The Morningstar Style Box is a graphic representation of an equity fund's exposure to two factors, market capitalisation and 'style'. Each factor is divided into three categories. For market capitalisation, the three categories are large-, mid-, or small-capitalisation; for style, the three categories are 'value', 'growth', and 'blend' (a combination of value and growth characteristics). What results is the ubiquitous 9-square grid that Morningstar has used since 1992 to help investors determine the broad investment style of funds. In this article we will explain the rationale for identifying a fund's style exposure, the long-term performance of the style categories, as well as take a look at style indices and the ETFs that track their performance.
Styles to Choose From
So what are the characteristics of 'growth' and 'value' stocks and/or funds? There are no hard-and-fast rules, but the basics are generally agreed upon. As you might expect, growth stocks are those that are rapidly expanding revenues, earnings, cash flows, and book value. With a five-year annualised average revenue growth rate of 37%, net income growth rate of 42% and free cash flow growth rate of 34%, Google (GOOG) certainly qualifies as a growth company. Value stocks are those that have generally fallen out of favour with the market, and so trade at bargain prices. These shares can generally be spotted by their depressed valuation ratios (price-to-earnings, price-to-book, price-to-cash-flow) relative to historical averages and their closest competitors. An example is Agfa-Gevaert NV (AGFB), which trades at a price-to-book ratio of about 0.5, or less than half of its five-year average of 1.3 times book value. The two styles aren't mutually exclusive, as some stocks may have characteristics of both growth and value. No less an authority than Warren Buffett once said that "Growth and value investing are joined at the hip".
It’s Academic
There is ample academic research which has sought to explain the performance of style factors. Take for instance a basic return model where the holding period return on a stock is the sum of the returns from dividends and from capital gains. In their 2007 paper 'The Anatomy of Value and Growth Stock Returns', Fama and French further broke down the returns from capital gains into the growth in equity or book value (mostly from retained earnings), and the convergence in the price-to-book (P/B) ratio between growth and value stocks (as well as a minor historical upward drift in P/B ratios which we can ignore as it applies to both value and growth stocks). Because dividends are paid out of retained earnings, and if retained would otherwise go to increasing book value, we can also ignore them for the purposes of this explanation.
When stocks are identified by style, the resulting value and growth portfolios will have widely divergent P/B ratios. Growth will tend to exhibit a much higher P/B ratio than value because investors perceive the equities as those of fast-growing, highly profitable companies and accord them a lower cost of capital (lower expected return). Value stocks, on the other hand, are generally less profitable, slower growing, and have a higher cost of capital (higher expected return).
The subsequent performance of stocks categorised as value or growth can be explained by the convergence of P/B ratios of the two groups over time. Growth stocks tend to grow their book value rapidly relative to their price, thus decreasing the P/B ratio. The growth in book value can occur quickly as the companies reinvest in their business, while over time competition and diminishing opportunities for reinvestment curb the firms’ growth rate and investors respond by lowering the multiple they are willing to pay for these firms’ shares.
On the other hand, value stocks tend to see little if any increase in book value. Instead, the multiple of book value that investors are willing to pay increases as profitability improves--due to restructuring, layoffs, or expansion into more profitable activities.
(to be continued)
