One of the first questions fund managers are often asked is – ‘Is the fund value or growth focused?’ This could be the sales team looking for a way to market the portfolio or potential investors gathering information on the fund, the process and the manager’s thinking. Nonetheless most funds will be classified as ‘value’ or ‘growth’ before progressing on to further discussions.
While the manager’s style bias can help with choice overload and the focus on desired fund characteristics, the discussion over what constitutes value, and in turn what we mean by growth investing, is not clear cut. This debate has no definitive answer, however, it may be helpful to consider how other prominent investors have sought to distinguish between the two styles.
As a rule, growth investors are attracted to companies that are expected to grow faster than the overall market. As growth is the priority, companies reinvest earnings in themselves in order to expand and they rarely pay dividends. Growth companies offer higher upside potential and therefore can be inherently riskier as there is no certainty that their investment in growth will successfully lead to profit. As famous growth investor, Philip Fisher, claimed:“[The] growth stock offers by far the greatest possibility of gain. Sometimes this can amount up to several thousand percent in a decade…[with] products that might bring a sensational future”.[i]
Value investors are attracted to companies whose stock prices don't necessarily reflect their fundamental worth. As time goes on, an efficient market will properly recognize the company's value and the price will rise. As Warren Buffett famously put it: “You walk down the street and you look around for a cigar butt… Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it… You get one free puff on it and then you throw it away and try another one. It is not elegant. But it works.”[ii] Additionally, value funds don't emphasize growth above all, so even if the stock doesn't appreciate, investors typically benefit from dividend payments. Value stocks have more limited upside potential and therefore can be safer investments than growth stocks.
This is not by any means a comprehensive or complete comparison, however, it can be deduced that growth investing tends to involve high octane and disruptive companies either growing at an accelerated rate or failing, and in turn can be a high risk, high reward strategy. In contrast, value tends to represent incumbent companies with established business models with no exciting growth to exploit so excess returns are paid out as dividends – often regarded as a safe pair of hands but won’t shoot the lights out.
This loose classification is, however, hard to accept. It is rare for a growth investor to think their portfolio is overvalued, and equally rare to find a value investor who thinks that their portfolio has no growth potential. Furthermore, recent global developments in terms of Covid-19 have completely flipped this on its head! Firstly, some of those “safe pair of hands” investments have been decimated by Covid-19; with dividends cut, restructuring required, and additional capital raised in order to survive. Whereas some of those “risky” growth companies have gone from strength to strength, and to a degree seen their share prices driven to new highs since the pandemic. This begs the question - is expensive growth the only way to go now?
This might be the case for large cap equities. Followers of MI Downing Monthly Income Fund will know of our views around the lack of dividend cover in large caps - a product of dividend growth outpacing earnings growth over several years. We have also previously emphasized the need for diversification within the UK equity income space – and the inclusion of smaller companies in a portfolio can both aid diversification and also provide an answer to the value or growth conundrum.
The MI Downing Monthly Income Fund currently sits on a forward price-to-earnings ratio of 10.7, a forward yield of 4.9% and a 3-year earnings compound annual growth rate of 17.1%[iii]. These metrics for UK large cap equities are 23.0, 3.6% and 9.2%[iv], respectively. The result is a premium yield and earnings profile but on a cheaper valuation than the market. Traditional large cap income funds are usually invested in what some may call value stocks but drawn from a narrow pool of potential investments. Conversely, dipping into the smaller cap end of the market offers a much larger investable universe. Given the much wider pool, the MI Downing Monthly Income Fund views income through a different lens. Whilst the fund will hold higher yielding positions, the smaller company focus allows the fund to exploit a favourable proposition in that some companies offer impressive yields at attractive valuations, while also exhibiting accelerated growth profiles. A quick comparison helps demonstrate this point.
Spirax-Sarco Engineering, a large cap industrial engineering company, sits on a forward price-to-earnings ratio of 43.3 and dividend yield of 1.1%. One might assume that a company trading on an 88% premium to the market would be offering dazzling growth. Consensus 3-year earnings CAGR is 5.6%[v], which is below forecasted market growth. So, is this a value or growth stock?
Sticking with the industrial theme, a company held in the MI Downing Monthly Income Fund is Volex, a global supplier of power cords and cable assembly solutions. Volex is 33x smaller than Spirax-Sarco at £224m[vi] market capitalization. However, the forward price-to-earnings ratio is 13.3, with a dividend yield of close to 3% and a 3-year earnings CAGR of 16.1%, which translates to a similar forward looking 3-year CAGR for dividends of 17.3%[vii]. These headline figures suggest that Volex offers a cheaper valuation but greater growth prospects. So, it appears the conventional thinking of what constitutes a value stock or a growth stock doesn’t appear to hold here. Obviously, there are other forces at play that drive valuations over time, but this comparison certainly paints an interesting picture.
In summary, to classify a fund as having a specific style bias is necessary, especially when looking at the equity income sector. Traditional thinking tells us a growth bias doesn’t fit well with income investing, but mainly because the traditional approach has been to concentrate on the very largest equities listed in the UK that struggle to grow in a meaningful way. Looking further down the market cap spectrum opens up an opportunity to not only diversify your UK equity income exposure, but also tap into a universe that largely refutes the argument that “value” or “growth” investing is a zero-sum affair.
Is the MI Downing Monthly Income Fund a value or growth focused fund? Well, in truth, it is both.
[i] Common Stocks and Uncommon Profits, Philip Fisher 1958
[ii] Lecture at the University of Florida School of Business, Warren Buffett 1998
[iii] Downing/Factset as at 31/07/20
[iv] Factset as at 31/07/20
[v] Factset as at 07/08/20
[vi] As at 07/08/20
19 August 2020
Risk warning: Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies. Diversification may not be achieved and investments may be in the same sector. Opinions expressed represent the views of the Fund Manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained in these documents.
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