15.4.3 Equity Manager Styles

Overview of Equity Manager Styles

Equity portfolio managers typically employ one of three main styles of investment management: growth, value, or sector rotation. Below, we’ll explore each of these styles in detail, examining their approaches, risks, and key characteristics.

Growth Managers

Growth managers prioritize companies’ potential for earnings growth, particularly focusing on earnings per share (EPS). They seek companies with earnings momentum, even if it means paying a premium for competitors. Typically, stocks in growth portfolios have lower dividend yields or none at all, and the portfolio turnover rate can be high.

Risks of Growth Investing

• If EPS growth slows, it can lead to significant price declines.
• Reported EPS deviations from analysts’ expectations can cause high market volatility.
• Vulnerability to adverse market cycles is comparatively higher.

Characteristics of Growth Portfolios

• High price-to-earnings ratio
• High price-to-book value ratio
• High price-to-cash flow ratio

The primary source of long-term returns is capital appreciation. Growth managers usually do not focus on quarterly fluctuations and expect clients to have a long-term investment horizon while tolerating substantial volatility and risk. This style usually excels in rising markets but struggles in bear markets.

Suitable Investor Profiles

Growth portfolios are best suited for aggressive investors who favor momentum investing and are comfortable with large market swings, and the potential for significant capital appreciation.

Additional Considerations

Due to the frequent portfolio turnover, investors with taxable accounts may experience higher capital gains tax liabilities.

Value Managers

Value managers aim to find stocks trading below their intrinsic value, using a bottom-up approach. These managers conduct intensive research to discover undervalued companies and typically experience low securities turnover, waiting for the market to recognize these stocks’ full value.

Risks of Value Investing

• Low stock prices which might remain low for extended periods.
• Lower annualized standard deviation and historical beta compared to growth investing.

Characteristics of Value Portfolios

• Low price-to-earnings ratio
• Low price-to-book value ratio
• Low price-to-cash flow ratio
• High dividend yield

Over the long term, value investing yields returns comparable to growth investing but with less volatility and higher dividend yield, typically performing better in down markets.

Suitable Investor Profiles

Value portfolios are best for investors with low-to-medium market risk tolerance and long-term investment horizons. Patience is crucial as the undervalued stocks’ recognition may take time.

Additional Considerations

In efficient markets, a stock trading at a low price could have valid reasons not apparent in its financial statements. Value managers often target companies requiring turnaround strategies.

Sector Rotation

Sector rotation adopts a top-down view, looking at overall economic conditions and investing in sectors expected to outperform based on economic phases. These managers focus on large-cap stocks for liquidity and rotate industries according to their growth prospects.

Risks of Sector Rotation

• High volatility due to industry concentration and rotation.
• Potential underperformance if economic predictions are incorrect.
• Frequent portfolio turnovers increase trading costs and taxable capital gains.

Characteristics of Sector Rotation Portfolios

The focus is on economic cycle trends and industry performance rather than specific companies, sometimes overlooking strong individual stocks. Sector rotation strategies center on outperforming market averages like the S&P/TSX Composite Index.

Suitable Investor Profiles

This style is suited for investors adept at anticipating economic trends and willing to endure high turnover and associated costs, targeting outperforming sectors.

Example: Recession to Recovery

During the late stages of recession, bank stocks and consumer growth stocks may rally, followed by consumer cyclical stocks, and eventually stocks benefitting later in the cycle like those in capital goods and commodity industries.

Figure: Industry Rotation through Economic Cycles

    gantt
	    title Sectors in Economic Cycles
	    dateFormat  YYYY-MM-DD
	    axisFormat  %m/%d
	    section Recession 
	      Banks        :a1, 2023-01-01, 30d
	    section Early Recovery
	      Consumer Growth      :a2, 2023-02-01, 30d
	      Consumer Cyclical :a3, 2023-03-01, 30d
	    section Late Recovery
	      Capital Goods :a4, 2023-04-01, 30d
	      Commodity-Based :after a4, 30d

Long periods of economic expansion drive heavy investment in capital goods and increased demand companies rely heavily on enhanced capacity.

Key Takeaways

1. Growth Investing: Higher risk but offers potential for substantial capital appreciation. Suitable for long-term and risk-tolerant investors.
2. Value Investing: More stable with higher dividends. Least risky compared to others but requires patience and suits long-term investors.
3. Sector Rotation: Focuses on macroeconomic trends, with industry focus outpacing stock selection. Suitable for investors confident in predicting economic shifts.

Frequently Asked Questions (FAQs)

Q1: What is the primary difference between growth and value investing?

• Growth investing focuses on companies with strong future earnings potential, typically trading at higher price ratios. Value investing seeks undervalued stocks with potential to rebound, showcasing higher dividend yields.

Q2: Are growth stocks always better investments in the long run?

• Growth stocks may offer higher returns, but they also come with significant risks and high market volatility. These are better suited for investors who can weather market fluctuations.

Q3: What makes sector rotation suitable for experienced investors?

• Sector rotation involves analyzing and predicting economic trends which can be intricate. Indexed sector performance can vary greatly, a precise macroeconomic diagnosis lifting targeted sectoral returns.

Usually coupling riveting returns with high-level analysis, this method is best reserved for investors familiar with market dynamics and economic phases.