Decades ago, the academic community and financial services industry, in an effort to better understand what causes good versus bad rates of return in stock markets, began studying differing styles of investment management. There isn’t a hope of my staying awake long enough to cover even a sampling of the variety of styles that are out there, so I’ll keep it simple. Two styles in particular get plenty of attention: growth and value.
With the growth style, portfolio managers use their ingenuity to identify companies that are growing most rapidly. Since I carried around a BlackBerry (aka CrackBerry) for many years, I’ll use its creator Research in Motion (RIM) as an example. When the company was first getting its legs, it offered me and other research analysts a free trial of a little device with a monochrome screen that allowed you to send and receive text messages. We became addicted to them overnight and believed that this kind of service would catch on. Early movers can grow businesses very quickly with sufficient research depth, management expertise, and capital. We professional money managers provided the capital to RIM and the rest is history.
Early on, RIM was a growth company because even though they weren’t profitable and wouldn’t be making money for many years, the company kept selling more and more units. Revenues grew like crazy and, with some occasional disruptions (a market crisis, the technology bubble bursting), so did the stock price.
Portfolio managers who specialize in companies such as RIM are commonly called growth managers. The funds they manage are “growth funds.” The portfolio will usually have many stocks in various industries. They can be fast growing companies in slow growth industries or companies benefitting from an industry that is suddenly growing. Growth stocks can be very expensive. Investors expect the company to grow fast and so are willing to pay a higher price. However, you’ll have to buy a book explaining price/earnings (P/E) ratios, P/E to growth rate ratios, price/sales (P/S) ratios if you really want to get into security analysis yourself.
A value manager is more interested in buying and owning cheap stocks. Some companies grow slowly but pay their shareowners high dividends as compensation. A stock can be in an industry that is out of favour with the investment herd, or an industry can be out of favour entirely, making all the stocks in the sector cheaper. There are measures such as price/book ratios (P/B) and price to net asset value ratios that analysts use to gauge whether a stock is cheap or not.
Growth funds are considered riskier or more volatile than value funds. For instance, if the market is going higher because of a particularly strong economy, then the growth fund should go even higher still. A value manager might not perform as well as a growth manager in a bull market but won’t do as poorly in a bear market. A value manager is therefore considered more conservative.
A strategist friend of mine of TD Newcrest Research allows me to use his charts on occasion. One of the most telling charts compares growth stocks in the S&P 500 Index to Value stocks. The adjacent chart is an older one. When the line is rising, growth stocks are significantly outperforming value stocks. You can see vividly the technology bubble – growth stocks skyrocketing relative to value stocks – prior to the bubble bursting in the year 2000.
The shaded areas are periods of economic stimulation (US Federal Bank monetary easing). During these periods it’s not unusual for growth funds to perform much more strongly than value-oriented funds.
Conventional wisdom says that conservative investors who can’t stomach as much volatility should use value funds and that investors who don’t mind a wild ride should use growth funds. Alternatively, you can invest most of your money into a value fund while also putting some into a growth fund so that you might occasionally get more returns in a buoyant market with at least a portion of your savings.
Why not growth when growth is performing and value at other times?
There are portfolio managers like me who hate being pigeonholed into either one of these styles. However, it is inevitable that one label or the other will be associated with a money manager because of the way consulting services are compensated and the way mutual funds are marketed (when growth is sexy, it only makes sense to promote the growth manager).
A maverick investor who understands the ebbs and flows of market sentiment will want to be invested in their favourite growth fund at the right time and to switch into a value fund at other times.
Whenever I’ve recommended a more active approach to selecting mutual funds in print or on television, such as using a growth fund and switching into a value fund when appropriate, I always get the same question: “How do you know when to switch?”
There is an easy answer, but nobody likes hearing it. The answer is: “You will know!” You should switch when your intuition or emotions tell you not too. It is that simple. If the fund you own has been doing extremely well and drifted up towards the top quartile or is now in the “best performing funds” category (rankings are available from a wide variety of publicly available services) and so you’ve begun to love it dearly, it’s time to switch into a different style of fund.
Here is a more current chart. In this case the shaded areas are periods of recession, and we are all aware that for the past few years monetary stimulus has been the norm. Not surprisingly then, growth stocks – avoided by most investors like the plague – have been outperforming value stocks.
As investors divest their income biased stocks (and bonds) they will naturally be tempted to move the money into the better performing growth style. However if history (and experience) is any guide, they’d be well advised to focus their attention on stocks and funds that have not yet participated in the recent market rally. In the event that government policy, encouraged by the rebound in the housing market, strong corporate earnings and slowly improving employment outlook, becomes less stimulative then value will in all likelihood become the place to be.