Smiling young man holds note saying VALUE ADDEDDon Bayley/Getty Images/iStockphoto
It's no wonder that so many investors wind up confused by their portfolio performance.
Consider "value" funds, for instance. You would think that all mutual funds that promise to invest according to a value philosophy should post very similar returns. But that's not the case.
Inspect the three- and five-year returns on any mutual fund database and you'll see value funds with outstanding results and value funds that lag behind the market.
How can value stocks both underperform and outperform at the same time? It comes down to how one views value. There are factors that make some value stocks more appealing than others and play a crucial role in determining their performance.
To test what truly differentiates one value stock from another, we examined the historic performance of two value portfolios: one that simply owned cheap stocks; another that favoured owning cheap stocks with some additional characteristics.
We assumed that both portfolios selected stocks with low price-to-earnings ratios and low price-to-book ratios, two common measures of value. The difference between the two portfolios was that the manager of Value Fund A focused simply on buying the least expensive stocks, while the manager of Value Fund B preferred to own the least expensive stocks with what we would define as "good earnings," as identified by three key characteristics:
Their earnings have grown;
They have generated better-than-expected earnings;
Analysts have raised their estimates of future earnings for the stock.
Using CPMS/Morningstar's back-testing program and real-time database, we selected each 40-stock portfolio from the S&P/TSX Composite Index. At the end of every month, we removed stocks that no longer fit the criteria. We replaced any stock we removed with the stock that ranked highest on our criteria. Each test was conducted using monthly data from December 1985 to December 2012.
So what impact does good earnings have on value portfolios?
Value Fund A (the one that simply bought cheap stocks) had an annualized return of 5.0 per cent over the 27-year test period, significantly underperforming the benchmark S&P/TSX Composite Index's return of 8.2 per cent over the same period.
Value Fund B (with earnings growth as part of the investment strategy) performed much better, generating an annualized return of 11.6 per cent over the past 27 years, easily outperforming the index.
In addition, Value Fund B outperformed Value Fund A in 20 of the 27 years tested. The performance of Value Fund B was also more consistent, generating positive returns in 21 out of 27 years versus a more modest 17 out of 27 for Value Fund A.
The test results clearly show that good earnings make a significant difference in the long-term performance of value stocks, helping to generate more consistent and superior returns.
It is clear that not all value funds are alike. Those that incorporate good earnings in their strategies are more likely to outperform.
So investors may wonder how they can be certain that they are buying a value fund that incorporates earnings growth in its decision-making strategy.
The answer is simple: Ask.
Ask the fund, or your financial adviser, to show you proof of the fund's current style and historic style. A good fund manager will be able to supply proof of their underlying approach to stock selection.
David Fruitman, CFA, is Vice President & Portfolio Manager; Brennan Carson, CFA, is Vice President of Client Service and Business Development at STYLUS Asset Management Inc.