How to Determine Your Equity Style in the Selection of Individual Stocks

The question often asked by investors is,"What types of stocks should

Should you rush to buy the small-capitalized stocks that have been responsible for the major moves in the Russell 200 Index? Or should you look for value stocks and technology stocks that have been hit in the downturn of the stock market (Dow Jones Industrial Average and the NASDAQ Composite) in the years 2001-2002? Related to this issue are the sizes of the companies. The rally has included the small-capitalization stocks while the mid-cap and large-cap stocks have been excluded, although small-capitalization stocks were also down in the early months of 2002.

Studies have shown that stocks can be classified into categories that have similar patterns of performance and characteristics. In other words, the returns of the stocks within the categories are similar, whereas the returns of the stocks between the categories are not correlated.* James L. Farrell found four categories for stocks; namely, growth, cyclical, stable, and energy. Other

*James L. Farrell, Jr., "Homogeneous Stock Groupings: Implications for Portfolio Management," Financial Analysts Journal, May-June 1975, pp. 50-62.

FIGURE 32.1 Market capitalization of stocks

Small capitalization: less than $1 billion Medium capitalization: $1-$5 billion Large capitalization: greater than $5 billion studies have measured stocks by their market capitalization, or size, which was then translated into small-cap, mid-cap, and large-cap stocks. Figure 32.1 lists the categories based on market capitalization of the companies, which is measured by the number of shares outstanding for the company multiplied by the market price of the stock. There are many variations in these amounts, depending on the source. What portfolio managers have found is that they can enhance their performance by moving their money into the different categories of stocks from time to time.

From these categories of stocks two investment styles have emerged; namely, value and growth investing. Figure 32.2 illustrates the common styles of equity investing. This style box originated from Morningstar Mutual Funds for mutual fund investing, but it can also be used to determine individual equity portfolio holdings.

Investors can use this style box to determine the bulk of the equity investments that suit their investment style, as determined by their investment objectives. Value stocks have different financial characteristics and, as we have seen, different performance returns over the past four years compared to growth stocks. Value stocks generally pay some dividends and have low price-earnings (P/E) ratios. (See pages 236-239 for a discussion of P/E ratios.) Growth stocks generally have high P/E ratios and are expected to experience high sales growth for a period of time. A blend would include a mixture of growth and value stocks. The size of the company is measured by market capitalization. Small-cap companies tend to be riskier than mid- or large-cap companies, but as many studies have shown, the returns over long periods of time from the small-caps have exceeded those of the large-caps. This has not occurred over the past four of five years, where large-cap growth stocks have outperformed the small- and mid-

FIGURE 32.2 Types of equity styles

Equity styles

Value Blend Growth

Large-cap stocks

Mid-cap stocks

Small-cap stocks cap stocks quite handily. However, before then small-cap stocks outperformed the large- and mid-caps. This does not include all the large stocks on the market. In fact, over half the stocks in the S&P 500 Index had declines in share price or ended up with returns of 6.6 percent or less for the calendar year 1998, while only a small number of stocks were responsible for the stellar returns.* This means that stock picking becomes extremely important for individual portfolios, particularly if there is no advantage in replicating an index.

For those investors who had chosen the large nifty 50 stocks in the S&P 500 Index and most of the Dow Jones Industrial Average stocks, the returns were very rewarding, and the implication was that it was easy to make money in the stock market. However, in more broad-based markets the choices are not so overwhelmingly easy to make, and the average annual returns are generally not in the double digits, as has been the case for the past four years.

The style box in Figure 32.2 illustrates the choices in terms of these dimensions. Investors can choose the current winners, which are small-cap growth stocks, in which to invest more money. Alternatively, some investors might not want to pay the high prices for these types of stocks and instead would look

*Anne Tergesen, "Sifting for Clues," Business Week, March 29,1999, pp. 110-111.

for the growth stocks that have been beaten down in the past year. These could be small-cap, mid-cap, or large-cap stocks, or a combination of them. Some investors might want to have a combination of growth and value stocks in the different size stocks. This style box can also be used with international stocks.

Research has shown that value and growth stocks do not perform in the same manner within the same time periods. This was evidenced recently by the spectacular performance of the large-cap growth stocks while the large-, mid-, and small-cap value stocks underperformed the market. Some investors will choose to invest all their funds in the stocks that are performing well and then shift to other investment styles when they perceive that things are about to change. This style of investing would be more conducive to an active management style, as opposed to a passive management style where investors would allocate their stocks among the different categories and then hold them for long periods of time. Active managers are more likely to be market timers, where they will be more inclined to be fully invested in stocks when they perceive the market to be going up. When they think that the market is about to go down, they will exit the market. Passive investors tend to stay fully invested in stocks irrespective of the state of the market.

Whether to be an active or a passive manager, or whether to choose growth stocks over value stocks are decisions that each investor will ultimately have to make. There are differences in investment styles and, therefore, the ultimate selection of stocks, but having a plan and a strategy can make the selection of stocks much easier. The ultimate selection of individual stocks can be made easier if direction is provided through an asset allocation model, which breaks down the different style categories of investments within the class asset. Table 32.1 lists a few examples of the different portfolio models. Investors could invest in a mixture of value and growth stocks, which can be allocated among domestic stocks and international stocks. Following this, investors would then decide on the amounts to allocate to the different stock sizes (large-, mid-, and small-cap). This is illustrated in example 1 in Table 32.1.

Examples 2 and 3 show selections 100 percent weighted toward value and growth stocks, respectively. Diversification within the stock sector of an investor's portfolio offers protection against the downside risk of being fully

TABLE 32.1 Asset allocation of stocks by style

Example 1

Value/growth blend

Value stocks

Large-cap U.S. stocks 20% Mid-cap U.S. stocks 20% International stocks 10%

Growth stocks

Large-cap U.S. stocks 20% Mid-cap U.S stocks 20% International stocks 10%

Total portfolio 100%

Example 2 Value

Value stocks

Large-cap U.S. stocks 25% Mid-cap U.S. stocks 25% Small-cap U.S. stocks 20%

International large-cap 20% International mid-cap 10%

Total portfolio 100%

Example 3 Growth

Growth stocks

Large-cap U.S. stocks 25% Mid-cap U.S. stocks 25% Small-cap U.S. stocks 20%

International large-cap 20% International mid-cap 10%

Total portfolio 100%

invested in one sector, such as large-cap value stocks, for example. If in the near future the tide turns against these stocks, investors will be protected by participating in the rising prices of the other sectors should the stock market rally become more broad based.

Many may wonder why they should take the time and effort to classify their stocks into these styles. There are a few convincing arguments. The first is that without the power of clairvoyance we have no way of knowing the future movements of the stock market. Consequently, by diversifying into different sectors of the market, investors can reduce the risk of loss from being too heavily invested in one sector of the market. This is amply illustrated by the sharp decline in technology and growth stocks during the years 2000-2001. Value stocks during that period increased and the small-cap indices outperformed the large- and mid-cap indices. This means, however, that currently small-cap stocks are not as cheap as they were before the rally and may be running out of steam.

Worksheet 32.1 provides the Morningstar grid to help you to determine your investment style and then to choose individual stocks or equity mutual funds.

WORKSHEET 32.1 Determine your equity style and choose your stocks/ mutual funds

Equity styles

Value Blend Growth

Large-cap stocks

Mid-cap stocks

Small-cap stocks

Asset allocation by style

Equity style _

Company size

Step 1 Choose your equity style(s).

Step 2 Determine the size sectors and list the individual stocks.

FINANCIAL CALCULATOR #33

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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