Morningstar Advisor - December/January 2012 - (Page 14)

Know-How How to Find Your Client’s Investment Style By Samuel Lee Should you be a value hound or a growth investor? increases the probability their employer will cut their pay or even fire them. The increased probability of such events means their human capital is less valuable than it otherwise would have been. If their job is insulated from market behavior or better yet anticyclical, consider loading up on value stocks. They effectively act as an insurer to investors who can’t or don’t want to hold recession-sensitive stocks. Therefore, they should expect higher returns. The partitioning of equities into growth or value styles has its strongest foundations in Eugene Fama and Kenneth French’s work on the value effect—the tendency for stocks cheap by fundamental valuation measures to outperform stocks expensive by the same measures. Before you dump your clients’ growth holdings, consider why this may be the case. Fama, French, and many other very smart people think value’s outperformance wholly sensible. Value stocks tend to do horribly during recessions; growth 810/0812/0802/09 /0811/0801/0903/09 stocks fare relatively well. It’s with this fact in mind that we decide how to allocate to growth and value. Value Stocks Do Poorly in Recessions Total Return During 2007–09 Bear Market 1.2 $1.0 0.8 0.6 S&P 500 S&P 500 Value S&P 500 Pure Value 3 Assess options The major large-cap value and growth indexes are almost identical in behavior. The index families distinguish themselves in their small- and mid-cap style indexes. As a good rule of thumb, the more small-cap- and value-laden a fund, the greater its recession sensitivity. Another point of caution: Dividend strategies can vary quite a bit in their recession sensitivity. High-yield and yield-weighted strategies tend to decline much more in bear markets than dividend-weighted strategies do. Not Just for Efficient-Market Types 0.4 0.2 09/ 07 12/ 07 03/ 08 06/ 08 09/ 08 12/ 08 03/ 09 1 Assess the true portfolio Your client’s portfolio isn’t just stocks, bonds, and cash. It’s his or her job, human capital, house, pension, and everything else that generates income. An easy way to estimate an income stream’s value is to see how much it would cost to replicate it with an annuity. If the client has lots of safe assets, consider holding more value stocks. If not, more growth. Recession Sensitivity 10/ 11/ 01/ 02/ 04/ 05/ 07/ 08/ 10/ 11/ 01/ 02/ 07 07 08 08 08 08 Stocks 08 08 09 09 High-Yield 08 08 More Recession Sensitive 2 Consider bear-market sensitivity If clients work in a highly cyclical industry, consider easing up on value stocks and shading toward growth stocks. A bear market We don’t think value strategies outperform only because they’re more sensitive to recession risk. Human nature has a strong hand in bidding up growth stocks. But even though value stocks may be consistently underpriced, they’re undeniably more sensitive to recession risk. All investors should consider this fact when pondering their portfolio allocations. K Samuel Lee is an ETF analyst with Morningstar. Small-Cap Value Small-Cap Blend Large-Cap Value Large-Cap Blend Large-Cap Growth Less Recession Sensitive 14 Morningstar Advisor December/January 2012

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012