbell of Harvard and Tuomo Vuolteenaho, now of Arrowstreet Capital. Here is a link to that article, published in 2003 but still certainly worthwhile reading for avid students of markets and CFA's.

They argue that returns on the market portfolio have two components, and that recognizing the difference between these two components can eliminate the incentive to overweight value, small, and low-beta stocks. The value of the market portfolio may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate or cost of capital that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. These two components should have different significance for a risk-averse, long term investor who holds the market portfolio. Such an investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns.

The "discount rate" risk is essentially the risk that interest rates will rise. Growth stocks, since much of their value occurs from future earnings, are very vulnerable to changes in interest rates. Far off future earnings which are discounted to a present value are worth less when that discount rate increases.

The "cash flow" risk is essentially the risk that a company will not sustain its ability to continue to grow its cash flow, perhaps because of competitive forces, perhaps because of business risk, perhaps because of its own financial leverage and capital structure.

For a long term investment horizon, say ten years or more, discount rate risks are less threatening. Interest rates rise and fall, ebb and flow with business conditions. Hence, growth stocks which fall off because of their greater sensitivity to interest rate hikes should come back over time since these risks are self-correcting. However, for cash flow risks, the comeback trail is very difficult when the competitive advantage period has run out.

Hence, the need to blend both value and growth stocks into a portfolio. Much like a high cholesterol level that consists mostly of "good" cholesterol, portfolios that contain a skew toward the "good" discount rate risk serve long term investors well.

Building on this paper is some research by Luis Viceira and Jakub Jurek of Harvard entitled Optimal Value and Growth Tilts in Long-Horizon Portfolios. Here is a link for that paper.

Here is one of their summations:

"We find that the mean-allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons."

If your time horizon is short-and I am not talking about before today's close or settlement date- but say a couple of years. You should place almost your entire equity allocation ( stress-not all your capital but just your equity allocation) into value stocks. An investor with a long-term horizon, say ten years, should be willing to allocate up to half of the equity portion of his/her portfolio to growth stocks.

As the authors describe it:

"We find that on average equity-only investors with short horizons optimally choose portfolios heavily tilted toward value and away from growth, regardless of their risk aversion. Aggressive short-term investors find it optimal to hold long large positions in value stocks offset by large short positions in growth stocks, because the mean return spread between value and growth is positive, and their returns are highly positively correlated. Highly risk averse short-term investors hold large positions in value stocks because of their smaller return volatility and high correlation with growth. However, the optimal allocation to value decreases dramatically— and correspondingly the optimal allocation to growth increases— for investors with longer horizons. This effect is strongest for long-horizon, highly risk averse investors, who hold large long positions in growth stocks. The increasing portfolio demand for growth stocks across investment horizons is driven by inter- temporal hedging motives. Growth stocks are better suited than value stocks to hedge against adverse changes in investment opportunities in the equity market, because they are more highly negatively correlated with changes in aggregate stock discount rates than value stocks are. Thus long- horizon “representative” investors find value stocks riskier than growth stocks, and see the unconditional value spread as a risk premium for bearing this risk."

The importance of understanding the optimal value and growth tilts in the portfolios of long-horizon investors is underscored by the composition of the retail mutual fund universe. Morningstar and Lipper want to put funds into their "appropriate" boxes, a characterization that I have always found quite artificial and misleading. Nevertheless, value and growth tilts are the norm, rather than the exception, in the mutual fund industry that serves the investment needs of most retail investors.Funds with a dedicated value or growth tilt accounted for 78% of total assets under management (36% growth and 42% value).

What I suggest here is not to go blindly into every growth story with audacity and newfound certitude based on these findings. Seek great businesses with earnings power. Look for quality when it is there, not when it may have a chance to develop!

Don't accept high risks with low probabilities with nonchalance. Many "story" stocks are best kept fictional rather than finding the reality of your hard-earned savings in your portfolio.

Don't shun growth ideas if you describe yourself as a value investor. Don't shun value stocks, even if you have a long time horizon. There are great opportunities in both, especially if you have time to allow the magic of compounding to build your wealth.


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