Investments

VALUE

PROPOSITION

In both the long and short term, the value style
has outperformed growth as well as Canada's major
equity index, pension funds should ensure their
money managers adopt a disciplined and quantitative
approach to value investing.

By Sam Wiseman

In its May-1999 issue, BENEFITS CANADA presented
a study of investment styles that revealed the
value style dominated the Canadian equity mar-
ket to the extent that growth managers had to be superb
stock pickers to compensate for their style's systematic
underperformance. The article concluded with the obser-
vation that there were glaring inefficiencies in the Canadi-
an equity market that could be exploited. It was predicted
that plan sponsors would add more value stocks to their
portfolios overall, and that by investing sufficiently in this
style they would lose less value in down markets.

Three years later, the markets have undergone some
major changes. Yet, all of the above observations still ring
true—perhaps even more so today than then.

In Canada, value—as measured by the Barra value
index—has outperformed growth as well as the Toronto
Stock Exchange (TSX) 300 total returns index in both the
short and long term, extending back 20 years (see "Pure
style indexes," page 38).

The picture is somewhat different in the U.S., though.
Due to its larger size, that market is able to accommo-
date multiple major styles. Both the value and the
growth style alternatively outperform one another for
two- to three-year stretches. In contrast, Canadian
investors will not pay more for a stock than they believe
it is worth for any length of time. This is why value out-
performs growth in Canada.

GROWTH RALLY

From the last quarter of 1998 to the first quarter of
2000, Canada witnessed a growth rally driven by a
handful of high-technology stocks. Following 16
months of superior performance, growth investments
peaked on both Canadian and U.S. indexes in February
2000. That quarter also marked the greatest difference
on record between value investments and the equity
market in both Canada and the U.S. (see "All-cap char-
acteristics," page 38). This occurred just as a wave of
Canadian money managers was planting itself firmly in
the growth camp and confidently declaring that value
was obsolete.

Today, half of the capitalization of the TSX 300 is cate-
gorized as growth, including Nonel Networks. The stock
remains a risky play today, according to die Barra model—
a tool used by investors to quantify the risk of a particular
stock or portfolio. No manager would want to be seen as
buying overvalued stocks, but with average price-to-earn-
ings ratios of 50 times, this is exactly what occured at the
height of the market in 1999-2000.

FOLLOWING THE CROWD

During the tech mania of late 1998 to early 2000, value
managers were under pressure from the burgeoning
weight of Nortel in the TSX 300, as well as the prevail-
ing belief among plan sponsors that the weighting of
high-tech stocks in their portfolios had to be much high-
er than their investment style would normally indicate.

As a result, many value managers followed the crowd to
growth stocks. In doing so, they lost their way and were
noc objectively evaluating the strengths and weaknesses
of their equity investments. If any Canadian firm had
remained a steadfast value investor over the past 10
years, it would have been a top-performing manager in
the country, beating the TSX 300 by 2.8% a year.

Pure value investments are less volatile than the TSX
300. They have a lower beta and a long-term correla-
tion of only 40%, compared to 85% or more for the
typical Canadian equity manager. Over 2000 and 2001,
the correlation between value and the TSE 300
dropped to only 19% as the style continued to outper-
form the index by a large margin.

VALUE TRAPS

The Barra value index is based on one definition of value,
which is a combination of price-to-book earnings and div-
idend yields. Although these are important value charac-
teristics, their exclusivity leads to several inefficiencies in
the index. However, exploiting these inefficiencies in a
disciplined manner can add to returns.

It is important to address the composition of the index.
The Barra value index contains what are known as value
traps. These are stocks that appear attractive to the Gra-
ham and Dodd approach (characterized by bottom-up
stock picking) but are priced lower than the industry aver-
age. That is for good reason—they are inefficiently man-
aged and never outperform in the long term.

A disciplined, active management process applied to
the value universe would outperform the Barra index.
Going forward, firms adopting this approach can expect
to rank among the top Canadian money managers.

Enabling a manager to successfully add significant
risk-adjusted value means allowing the individual or
firm to focus on more than just value-index stocks.
Some industries may not be included in the value index
or in typical value screenings, resulting in missed value
stock opportunities.

All-cap characteristics
All-cap is a sample of large-, mid- and small-cap value stocks used as a proxy for the value style in
Canada.
As of July 2002                    All-cap	TSX 300
Price-to-book                        15x	1.8x
Price-to-earnings                 10x	12x
Dividend yield                       1.91%	1.46%
As of February 2000            All-cap	TSX 300
Price-to-book                        1.4x	2.8x
Price-to-earnings                 15x	17x
Dividend yield                        2.38%	1.13%
Source: wise Capital Management Inc.

But active value management is not as simple as, say,
screening for low price-to-earnings ratio stocks. That
would result in getting caught in value traps and miss-
ing undervalued stocks in several sectors. The value-
added process isn't as easy as being a good stock picker
either. Sector weightings is an important factor to
manage. The financial sector has always comprised
about half of the value index.

Over the last few years, including stocks in a portfolio
with both strong value and growth characteristics would
have resulted in the most efficient return-risk tradeoff. As
a bonus, since the fall of 2000 these stocks have been
among the strongest performing names on Canadian and
U.S. indexes.

COMPREHENSIVE APPROACH

A quantitative approach is needed to comprehensively
manage the increasing flow of data available on compa-
nies today. A generation ago, about 40 Canadian stocks
were liquid and managers could rely on memory for
their essential characteristics. Today, there are over 500
liquid stocks, and even a large team of analysts cannot
do a thorough, bottom-up job of analyzing this large
volume of names.

Screening alone, though performed by many Canadi-
an firms, is not comprehensive. If a manager screens for
stocks below a given price-to-earnings valuation, he or
she will miss stocks that are undervalued based on other
important criteria, such as the price-to-book ratio. In
addition, several Canadian managers now have one or
two levels of risk control. However, successful U.S.
investment firms employ many more measures.

A quantitative approach is also needed to tackle the
subjectivity of portfolio weighting and to address issues
such as: What percentage of Bank of Nova Scotia shares,
for example, are needed in the portfolio? How subjective
should the weighting be? And, how much risk is added
by this subjectivity?

Going forward, firms adopting a disciplined, rather
than subjective approach can expect to be among the
most successful performers. And the tools have been
established to enable managers to achieve this goal at
lower-than-market risk levels.

The bulk (85%) of a pension fund's equity perfor-
mance is attributable to an investment manager's style.
Over time, it is more important to ensure that equity
managers maintain a pure value style than it is to worry
about minor changes in asset allocation. This is because,
historically, even a small tilt towards value has improved a
fund's equity returns.

Pension funds can ensure that their managers are com-
mitted to value investing by closely monitoring their
holdings' underlying style characteristics.             BC

Sam Wiseman is the chief investment officer with Wise Capital
Management Inc. Toronto. info@wisecapitalmanagement.com.

www.benefitscanada.com                                                         SEPTEMBER 2002