Text: Yan Xiang, Jin Han
Key conclusions:
The style rotation phenomenon of the A-share market has always attracted much attention, which describes the market characteristics of different market styles alternating in a certain period of time. Studying the pattern of style rotation can help investors segment the various types of stocks in the market, so as to formulate investment strategies more accurately. Style rotation is usually driven by changes in market participants' preferences for different types of stocks, which are influenced by multiple factors such as macroeconomics, interest rate levels, market sentiment, industrial policy orientation, and industry development trends.
This report not only focuses on the changes in the stock market over the course of history, but also covers the comparative analysis of domestic and foreign stock markets, focusing on the comparative study of three core styles (large cap and small cap, growth and value, and dividend and quality). Historically, the style rotation cycle of the A-share market has a long period, which has a significant impact on investment returns. Through in-depth research on the regular, characteristic and driving factors of A-share style rotation, investors are expected to better grasp the market rhythm and capture appropriate investment opportunities in the complex and volatile market.
Risk warning: historical experience does not represent the future, macroeconomic is less than expected, economic policy change risk, geopolitical risk, etc
The main body of the report
1. The significance and difficulties of style research
With the increasing number of listed companies, the market has become more complex and specialized, and structural market has become the dominant market. In recent years, the A-share market has shown significant structural differentiation, such as the volatility between large-cap and small-cap, growth and value, dividend and quality, etc. Style rotation is usually driven by changes in market participants' preferences for different types of stocks, which are influenced by multiple factors such as macroeconomics, interest rate levels, market sentiment, industrial policy orientation, and industry development trends. Through in-depth study of the regular, characteristic and driving factors of A-share style rotation, we can better grasp market opportunities.
In the process of style switching research, there are some problems and difficulties as follows. The first is the subjectivity of style definition, different researchers may define the style of the stock market according to different standards and methods, which is a conceptual issue that needs to be clarified first. For example, only when we have a common basis for identifying what is a growth stock and what is a value stock can we discuss the laws behind driving growth and switching value styles. In this regard, the market's definition of large-cap and small-cap styles is far clearer than value and growth, dividends and quality, etc. The second is the complexity of logical attribution, and the style switch is affected by various factors such as macroeconomy, interest rate level, market sentiment, industrial policy orientation and industry development trends. These factors are intertwined, making it difficult to perform a simple linear analysis. The third is the limitations of historical experience. We have found many periodic patterns and logical attributions of style rotation, but it is very difficult to predict the timing and duration of style switching. History may repeat itself, but it will not simply repeat itself. The style switching patterns of the past are not necessarily applicable to the future, as the market environment, investor structure, technological advancements, etc., are constantly changing.
2 Over vs. Under style
2.1 Criteria for dividing the over-cap vs. small-cap style
From the perspective of style definition, the characteristic indicators of large-cap and small-cap styles are relatively clear, and they are mainly classified by total market capitalization. In different compilation schemes, there are some differences in the determination of classification threshold, weighting method and exclusion principle of style index. We use the CSI 300 Index (approximately 1-300 by market capitalization) to represent the large-cap style, and the CSI 2000 Index (approximately 1801-3800 by market capitalization) to represent the small-cap style.
In addition, the market also pays attention to the CSI 1000 Index, the CNI 2000 Index, and the Wind Micro Cap Index. Among them, the CSI 1000 Index (ranked about 801-1800 in market capitalization) before 2013 when there were less than 2,500 A-share listed companies can better represent the small-cap style, and now the number of listed companies has exceeded 5,000, so it is more appropriate to classify it as a mid-cap style. The CSI 2000 Index is ranked between 1,001 and 3,000 in terms of market capitalization, and when it comes to small-cap stocks, the style is not as distinct as that of the CSI 2000 Index. Wind Micro Cap Index (8841431) selects the 400 stocks with the smallest market capitalization as the components, and calculates them with equal weights on a daily basis.
2.2 The Cycle of Large Cap and Small Cap StylesWe use the CSI 1000 Index (2013 and before) and the CSI 2000 Index (2014 and later) to represent the small-cap stock style, and the Wind All A Index is used as the market comparison benchmark, and the excess returns of the CSI 1000 and CSI 2000 are used to measure the relative performance of the small-cap stock style compared with the overall market. It can be seen that since 2005, the dominant style of large market and small market has always rotated, and there is no one style that can continue to lead and become the dominant direction in the future. Some people think that "investing in small-cap stocks is all about speculating on small stocks" or that "large-cap stocks will continue to prevail as investors become more rational", all of which are inaccurate from the perspective of domestic and foreign stock market history. Specifically, looking back at the style trend of the A-share market, it can be found that the changes in the style of large and small caps can be roughly divided into four stages: the first stage, from 2005 to 2008, the market style is generally balanced, and the large and small market styles are dominant back and forth; In the second stage, from 2009 to 2015, the overall style of the market was the dominance of small-cap stocks, during which there was a significant style switch between the end of 2012 and the end of 2014, resulting in the short-term dominance of large-cap stocks. In the third stage, from 2016 to 2020, the market generally showed the dominance of the large-cap stock style, and during this period, the dominance of the large-cap style basically continued, and there was no obvious short-term switching; In the fourth stage, from 2021 to the present, the market has re-emerged in the small-cap dominant style, and the rapid interpretation of the market has led to a "stampede" decline in small-cap stocks in early 2024.
The changes in the style of the U.S. stock market can be roughly divided into the following stages: the first stage, from 1950 to 1964, the market style was generally balanced, and the excess returns of the large and small caps were not obvious; In the second stage, from 1965 to 1968, the performance of small-cap stocks was clearly superior, corresponding to the famous "tronics market" in the market at that time, that is, the electronic stock market, "tronics" is the last few letters of the English "electronics"; In the third stage, from 1969 to 1974, the style of large-cap stocks was clearly dominant, and during this period, the famous "Beautiful 50" market of US stocks broke out from 1970 to 1972; In the fourth stage, from 1975 to 1983, in the post-"Beautiful 50" era, the style of the U.S. stock market reversed, and the longest and largest round of small-cap stock market in the history of U.S. stocks broke out; In the fifth stage, from 1984 to 1998, the U.S. stock market once again entered the dominant style of large-cap stocks, during which there was a short-term style switch from 1991 to 1993; In the sixth stage, from 1999 to 2003, there was a wave of small-cap stocks that were not long but had a large range. In the seventh stage, from 2004 to 2022, the market style is generally balanced, and there is no particularly obvious large-cap or small-cap dominant style.
Historically, the over/under style has a strong mean reversion or rotation. Whether it is in the A-share market or in the U.S. stock market, we can see that the excess returns of large and small caps generally show mean reversion, that is, "30 years in Hedong, 30 years in Hexi", such a back and forth state, and there is no trend of a particularly strong dominant style. If you have to compare the advantages and disadvantages, in terms of the time when the small market is dominant and the time when the large market is dominant, you will find that the time when the small market is dominant may be a little more overall. In terms of cumulative gains, the small-cap style of U.S. stocks has outpaced the broader market over the past 70 years. The alpha curve of small-cap stocks can shed light on some common pitfalls in the investment process. First, it is often said that when the market matures, there will be no more small-cap stocks, and a similar statement is that there will be no small-cap stocks after the registration system. Judging from the history of U.S. stocks over the past 70 years, this statement is not true, and the large-cap and small-cap styles have been switching back and forth. The second is that large companies and good companies should have a valuation premium, so large-cap stocks should rise better. In fact, it should be noted that the valuation premium does not mean that it will rise, the valuation premium itself will change, and if the valuation premium rate falls, then it will also fall. Third, domestic investors often perceive large-cap stocks in overseas markets as performing better than small-cap stocks. Judging from the trend of the excess curve of U.S. stocks, it is obvious that this sentence is incorrect. An important reason for this feeling may be that we, as Chinese investors, cannot remember some small and medium-sized companies in overseas markets, and we can be familiar with those large companies with Chinese names, so it will form a relatively strong cognitive bias. 2.3 Drivers of the Large-Cap vs. Small-Cap StyleIn addition, some more intuitive conclusions can be drawn from the above data. The first conclusion is that there is more of a rotation between the over/under styles, and there is no one style that can always lead. We can see that the mean reversion characteristics of the over/under market are relatively obvious, and the mean reversion is reflected in two aspects. On the one hand, there is the mean reversion of excess returns, which we have observed in the CSI 1000 and CSI 2000 excess returns, as well as the performance of small-cap stocks in the US stock market compared to large-cap stocks. On the other hand, we divide all A-shares into 5 groups according to market capitalization, and the median P/E ratio ratio and the median price-to-book ratio ratio of the smallest market capitalization group and the median price-to-book ratio of the largest market capitalization group oscillate around a horizontal line, showing obvious mean reversion characteristics. In terms of specific operation, we are grouped according to the market capitalization of all listed companies, which are divided into 5 groups (re-ordered and updated samples every month), the first group is the 20% of the companies with the smallest market capitalization, and the 5th group is the 20% of the companies with the largest market capitalization, and then calculate the median price-to-earnings ratio (price-to-book ratio) of each group. Divide the median price-to-earnings (price-to-book ratio) of Group 1 companies by the median price-to-earnings ratio (price-to-book ratio) of Group 5 companies to measure the relative valuation trend of small-cap stocks. Overall, in the past 20 years, whether it is a price-earnings ratio or a price-to-book ratio, the relative valuation trend of large and small caps has also been range-bound mean reversion.
At present, the logical attribution that we can draw to drive the over/under style is first of all two negative factors, that is, it is relatively obvious that some things are not very related. First, it has little to do with liquidity, and the small-cap style can appear when liquidity is loose (A-shares in 2015) or when liquidity is tight (A-shares in 2013, U.S. stocks in 1974-1982). The second is that there is no inevitable connection with the economic cycle, sometimes it is said that when the economic upcycle, the earnings elasticity of large-cap stocks is large, and small-cap stocks are the subject of speculation, so large-cap stocks are dominant, and sometimes it is said that when the economy is down, large-cap stocks have stronger anti-risk ability and profit stability, so large-cap stocks are dominant. Market investors are prone to congenital preferences, preferring the large-cap style rather than the small-cap style, so everything is explained to the dominance of the market. In fact, in terms of data, it can be clearly seen that the core factors driving the style of the small and small caps have little to do with fundamentals and liquidity.
The second conclusion is that whether it is the A-share market or the U.S. stock market, a significant round of large-cap or small-cap market usually lasts for about 4 to 5 years. This length of time is much longer than the unilateral time of most economic or monetary cycles. This can also be a disguised proof that the over/under style has little to do with these factors. We find that when the U.S. is dominated by small-cap stocks, almost all sectors are small-cap (as represented by the performance of the sector's non-S&P 500 constituents divided by the performance of the S&P 500 constituents in that sector). The reasoning behind this is instructive, as the juxtaposition of small-cap stocks across sectors means that the style itself is not driven by fundamentals, but by investors' inner aesthetic preferences, or by money-making effects. Therefore, in the short term, the small-cap style will not be affected by changes in economic fundamentals or monetary cycles, and thus will indeed last longer than economic cycles or currency cycles. 3 There is a lack of unified standards for the definition of value and growth style, and the two styles have their own focus but are not mutually exclusive. The value factor is undervalued, and the growth factor is the growth of past earnings. Some companies meet both the lower valuation in the value style condition and the higher growth ability in the growth style condition, and can be classified as both value stocks and growth stocks. For example, CNI Value and CNI Growth both use CNI 1000 as the sample space, and 332 stocks are selected each, of which the number of duplicates is as high as 70. 3.1 Criteria for the division of value and growth styleValue and growth style are very important to investors, but they are actually unclear from the perspective of style definition, especially in the very unclear definition of growth. It should be noted that there are differences in the selection of factor indicators for the value and growth style indices in different compilation schemes. If we look at the existing ready-made indexes, the various "value indexes" in the market are essentially "undervalued indexes". The main basis for the compilation of various types of "value indexes" (including "value" in the index name) in the A-share market includes the CNI Value Index (399371), the CSI 300 Value Index (000919), the CSI 500 Value Index (H30352), and the CSI 800 Value Index (H30356). Therefore, in general, the existing value style index in the market is mainly characterized by low valuation. Taking the CNI Value Index and CSI 800 Value Index as examples, the value factor referenced by the index contains four variables, namely: (1) dividend yield (D/P), net assets per share to price ratio (B/P), net cash flow per share to price ratio (CF/P), and earnings per share to price ratio (E/P). After standardizing the Z-score treatment of these four variables to exclude the influence of extreme values, the Z-value mean of the four variables was calculated, and the stocks with the highest average values were selected to calculate the CNI Value Index and CSI 800 Value Index respectively.
And what is the definition of growth style? From the perspective of existing indexes, various "growth indexes" in the market mainly refer to indicators such as the growth rate of a company's (past) revenue and earnings to define whether a company belongs to the "growth index". For example, the CNI Growth Index refers to three growth factors, the growth rate of main business income, the growth rate of net profit and the return on net assets. By normalizing the Z-scores of these three variables and finding the average, the growth Z-value of the company's stock is obtained, and the highest growth Z-value is the sample stock of the CNI Growth Index. The growth factors of the CSI 800 Growth Index include three variables: the growth rate of main business revenue, the growth rate of net profit and the internal growth rate. By standardizing the Z-scores of these three variables and obtaining the growth scores of the company, the highest growth score is the sample stock of the CSI 800 Growth Index.
This method of compilation can lead to several problems. The first problem is that the value style and the growth style may coincide, because in the process of compiling the index, it is actually compiled according to two completely different sets of ideas. So in this case, when some low-valued industry sectors happen to be in a relatively high earnings growth rate, then it is both value and growth. Therefore, it can be seen that the CNI Growth Index or the CNI Value Index, if they both use the Wind All-A Index as the benchmark, their excess return trends will rise and fall in many cases.
The second problem is that the Growth Style Index is not necessarily representative of true growth companies. The growth style index is compiled to use past financial data to derive the future, but the high growth in the past does not represent the high growth in the future, and often after a company has been growing high for several years, when it is included in the index, the growth rate may slow down. This is a troublesome place, and there is no way to select future high-growth companies based on historical data. Therefore, in current practice, there are very few "growth indexes" that are commonly recognized by investors.
We believe that "growth" is not a unique attribute of some industries, but the performance of the characteristics of different industries at different stages, not only TMT and new energy are growth stocks, railways, steel, banks, home appliances and other industries have appeared as "growth stocks" at different stages of economic development. From this point of view, we believe that the essence of "growth" is the upward prosperity of the industry. According to the different ROE trends of listed companies, a clear definition of "growth" and "value" can be given: in the first case, the ROE trend is upward, which is what we consider to be "growth" stocks. This is the preferred product in the sector rotation, in which case investors can make money on both performance and valuation. In the process of ROE continuing to rise, it is generally a process of continuous increase in valuation. Historically, these sectors have had excess returns. In the second case, ROE is basically flat in the sector, which is what we consider to be "value" stocks. Because ROE is basically flat, valuations have generally remained at a certain level and have not changed much. Therefore, this variety is basically a quasi-fixed income asset, and investors can make money on performance, but not on valuation. In the third case, the ROE continues to decline, and the industry in this case belongs to the recessionary industry sector. This kind of sector should be resolutely avoided, because the ROE continues to fall, and it is not known where the bottom of the valuation is, so if investors buy on the grounds of low valuation, they will often fall into the trap of low valuation. According to this analytical framework, no industry sector is inherently growth or value, and the same industry sector can have different growth value attributes at different time stages. Typically, taking the liquor industry as an example, the growth and value attributes are not the same at different times.
3.2 The Cyclical Law of Value and Growth StyleFrom the perspective of long-term history, similar to the relationship between large-cap and small-cap styles, there is no superiority or inferiority between value and growth style, and the long-term trend of the global stock market and the A-share market shows that value and growth styles rotate repeatedly.
3.3 Drivers of Value and Growth StylesIt is relatively easy to judge when value styles prevail. Generally speaking, when nominal economic growth is on the upswing, the value style usually prevails. Since the nominal economic growth rate is equal to the real economic growth rate plus the inflation rate, and the change in the inflation rate is much larger than the real economic growth rate in the years when the inflation level fluctuates significantly, it can also be considered that the value style performance is superior during the period of rapid inflation rise.
From the perspective of the industry composition of the value style index, it is also easy to understand that the top three industries with the highest weight in the CNI value index are finance, materials, and industry, and in general, these industries are obviously pro-cyclical. During the period of upward nominal economic growth, the profitability of these industries has generally improved.
It is worth mentioning that the predominance of value style has obvious post-cyclical attributes. Value-style excess returns have some lag compared to changes in nominal economic growth. The value style of the upward cycle of nominal economic growth just mentioned is superior, but the reverse is not true, similar to the fact that the upward growth rate of nominal economy is a sufficient but unnecessary condition for the superiority of the value style. We note that when the economic cycle begins to switch and enters the downward cycle, the market generally falls, but the value style has a low valuation defensive attribute, so it can often outperform the market for a period of time, which is the case in 2013 and 2018. On the whole, the value style is usually dominant during the upward period of nominal economic growth and the early stage of the downturn. It's relatively complicated when growth styles prevail. Judging from the historical experience of A-shares, the leading sectors over the years are basically industries with upward prosperity (that is, sectors with an upward trend in industry ROE). For example, liquor from 2016 to 2019, coal from 2021 to 2022, lithium batteries from 2019 to 2021, etc. From this point of view, whether it is the A-share market or the overseas market, investors are actually looking for industry sectors where the market boom is accelerating at any point in time.
However, an important difficulty in actual operation is the non-linear consistent change of the stock price trend and prosperity change of the plate, which is reflected in two aspects: one is overshooting, and the other is rushing. The so-called overshoot is when the initial change in the stock price will exceed the equilibrium level it should eventually reach. The main reason for the overshoot is that the market is prone to linear extrapolation of fundamentals, which is prone to the characteristics of stock price changes that significantly exceed the changes in fundamentals. And the problem of front-running is even more tricky. Stock price changes lead fundamental changes, and the market diverges sharply. For all these reasons, it is difficult to find an adequate and necessary indicator to explain the predominance of growth styles. 4 Dividends and Quality StyleFrom the perspective of style definition, dividends and quality are not completely relative concepts, but from the perspective of historical trends, the negative correlation has been obvious in recent years. The dividend style focuses on dividend yield and dividend stability, while the quality style focuses on earnings quality and cash flow. The dividend style has obvious advantages over the low valuation style or the value style, and the driving factors for achieving excess returns include the low interest rate environment and the company's stable earnings, while the characteristics of the quality style are not distinct. 4.1 Criteria for Dividing Dividends and Quality StyleThe base dates of the CSI Dividend Index and the CSI Quality Growth Index are the end of 2004 and mid-2005 respectively, which are two indices with a long time span for studying the historical law of A-share dividend style and quality style. The CSI Dividend Index adopts a dividend yield weighting method, focusing on the dividends of the past three years and the past year. In terms of specific operation, the bottom 20% of the securities ranked in the average daily total market value or average daily turnover in the past year are first excluded, and then the listed companies that meet the conditions of continuous dividends in the past three years are screened, and then the top 100 companies are selected to enter the constituent stocks according to the average dividend yield from high to low.
The CSI Quality Growth Index (Quality Style) adopts the smart beta method and takes into account four quality factors, including ROA, growth, cash flow from operating activities to debt ratio, and earnings quality indicators calculated based on financial report data and models.
4.2 The cycle law of dividends and quality styles is not too long in the history of A-shares, it is difficult to make a clear distinction between dividends and quality styles, and there are more frequent style switches between the two, which may be switched about once every 3 years.
From the definition of the index, the quality style characteristics are not very clear. The biggest problem brought about by the comprehensive weighting of the four quality factors is the unclear risk exposure of the index. From the perspective of alpha trends, it is more difficult to find indicators to characterize or explain the rise and fall of quality style due to the mixing of multiple variables. It is possible to compile the quality index under different sample spaces (CSI 300, CSI 500, CSI 1000, etc.), and their differences will be relatively large.
Historically, the dividend style has been an advantageous strategy over the low valuation style. If the CSI Dividend Index is used to remove the low price-earnings ratio index, it can be seen that the dividend style is basically completely dominant, and long-term and stable excess returns have been achieved. If the CSI Dividend Index is used to remove the Wind All A Index, it also shows a general upward trend, which is obviously different from the previous value style compared with the flat trend of Wind All A.
4.3 Drivers of Dividend and Quality StyleFactors driving the excess return of Dividend Style include a low interest rate environment, stable corporate earnings, etc. The former is easy to understand, when interest rates go down, dividends tend to perform better. Because for investors who are looking for high dividends, the opportunity cost of holding dividend stocks is the interest rate. Judging from the stock market performance of the United States and Japan over the past 30 years, the dividend (high dividend) index has achieved significant excess returns compared with the domestic broad-based index during the downward phase of long-term treasury bond yields. The trend of the A-share market is similar, in recent years, in the process of rapid decline in interest rates, the entire high dividend style, that is, the dividend style, has performed relatively well. The second factor, stable corporate earnings, is the most important reason for the significant divergence between the dividend style and the undervaluation style. Univariate undervaluation indices fluctuate, but there is no excess for a long time, and if you add the variable of stable earnings, you will find that you can obtain better sustained excess returns.
Finally, to make a brief summary, from the above three groups of styles (large and small, growth and value, dividend and quality), we can find the following rules: first, the large and small market style has obvious mean reversion characteristics, and the mean reversion is reflected in two aspects, the mean reversion of excess returns and the mean reversion of relative valuation; Second, the value style has excess returns in the early stage of economic upswing and downturn, and shows obvious post-cycle attributes. Value constituents tend to be pro-cyclical, with superior profitability improvement performance during the upward period of nominal economic growth, and low valuation defensive attributes in the early stage of downturn. Third, the dividend style is a dominant strategy compared with the value style, and the driving factors include the low interest rate environment and the company's stable earnings. Fourth, some styles may last longer than the economic cycle and the monetary cycle, which may be related to behavioral finance, and it often takes more time for the market to reach a consensus in a market where the drivers are not clear. Fifth, investable style factors should be variables that can be identified based on past information, and should not include variables that need to be predicted for the future. For example, growth investment strategies and reasonable valuation strategies (GARP) have the risk that the past is not indicative of the future. 5 Risk Warning: Historical experience is not indicative of the future. There are many risks associated with inferences based on historical experience, and many changes in the market environment over time, including political, economic, technological and social factors, may result in past investment experience no longer being applicable in the future. The macroeconomy is worse than expected. A weaker-than-expected macroeconomic situation could adversely affect the stock market by leading to a decline in corporate earnings and a decline in investor confidence. Risk of changes in economic policy. Changes in economic policies may lead to increased market uncertainty, which may lead to disagreements among investors about the future economic and market outlook, increasing market volatility. geopolitical risks, etc. Political turmoil and geopolitical conflicts can cause investors to worry about the economic outlook, capital outflows can cause stock markets to fall, and exchange rate fluctuations can also affect international trade and investment. This article is from the report "A-share Style Rotation: Cyclical Laws and Driving Factors" released by Huafu Securities Research Institute on May 14, 2024. Analyst: Yan Xiang, S0210523050003 Jinhan, S0210523060002 new book recommendation |"Pursuing the Road to Value: 1990~2023 Chinese Stock Market Review" This book systematically reviews the market trend of A-shares in 1990~2023 since the establishment of China's stock market, and pays more attention to the use of quantitative empirical evidence to explain market changes. The author tries to construct a "four-in-one" analytical framework for review, that is, macroeconomy, corporate earnings, interest rate level, and asset price comparison. Each year's market review is divided into three parts: the first part is a review of major events, which provides a narrative description of key events affecting the capital market; The second part of the economic situation analyzes the macroeconomic situation and the changes in the earnings and valuation of listed companies; The third part of the market characteristics analyzes and explains the structural characteristics of the stock market in the current year. The last two chapters of the book provide an overview of the investment framework, methodology and key issues of the A-share market. In order to do a better job in the review research, the new version of "The Road to Pursuing Value" has made a lot of revisions, including: first, it has continued to write the review of the A market in the last three years from 2021 to 2023; The second is to reconstruct the annual strategic topics, and the methodological part with universal significance is summarized in the last two chapters of the book for a framework summary, so that readers can better understand the basic logic of A-share operation; the third is to increase a large number of special columns to think and discuss many special issues; Fourth, add inductive tables and data summaries to highlight the reference book attributes of this book; Fifth, the content of the original chapters has been supplemented and revised to a considerable extent. Overall, no less than 40% of the new version has been updated and revised. At a time when the mainland is speeding up the construction of a financial power, the era of a comprehensive registration system has begun, and the capital market has attracted widespread attention from the whole society, we sincerely hope that the new edition of "The Road to Value" can help readers better understand the historical details of the past A-shares, so as to rationally and scientifically judge the short-term, medium- and long-term trends of the future market.
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