Andrew Newell, Head of Business Development at Cannon Asset Managers, explains the importance of understanding the source of investment returns and gives pointers on where to look in the future.

Most investors want not only high equity returns, but returns that are even better than the market itself. This points them to the practice of active management. It also means that investors have to have a better understanding of the various sources of returns in the market. It is not just about which shares or sectors did well, but more subtle attributes such as investment style – growth, value or GARP – or the size of the underlying investment (large, medium, small companies).

A very effective way of plotting these attributes is through heat maps, which are a useful and easy-to-understand visual representation of these factors.

Using widely-accepted and known measures, Cannon has built the two matrices shown in Charts 1 and 2. Each matrix is constructed by segmenting the All Share Index into large-cap, mid-cap and small-cap stocks, in the three columns from left to right. Then, using a one-year trailing PE ratio, we show high PE (growth), average PE (GARP) and low PE (value) stocks, in the three rows from top to bottom. The beauty of this study is that it uses only known data – so there is no forecasting – and we use JSE size definitions.

To be clear, the box on the top left shows those stocks that are large-cap and that are on the highest one-third of PE ratios, and those stocks in the box on the bottom right carry the lowest PE ratios and are small-cap. The number in each segment reflects the average annual return from that segment over the measurement period.

It is clear that, over the long term, the best returns come from smaller, value stocks, whereas larger stocks that are priced on growth multiples lag noticeably. The difference of more than 10% per annum is material when compounded over time. By definition, though, most investment capital will be in larger stocks. In addition, the counters that are on higher multiples are currently more popular, making it emotionally hard to invest away from them.

However, the long-term result does not develop in a consistent and linear fashion, and these various attributes work in shorter cycles. What about the recent past then? This is shown in Chart 2, which reflects performance for the calendar year 2013.

In this matrix we see the opposite of the long-term evidence. Larger stocks that are on growth multiples (high PE) have performed strongly, whereas the value counters have lagged noticeably. By inference, asset managers who have performed well over the last few years must have been primarily exposed either to growth stocks, or to large-cap stocks.

We know anecdotally that investment managers who follow value philosophies have battled to keep pace with the rapidly-rising equity market, and that firms which have enjoyed good performance over this time-frame must have, to some degree, followed a strategy that is focused on growth investing. This is not to say that one approach is right and the other wrong, but it serves investors well to know where the returns have come from.

The real issue is that, if these attributes revert to their long-term trend in which smaller and typically value-priced companies outperform, what are the implications for your portfolio, and where are you currently exposed?

Finding an explanation

Finding an explanation for what has caused the current trend away from the long-term norm is tricky, and could be ascribed to any one of a number of factors including foreign investors’ appetite for emerging-market equities, buying growth at any cost in a world where growth is hard to locate, or the notion that big is safe.

Regardless of the reason, the fundamental drivers of the long-term result have not changed, being the fact that ultimately it is earnings that drive share prices. It is worth noting that earnings don’t have to disappear in order for investors to be disappointed – they just need to be lower than expected.

Given the long-term results which, importantly, also hold globally, and the near-term experience, Cannon Asset Managers has positioned its clients’ portfolios to be biased away from larger stocks that are on above-average price-earnings ratios, and tilted them towards mid- and small-cap stocks that are attractively priced. A good investment result does not rely on these less-popular stocks becoming the flavour of the day, or suddenly finding the “next big thing”, but rather, it relies on them continuing to generate good earnings, and to be priced back to a fair level, not even a high level.

It is also important to note that the matrices illustrate the aggregate result so one should not simply buy the cheapest and smallest stocks one can find. Instead, investors should couple their search for these stocks with a keen sense of the businesses’ financial and commercial quality, measured with a number of tools. Some companies deserve their low price, others don’t, and investors need to identify which category a share falls into. Just because a company’s share price hasn’t performed well, doesn’t mean that the company itself hasn’t. If an investor is able to stay true to the task of identifying good businesses that are attractively priced, the returns will take care of themselves.

Cannon Asset Managers is a niche investment management company that applies the philosophy and principles of value investing.