In our view, a more important factor than style, declared or otherwise, is a manager’s discipline to his or her particular set of decision-making criteria.
Value investing and growth investing. In normal times, most stock-fund portfolio managers fall into one of these two style categories. (In other times, when stocks in certain industries soar, momentum investing attracts a lot of followers.)
But while clear descriptions of these two management styles exist, few managers actually operate according to one at the exclusion of the other. What’s more, many shades of grey exist between the two.
Today’s asset value vs future growth
In simplest terms, value investors look at a company’s assets with replacement value in mind. These investors want high book value relative to share price. They want low share price relative to actual earnings in the latest year. They look for high dividend yields, steady and reliable earnings, and hidden assets.
In short, value investors look for stocks trading at prices below the value of the assets today.
Growth investors, on the other hand, look to the future. We may know a company’s earnings in the immediate past. But what about next year? Surely, a company with rapidly-growing earnings is worth more today than one whose earnings grow slowly.
Expansion of earnings tends to show up in different industries at different times. Today, for example, technology stocks such as Apple have enjoyed rapidly-growing earnings. On the other hand, grocery stores have seen their earnings grow more slowly because food retailing is a mature industry.
This may all sound simple enough. But what happens when a company’s earnings grow more slowly than investors’ expectations? Disappointment can lead to dramatic declines in share price. That’s the problem with growth investing. It involves guessing about the future.
In the case of value investing, things can get similarly complex. In most cases, assets have value only if they can generate future earnings. A classic valuation problem asks for how much General Motors could sell its real estate in Flint, Michigan. When not used for making cars, that land has proved to be worth little.
That assets have value only as they can be used to generate earnings means the distinction between these two styles is often blurred. And so you have hybrid investing styles such as “growth at a reasonable price”.
Investors often think of value investing as the more conservative. If a company’s shares have a low price relative to what’s known today, they aren’t likely to fall much in a poor stock market. But expectations for future earnings can change quickly and dramatically. And that can drive share prices sharply lower.
Meanwhile, of course, proponents of growth investing feel short-term stock-market fluctuations have little to do with a company’s ability to increase earnings in the longer term.
Discipline is critical
In our view, a more important factor than style, declared or otherwise, is a manager’s discipline to his or her particular set of decision-making criteria. The best managers use a consistent approach to stock picking, even when nothing seems to work.
After all, if you sell a stock simply because it’s performing relatively poorly, you will have participated in at least part of the under-performance. Then, if you move to a stock that looks better, you will have missed part of that superior performance. And what if that superior performer then turns into an under-performer? Do you repeat the same process over again?
To abandon an out-of-favour style, then, may be simple folly. So remaining true to a set of proven criteria becomes the second-most important factor in portfolio management. The first and harder part, of course, is finding the proven set of criteria.
This is an edited version of an article that was originally published for subscribers in the September 25, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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