Investment Styles: Equities

Posted By: Advisor Analyzer Team

When I hear the word style I think hair…and tight fighting leather clothes. Automatically, images of 80’s punk rockers with Mohawks and too much make up fill my head. In a sense, style is what differentiates us from the next guy. Much like the fashion industry, in the world of investments, portfolio managers use different techniques to produce different returns. Needless to say, equity investing is anything but repetitive.

Style #1: Value Investing

Investors focusing on the numerator of the P/E or P/B ratios (the price) of an investment focus more on a low market price relative to the earnings or book value. Therefore, they buy investments with low P/E ratios. Value investors believe stock price depreciation is temporary and will eventually rise in the future. Their investment decisions are consistent with behavioral finance, which assumes investors generally overreact to bad news, pricing the investment too cheap.

 

Within value investing are sub styles that further distinguish investors. Some look for high dividend yields as a source of compensation for waiting for the price reversion. Others look for lower price multiples in hopes that cyclical macroeconomic factors will eventually increase the market values as a whole. There are also contrarian investors who deliberately look for depressed securities with the potential for appreciation that sell for less than book value.

 

Critics of value investing believe that overall, the markets are efficient. The discounted price is merely a reflection of market and liquidity risk, and the price valuations are fair for the amount of information available. Regardless of whether this is right or wrong, value investors should consider what factors would be required to return the company to industry ratios, as well as the timeframe to do so.

Style #2: Growth Investing

Unlike value investors who avoid investing in high earnings multiples investments, growth investors focus on a firm’s expected future growth in earnings. Put another way, value investors focus on the numerator, and growth investors focus on the denominator of the P/E ratio. Therefore, growth investors place less significance on the market price of a company and focus more the growth prospects of earnings.

 

This strategy usually performs best when the economy is in a contraction state, since this is when firms have the least growth prospects, and thus most likely to see valuations increase. In periods of high expansion, growth stocks will tend to grow quicker, therefore the premiums are generally reduced if not eliminated.

 

While this may seem counter intuitive, think about it logically: in recessionary times, growth stocks will not be purchased since the future earnings prospects are relatively bleak. Purchasing these companies prior to the expansion phase and holding them throughout this period will be the optimal choice. Conversely, purchasing the same companies at the peak of their earnings growth cycle, will most likely result in poor returns and accelerated slow down of earnings.

 

Growth investing is usually categorized into two sub styles: consistent earnings growth expectations, and momentum. As the names imply, the consistent earnings sub style tends to focus on companies with predictable growth rates while momentum looks for accelerated growth and record earnings. Portfolio managers may hold these companies as long as the momentum trend is in play, but sell when the growth rate begins to decline.

Style #3: Market oriented investing

Market oriented investing is neither a value nor growth style, but a blended core approach. Market oriented portfolios resemble the returns of broad market indices over time, but it may also focus on stock prices or earnings of a company as well (i.e. the numerator and denominator of the P/E ratio). Due to the fact that idiosyncratic factors are taken into consideration, market oriented investing is not a passive investment approach. Therefore, a major challenge for those utilizing this method is to consistently outperform the benchmark index. Failure to do so over the long term will make justification of active management fee’s difficult, since investors would be better off in low cost exchange traded funds.

 

There are three sub-styles used under the market oriented approach: value or growth tilting, growth at a reasonable rate (GARP), and style to factors. Value or growth tilting is a combination of the previous styles to the diversified market portfolio. The GARP method searches for stocks with promising growth potential that are priced at moderate valuations. The style factors approach is most flexible in that it allows the manager to adopt any style they feel will outperform in the future.

Conclusion

While there are many more styles that are utilized in the investment profession, these three are usually the most recognized by the overall industry. Investors should note different styles are better/ worse than others depending on the market environment. Granted, the range of investment styles available don’t hold a candle to the eclectic hairstyles and colorful clothing that littered our magazines and runways of the 80’s. However, I honestly believe few things in life ever will.