Style Investing Revisited: A Disciplined Approach Means More Than Adhering to a Style Universe
The Royce Funds
October 15, 2011
Over time much has been written about style investing—growth versus value—within the small-cap universe. In fact, investors often rely on style indexes such as the Russell 2000 Value Index and Russell 2000 Growth Index as proxies for a particular style and/or performance pattern, such as moving to value in anticipation of a bear market or growth in expectation of a bull. While this is certainly easy and convenient, especially for performance comparisons, style indexes are often more about a particular type of company or narrow set of criteria as opposed to a specific investment approach.
Most style indexes use simple screens to determine whether a company should be classified as value or growth. Inherent in this methodology are certain biases regarding the investable universe. For example, financials (primarily banks) and utilities are almost always classified as value stocks, while technology stocks are nearly always identified as growth. Should a manager who is underweight banks and utilities be said to use a growth approach? Similarly, does a manager who is underweight technology reveal a value bias?
Here at Royce, we have been using a disciplined value approach for nearly 40 years. We began to cultivate this approach long before the small-cap universe was divided into value and growth components. We have never limited our stock selections to the "value universe" when we survey the large and diverse small-cap market.
We would argue that value has more to do with finding attractively priced companies than it does with constructing a particular investment universe using a limited set of metrics. Therefore, our efforts are directed at the entire small-cap universe—we select from any segment or sector as long as a company meets our exacting valuation standards. We prefer an approach that focuses on the value of a business as opposed to adhering to the pre-set criteria of a style universe, which is one reason why we never adopted the Russell 2000 Value Index as a small-cap benchmark.
In our experience, value is often rooted in low expectations rather than a preconceived notion of what's statistically attractive. While technology stocks are thought to fall well outside traditional definitions of value, current expectations for the sector are quite low. Such low expectations generally translate into a more limited downside because the world is expecting very little, and disappointment does little to change that perception. Upside surprises are often more meaningful because they spring from low-expectation bottoms.
In the current market, we have seen the prices of many of what we regard as low-expectation stocks fall across all sectors and industries. Not all of these stocks would grade out as statistically cheap by the standards of style indexes. Style indexes are typically built by sorting statistical measures such as P/E and P/B, but do not include more subjective measures like low expectations.
Keeping this in mind may help to explain recent performance and longer-term market cycle results for small-cap value and growth. It is interesting to note that when measured over full market cycles both small-cap growth, as measured by the Russell 2000 Growth Index, and small-cap value, as measured by the Russell 2000 Value Index, each outperformed in an equal number of periods. Since the Russell 2000's inception on 12/31/78, there have been 10 full market cycles, with the most recent cycle concluding with the 4/29/11 peak. Small-cap growth and small-cap value have alternated leadership in each of the last six market cycles. Prior to that, each style index outperformed for two consecutive periods before ceding leadership.
One has to wonder if style investing is less relevant than reversion to the mean. Considering the equal number of outperformance periods for each small-cap style, one could argue that as style index investing has entered the mainstream, its return patterns have become less predictable, at least over long-term market cycles. In fact, the returns above suggest that style index outperformance has become something of a non-factor due to higher institutional acceptance. We would argue that careful stock picking and reversion to the mean account for more of any long-term outperformance premium. Our belief in reversion to the mean relates to our conviction that markets are cyclical and that these cycles often move in ways that are independent of one's expectations for value or growth styles. This is evident in the back-and-forth nature of style leadership in small-cap market cycles.
A closer look at these cycles shows that small-cap growth and small-cap value again outperformed one another in an equal number of trough-to-peak periods. As was the case in the just concluded full market cycle (peak-to-peak) period, the Russell 2000 Growth Index also won in the most recent trough-to-peak period (3/9/09-4/29/11) while leading in five out of 10 such periods since the small-cap index's inception.
Conventional wisdom has it that small-cap growth should outperform during updrafts, but this has clearly not been evident in the small-cap universe, particularly with leadership rotating between the two styles over the last four trough-to-peak cycles. The conventional wisdom regarding small-cap style performance patterns seems less wise when reversion to the mean is considered.
Interestingly, it was only during peak-to-trough periods where a style emerged with more victories than defeats. The Russell 2000 Value Index outperformed the Russell 2000 Growth Index in seven of 10 peak-to-trough periods since the inception of the small-cap index. During periods of market decline, it stands to reason that statistically cheaper stocks will generally fall less, and the stocks that populate the so-called value universe are typically cheaper and, to some degree, have lower expectations, though not always.
In studying market cycle performance patterns, we were struck by the meaningful difference between a disciplined, stock-centered value approach and a value universe, which brought home to us the power and importance of reversion to the mean. Especially in the current environment and into the foreseeable future, we see disciplined stock selection as the crucial factor in long-term small-cap stock performance.
Important Disclosure Information
The thoughts in this essay concerning the stock market are solely those of Royce & Associates and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future.
(c) Royce Funds