A Matter of Style: Equity Style Investing

There are no free lunches in investing. Yet two types of stocks have outperformed in the long run: small (versus large) caps and value (versus growth) equities. The performance of these traditional equities investment styles has been anything but consistent (nobody said making money was easy).

Against a backdrop of small cap outperformance and a value versus growth stalemate, we debated the prospects for the traditional style boxes in equity investing. Our main conclusions:

• Style exposures are key drivers of portfolio returns because different investment styles can outperform (or underperform) for prolonged periods of time.
• Think outside the box. It pays to understand the content of a style box, and how it changes over time. Sector weights within investment styles can shift dramatically. This is important, because industry sectors behave differently in different economic conditions.
• Small caps today are pushing against historic valuation ranges by most metrics. Yet Low for Longer interest rates, below-average operating margins and rising merger and acquisition (M&A) activity suggest further potential upside.
• Global growth equities today are slightly cheaper than value compared with historical valuations. The valuation gap between growth and value has hit a decade high in Europe, however, potentially setting markets up for a value revival.

The outperformance of small caps and value equities is a much-debated anomaly in finance. The evidence is clear—at least in the very long run: U.S. small caps racked up an average annual return of 12% from 1926 through 2013, 2.4 percentage points more than large caps, according to Fama French data. This may seem like small fry, but it means a 6.5-fold difference in total return when compounded over almost a century.

This phenomenon is similar to the power of reinvested dividends over very long time periods. Other factors such as earnings and sentiment swamp dividends over shorter horizons.

Similarly, “cheap” stocks with low price-to-book ratios (value) have delivered cumulative returns of 5,000% since 1980 in the United States, versus a near 3,000% return for “growth” stocks with high price-to-book ratios, according to Russell data.