Quality is a factor for those seeking valuable investments. By Tony Lyons
In the past, active fund managers were divided into those who favoured growth stocks and those trying to find the greatest value. But nowadays, with the change to a low growth, low inflation economy, the growth followers have the upper hand.

The division between the two styles, however, is a fundamental one. And while the battle between them may appear to be over, this is because the leading value management groups, such as M&G and Fidelity, have refined their investment philosophies to suit today's market conditions.

In fact, much of the poor performance of the recent past at M&G was seen by outside financial advisers to be a result of the group slavishly following its investment policy without adapting it to meet the changed economic environment.

"We don't just look for low valuations, it's more sophisticated than that," says John Hatherly of M&G. "So while looking for a low share price relative to a company's prospects, we also look at the quality of the company."

For much of the post-war period, the UK has had a high inflation, high interest rate economy, with its boom-bust cycles. Looking at it simplistically, value followers would seek to invest in companies whose shares were out of favour at the time, holding them for the next phase in the cycle. These so-called cyclical stocks were typically industrial companies, usually medium sized or smaller.

So when interest rates were near their high point in the cycle, sectors such as engineering fell out of favour, squeezed as they were by the high costs of borrowing and high rates of sterling, making their exports expensive.

Value managers would buy these shares knowing that, when the government of the day took corrective measures, these stocks would come back into favour. After this, they would then switch to defensive stocks, such as food retailers, gainers when the screws were tightened.

Managers with a growth investment policy ignore this search for value. "Growth followers don't mind paying a high price for a share, as long as that particular company's earnings continue to grow," says John Ross of Fidelity.

Its followers believe that the long term value of any company's share is solely determined by its future income stream. "If you find a stock with a history of good returns, this is likely to continue," explains Simon White of RCM Dresdner Kleinwort Benson. "It helps if the shares are underpriced, that they haven't been spotted by the rest of the market."

In other words, "growth followers are after companies with above- average growth prospects," says Bob Yerbury of Perpetual, a leading group using this investment theory. "We look basically at the price earnings ratios of companies, trying to buy as cheaply as possible those with the greatest promise. With low inflation and falling interest rates, growth stocks will continue to do better."

"Today, with the bias against cyclical stocks and heavy industry, it's evident that those who used the old value style were basically trying to predict the future state of the national economy," explains John Ross. "If their forecast failed to happen, the value in their shareholdings wouldn't be realised, so their funds ran into trouble."

Value followers have had to redefine their philosophy to meet the changes. In some groups this saw the spilling of some management blood on the way. M&G, for example, had accompanied its amended investment philosophy with a number of key changes in personnel.

"Nowadays, we use a sophisticated checklist when looking at companies," says John Hatherly. "This includes looking at their balance sheets, cash generation, market position, profit and dividend generation, their growth focus and the overall quality of their management. We then end up with a list of value and qualitative scores. These will show the difference between those that have a low current value for good reasons, and those where there are prospects that the valuations will change for the better."

This almost seems like a variant of the growth theory, with its adherents trying to get in on the ground floor before the rest of the market has spotted a change in a company's fortunes. Maybe value-followers are turning into quasi-growth strategists now.

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