Growth, value, momentum and income investing: which is best?

income-growth-momentum-and-value-investing

Over the decades a small number of professional investors have managed to stand out from the crowd and make names for themselves - as well as plenty of money.

Our feature on pages 32-33 of our February issue looks at the secrets behind each investor's success, and highlights UK-listed stocks that currently tick the boxes on their stock-picking checklists.

These gurus, however, follow different styles of investing, which broadly break down into growth, value, momentum and income investing. Some mix and match between the different methods.

So here we look at each strategy in turn, highlighting how investors can profit from each.

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GROWTH AND QUALITY GROWTH

Growth investors scour the markets for businesses that have the potential to grow faster than the market. Some fund managers who specialise in the area focus their sights on small companies that can grow market share exponentially over the long term.

They tend to prioritise reinvesting profits back into the business, to boost growth organically or enhance firepower to fund future acquisitions.

Others look for quality businesses that, all things being equal, should be able to stand the test of time over the coming decades. Unlike other growth stocks, these quality growth shares tend to pay dividends.

To assess whether a company is superior compared to its competitors, quality growth investors look for certain attributes that help give the business an edge, such as possessing intellectual property, generating recurring revenues from repeat sales, or having strong pricing power.

The theory is that with one or several of these characteristics, companies should be able to grow their earnings through thick and thin, regardless of the economic backdrop.

The downside to both growth and quality growth investment, however, is that investors risk buying at the wrong time and paying well over the odds. The trick is to try and buy shares that are priced below their intrinsic value, but this is much easier said than done.

At the current time this is particularly pertinent. The quality growth part of the UK market, particularly the consumer goods sector, home to the likes of Unilever and Diageo, has shone over the past six years or so.

Investment commentators maintain that the low interest rate environment has helped turbocharge returns, with a flood of money coming from more conservative investors hunting for reliable income sources.

While these high-quality names are not income stocks per se, most do pay a dividend; although yields are nothing to get too excited about at around 2.5 to 3 per cent, they compare very favourably with the gilt market, and the majority grow their dividends pretty consistently over time.

The widely held view, however, is that when the interest rate cycle turns and other assets start to look attractive again, bond proxies will be ditched and their share prices will fall.

David Jane, a multi-manager at Miton, says these businesses cannot continue 'squeezing the lemon forever' - producing high single-digit dividend growth year in, year out.

Furthermore, Daniel Needham, global chief investment officer at Morningstar, makes the point that fund investors who continue to plough money into a fund manager that focuses on high-quality growth stocks are unwittingly increasing risk.

'Warren Buffett buys these franchises and then keeps hold of them, but the difference is that he doesn't have to buy more when valuations become excessive.

'In contrast, a fund manager has no choice, providing that money is coming into the fund, but to keep on buying and paying more and more as the valuation goes up.

'One would expect high-quality business to command a premium price, but I do think at the moment bond proxies are irrationally overpriced.'

Examples of portfolios jam-packed with high-quality businesses include Fundsmith Equity and the Finsbury Growth and Income trust.

Ryan Hughes of AJ Bell names Axa Framlington UK Select Opportunities and Old Mutual UK Smaller Companies as two growth-focused funds that he favours.

He adds that passive fans should simply seek out a cheap developed market tracker or exchange traded fund (ETF), which has a low tracking error, such as the iShares Nasdaq 100 UCITs ETF.

VALUE

Value has underperformed versus growth for almost a decade. In 2016, however, the tables started to turn, particularly in the second half of the year, with value outperforming growth.

From the start of the year up to the end of November, the MSCI World Value index outstripped the MSCI World Growth index by 7 percentage points.

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Indeed, over the long term value has established an edge. According to Orbis, a fund manager that specialises in value investing, from 1975 to 2006 value shares beat growth shares by 3.4 per cent a year on average. That number, however, falls to 2.1 per cent when the last 10 years are included.

Quantitative easing has been blamed for putting value investing in the shade, as it has made stock markets much more correlated, leading stocks to rise and fall together in tandem, with valuations taking a back seat.

This has favoured the momentum approach, and made life more difficult for investors who follow an investment discipline based on hunting for shares that have been mispriced by the market.

The idea behind value investing is that a catalyst will occur to revive an underpriced company's financial fortunes, in the form of a restructuring, refinancing or management change that increases its earnings and dividends.

Nigel Waller, chief investment officer of Oldfield Partners, a value-oriented fund manager, draws on a variety of valuation measures to find cheap shares with good prospects, including price to earnings, price to book and price to cash flow.

Another measure is Cape or the Shiller p/e, which has proved useful at predicting potential long-term investment returns.

'By putting relevant safety checks in place, such as steering clear of companies with operational gearing, we are able to avoid stocks that will remain out of favour,' says Waller.

But Hughes says the downside is that because value fund managers by definition purchase unloved stocks, they can stay out of favour for a very long time if nothing changes.

'Great patience is required, and so is a tolerance for risk. Value hunters also tend to look at situations where something is going wrong and the share price is in retreat, thereby ignoring the old market saying, "never catch a falling knife". Some cheap stocks are cheap for a reason.'

There's certainly not a shortage of funds that operate a value bias. Marcus Brookes, head of multi-manager at Schroders, picks out Investec Special Situations, GAM UK Diversified, Invesco Perpetual European Equity and Man GLG Japan Core Alpha as four value funds whose managements he rates.

According to Brookes, one of the reasons behind fortunes for value beginning to change is the shift in expectations towards better nominal growth.

When economic growth is healthy and interest rates are on the rise, cyclical and more economically sensitive stocks, which often fit the value description, tend to thrive because investors feel more comfortable boosting risk.

During a downturn the opposite plays out, as investors sell down value in the flight to safety, instead favouring high-quality names.

'With higher inflation pretty well assured for the first half of 2017, Donald Trump's election has (rightly or wrongly) now given the market a more pro-growth narrative on top. The majority of our equity assets are currently concentrated on the value style.

'Our view is that there's a window of opportunity between now and the next recession to benefit from a period of mean reversion, as the extreme crowding in bond proxies dissipates and owners of those assets suffer drawdowns,' says Brookes.

The chart below, click to enlarge, shows where value investors should be hunting, according to the Cape (cyclically adjusted price-to-earnings ratio) valuation measure.

Based on historical data for the US equity market shares (but also true for other developed markets), shares that are valued at a Cape of below 10 times tend on average to produce average annual returns of around 11 per cent over the next decade.

Oldfield Partners' Nigel Waller says the chart shows that the price investors pay is the biggest driver of future returns. Waller and his team currently see value in banks and miners, which have low Cape scores today.

cheap-shares-for-value-investors

Please note that the chart source for the Cape scores is Societe Generale, as at December 2009, based on the US equity market since 1880.

MOMENTUM

The momentum style completely contradicts the old investment maxim, 'buy low and sell high'; instead the strategy targets shares enjoying a purple patch. The approach sounds dangerous, but has been validated by a number of authoritative academic studies.

Thus over the period between 1926 and 2015, according to Professor Elroy Dimson, emeritus professor of finance at the London Business School, UK stocks that had outperformed the market in the previous 12 months went on to generate a return averaging 14.2 per cent over the next 12 months.

In contrast, those that underperformed one year returned an average 3.4 per cent the next.

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Phil Oakley, an investment strategist at SharePad, a data service for investors, says: 'This approach involves buying shares which have already gone up enough in the hope that they will keep on doing so.

'They will often have very high valuations attached to them, but profits are growing so quickly that analysts continually upgrade forecasts, which pushes the share prices higher.'

It is possible to make massive gains if you pick shares with price and forecast momentum, he says. Shares currently with wind in their sales include iron ore firm Ferrexpo, online fashion retailer Boohoo.com and engineer Weir Group.

But Oakley points out that the strategy is hard to execute and more suitable for traders, rather than the average investor.

'The big risk with this strategy is that you are buying into shares where valuations and expectations are high. There is no room for disappointment. If profits fail to meet forecasts, the shares can get hammered. You have to know when to sell and not get too greedy. This is not easy to do.'

Psychology also plays a big part. Most investors sit on the sidelines and wait for a share price to rise before committing. When they see a share price rise decisively, they act hastily because they fear missing out on an opportunity to make money.

When they buy, momentum is retained. It's also worth noting that momentum tends to thrive in a bull market; less so when stock exchanges are choppy and drift sideways.

There are ETFs that follow the momentum strategy, including iShares MSCI Europe Momentum Factor ETF and iShares MSCI World Momentum Factor.

INCOME INVESTING

Last but by no means least is income investing, or in other words the 'get rich slowly' strategy rooted in the effect of compounding.

footsie-all-share-with-and-without-dividends-reinvestedThe chart to the right, from JPMorgan, showcases the power of reinvesting dividends, which turn a one-off £5,000 investment in the FTSE All-Share 30 years ago into £88,396 to the end of 2016.

In stark contrast, if you'd pocketed the dividends each year you would have a pot today worth only £28,357.

Over time, reinvested dividends have contributed a major portion of investors' stock market gains. According to the London Business School, since 1990 UK equities with dividends reinvested have on average returned 5.4 per cent a year.

When dividends are stripped out of the calculation, the average annual total return for UK equities slips to a paltry 0.8 per cent a year.

Income investing, however, is not without dangers. Investors need to avoid 'value traps' - shares with unsustainably high yields that will at some point take an axe to their dividend payments.

One way to analyse a dividend is to look at the dividend cover, a key metric to assess whether a company is in a healthy position to return cash to shareholders.

As a rule of thumb, a low dividend cover score, around 1.5 times or lower, suggests dividends are vulnerable, as the company is using most, if not all, of its profits to fund the payout. A figure of 2 times or more is viewed as comfortable.

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HOW TO FIND SHARES THAT KEEP THE PROFITS ROLLING IN

While there are many ways to assess the strength of a business, arguably one of the most useful is a measure called 'return on capital employed' (ROCE), which can be calculated from a company's accounts.

The ROCE is the profit figure divided by the assets of the businesses. Warren Buffett is a fan, describing the measure in 1979 as 'the primary test of managerial economic performance'.

ROCE is considered more useful than the more familiar return on equity measure because ROCE also factors in debt and other liabilities.

There's no golden rule that dictates what a good or bad ROCE figure is; instead investors should look at whether it is rising or falling versus the company's historical ROCE value.

But Terry Smith, manager of Fundsmith Equity, does not consider investing in a company unless it can achieve a ROCE of more than 15 per cent.


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