Genus Quantitative Insights - April 09

Quantitative Insights Vol. 1, No. 01—April 2009

Exhibit 1: There is a Style Cycle in Canada

There is a Style Cycle in Canada and the U.S.

1.0%

Momentum relative to Value: 48-month moving average

0.8%

Momentum outperforms

0.6%

Momentum and value take turns in outperforming The cycle is shifting, momentum is giving way to value Style-diversification can overcome the best-of-times/ worst-of-times syndrome

0.4% 0.2% 0.0% -0.2%

Value outperforms

-0.4% -0.6%

87

91

93

97

00

04

08

09

Source: Genus Institutional Equity

O

ur research into investment style performance over the years confirms there have been definite periods in Canada and the U.S. where momentum has strongly outperformed value, and vice versa, typically for about four years at a time. As you can see in Exhibit 1, style leadership rotates: after four years of underperforming momentum, value is poised to seize center stage as the economy recovers.

The Momentum/Value Cycle is Shifting The market's results during the current cycle, while extreme in some ways, mirror past cycles. A momentum-driven market has historically preceded a recession—and worked well through it too. Once a recession nears its end, the market typically switches its focus to valuations. This has happened in every one of the past five recessions going back 40 years. It’s no different this time: the current momentum/ value cycle has begun to turn. We are anticipating the beginning of a new value regime once the economy recovers.

Why do These Cycles Occur? Momentum flourishes when investors latch onto the next big thing. For example: technology, real estate and commodities. In the most recent cycle, investors fell in love with the "Chindia" growth story, which saw sky-rocketing demand and prices

for commodities. As inevitably happens, as each momentum cycle ends, the "story" collapses. In this case the fall in commodity prices signaled the shift. Ultimately, when a momentum-driven bubble bursts, fear replaces greed and investors go back to favouring value and look for cheaper, overlooked sectors and stocks. It happens time and again - and being on the wrong side of the cycle can hurt portfolio performance.

Why Four is Better than One Although the cyclic nature of the two styles’ effectiveness is readily apparent, it is very difficult, if not impossible, to accurately forecast when one style will dominate the other. Rather than attempting to time the shift in styles, Genus blends the best momentum, value, growth and quality factors to identify opportunities that will deliver sustained outperformance, through both the Quantitative Insights

1

Quantitative Insights market and investment style cycles. Our dynamic four-is-better-than-one approach can overcome the best-oftimes/worst-of-times syndrome. It smoothes out returns related to style swings and can achieve consistent performance over a market cycle. In fact, the Genus strategy outperformed through the technology bubble and its implosion, through the oil bubble and its deflation, and through the commodity frenzy and its subsequent fizzle.

Cycles Within a Value Regime Our research shows that within value there are distinct sub-styles, including low Price to Earnings (P/E) and low Price to Book Value (P/B), which also cycle in and out of favour, typically for three years at a time. Exhibit 2 shows that we have completed a low P/B regime and are rotating into a low P/E cycle.

What Causes Cycles Within Cycles? During bubbles, investors trust that earnings and cash flow are solid, or they expect future cash flow and earnings to be strong. Therefore, they pay attention only to price; hence low P/ E stocks will outperform and result in a high P/E ratio for the market. When a bubble inevitably explodes, investors become suspicious of earnings predictability and stability: the Price to Earnings ratio is not their focus anymore and book value becomes the centre of attention. As the economy recovers, earnings and cash flow again become believable, and P/E subsequently comes back into play. Just as it is difficult to time style cycles, so too is it difficult to time the shift from

Exhibit 2: Cycles Within a Value Regime 0.8% 0.7% 0.6%

Earnings Yield relative to Book Value: 48-month moving average

0.5% 0.4% 0.3% 0.2% 0.1% 0.0% -0.1%

76

80

84

88

92

96

00

04

08

Source: Genus Institutional Equity

Exhibit 3: U.S. S&P 500 Versus Risk Index 20% 10% 0% -10% -20%

Risk Index (Leverage, Volatility and Earnings Variation)

-30% -40%

S&P 500

-50% -60% -70%

Jan 07

Jun 07

Jan 08

Jun 08

Jan 09

Source: Genus Institutional Equity

low P/E to low P/B within the value cycle. Our response is to blend different value factors, including low P/E and low P/B, in our valuation models for the various markets. Our approach, much the same as diversifying across styles, smoothes out volatility within a particular style and contributes to consistent outperformance.

Oversold Risk Index Recovering Exhibit 3 shows that the S&P 500 Risk Factor Index (earnings variation, volatility, and leverage) is oversold as a result of investor fear in the current bear market. The Risk Factor Index is positively correlated with the performance of the market, which means that as the market recovers, risktaking too will bounce back.

Quantitative Insights is published quarterly by Genus Institutional Equity, a division of Genus Capital Management 6th Floor~900 West Hastings St., Vancouver, BC, Canada V6C 1E5 T 604 683 4554 www.genuscap.com