Going for growth
Professional investors often have what’s known as a “style bias”: they tend to favor a certain type of investment over others.
That bias may be towards companies that are growing their sales, profits, and stock prices at a rapid rate – or, conversely, towards companies whose overall value, represented by their share prices, appears to be pinned by investors at a relatively low level compared to what they’re truly worth. The combined value of all the company’s shares could come in below the actual value of, say, the things the company owns, like property and machinery.
Then there are investors who like to wade in when companies are at a pivotal point in their development – perhaps having just made a major acquisition – or instead focus on the effect specific external factors are likely to have on a firm’s fortunes.
While it’s not always the case, pro portfolio managers often exhibit a marked preference for one type of investment. And seeing as you’re reading this Pack, you’ll be glad to hear that there’s nothing to stop you from doing the same if you choose. With that in mind, let’s get straight into it and lift the lid on the tastiest types of investment style.
Growth investing
The clue’s in the name: this style is all about “growth”. But what sort of growth, exactly? Essentially, investors adopting this technique seek to single out companies that they think will eventually be able to grow their profits substantially: ultimately, owners of their stock will benefit from those profits in the form of either regular dividends or simple share price growth as other investors cotton on and pile in.
But since these profits may not actually, er, exist until some potential point in the future, growth investors tend to focus on more immediately discernible evidence of green shoots – especially revenue growth. If a company is increasing its sales at a decent clip then, so the thinking goes, it should eventually figure out how to grow its profit too. Tech giants Amazon and Facebook (for more on which check out our dedicated Packs) are textbook examples of growth investing gone well; meal kit maker Blue Apron, meanwhile, is a prime paradigm of when things turn sour.
Over the past ten years, such “growth stocks” have outperformed the global stock market overall by about 2% per year, or almost 20% in total. The biggest growth stocks – the FAANGs, collective subjects of yet another Pack – have performed even better: the likes of Netflix have seen their share prices increase in value by more than 10 times the wider market. Perhaps unsurprisingly, given such performance, investing in growth stocks has become an extremely popular strategy…
The takeaway: Investors often adopt distinctive approaches – and growth investing, which involves seeking out stocks deemed likely to deliver progressively higher sales and profits, is one of the biggest.
Bargain hunt
Value investing
You might think growth investing is the only show in town – after all, doesn’t all investment involve betting on businesses that you think will grow? In many ways, however, “value” investing does precisely the opposite. Instead of focusing on what a company might be worth after a few more years of expansion, value investors focus on figuring out what a company is really worth right now. And if their calculations find that to be much more than its current stock market valuation, then they’ll buy the “cheap” stock – and wait for the market to catch up and re-value it higher.
Instead of searching for sales growth, value-oriented investors look at things like the present value of the equipment or real estate that a company owns. They also tend to weigh up how much profit the company is making today, and especially how much actual cash it’s generating: “profit” from an accounting perspective and the money that goes into a company’s bank account at the end of the year can be two very different things. Terms like price-to-book ratio, which means the value of the company relative to the assets it owns, and measurements like dividend yield – how much of its profit the company shares with investors as a percentage of its market value – tend to be very important to value investors. And it’s an approach that can, er, pay dividends – check out our Pack on Warren Buffett to find out more about just how the undisputed king of value investing does it.
“Magic formula” investing is one popular investment process that uses relatively straightforward value-focused metrics to identify attractive stocks. This and other strategies claim that, since they involve buying companies that are relatively cheap _right now _– easier to work out than predicting the true value of a company in, say, five years’ time – then the likelihood that they’ll lose you money is relatively low, especially compared to just investing in the entire stock market. It’s kind of like buying a used car at a good price: it shouldn’t get much cheaper – unless, of course, it falls apart.
Growth versus value
The fact remains that growth investing strategies have outperformed value investing over the past decade. While attempting to explain that phenomenon could – and does – fill entire books, two major reasons for this are the revolutionary technological changes that the world’s undergone in that time – favoring young and innovative companies like Google parent Alphabet – as well as the ready availability of investor money.
Tesla is another great example of a winner: it would have been near-impossible for the nascent electric car company to survive a major recession or some other event that put investors off perennially loss-making businesses. In the absence of this, Tesla has instead raised billions of dollars from investors to fund the development of its transformative technology. As the world embraces electric cars, Tesla has ended up well placed to take advantage – and its stock price has accordingly zapped higher.
The takeaway: Value investing attempts to find companies that are undervalued based on what they own and/or how much they earn today – but while proponents claim it’s a lower-risk approach than growth investing, it’s also proved lower-reward recently.
The X factor
Growth and value investing are just two examples of factor investing: using a set of fixed rules to find investment ideals. And there are several other popular factors to be aware of. One is momentum investing, where investors “screen for” stocks whose prices have gained the most recently in the hope that that performance will continue.
Then there’s the low volatility factor, where you try to select those stocks whose prices have swung up and down the least recently. Or the factor that allocates money to smaller stocks in the assumption that they could stand to gain more, percentage-wise, than larger ones.
On the face of it, these strategies might sound a bit far-fetched – or at least too simple to succeed – but plenty of smart people spend their whole careers trying to prove (or disprove) that these factors can reliably beat the wider market.
You can screen for factor-fitting stocks yourself using share data available online; but you can also easily find exchange-traded funds (ETFs) that track these factors and many more. You might see them marketed as “smart beta” ETFs. We’ll give you a few names in the next session – but check out our dedicated Pack on ETFs And Smart Beta if you want to know more.
Special situation investing
Outside of these smart beta factors, there are a few other approaches to discuss. One big one is “special situation” investing – also known as “event-driven” investing, which is perhaps an easier way to think about it: an event happens, and an investor tries to take advantage of it. The favorite type of event varies: perhaps it’s a company missing a loan repayment, or one business buying another. But whatever the occasion, the special situation investor usually takes a view that it fundamentally changes the outlook for a particular company – and looks to profit from this by betting either on or against the firm.
An event-driven investor may, for example, “short” the shares of a company that’s just agreed to spend a significant sum buying a rival. There are all sorts of risks associated with a big merger, and perhaps the investor feels the acquiring company won’t be able to get enough value out of the deal given the price it’s paying. On the other hand, some investors might take the view that the market is misunderstanding the takeover and is failing to appreciate just what a great deal it in fact is.
Developing such sophisticated views – and, crucially, being correct about them – usually requires the specialist skills of an experienced expert like an investment banker (or an accountant, if the company is facing potential bankruptcy). For these reasons, special situation investors tend to look a bit different to your typical stock-picker. Some, indeed, are so confident of their assertions that they seek to create certain situations for companies: the so-called activist investors. But those rarefied abilities also mean their portfolios are less likely to correspond to the value of the overall market, instead offering something very different. The diversification thus offered by a special situation fund can sometimes be very attractive to other investors – and very profitable.
The takeaway: Special situation investors take a view on how certain events will pan out for companies – while factor investing involves looking at stocks in light of particular characteristics.
Substance over style
Before we introduce you to some of the biggest funds out there allowing you to invest with either a growth or value style bias – and with ease – it’s important to differentiate between the “passive” and “active” approaches on offer.️
Passive funds tend to simply track an investment index – but do so at a relatively low cost. Just as you can buy funds that track the performance of, say, the US S&P 500, so too can you find passive investment options incorporating a factor-based approach. Instead of following well-known indexes like the S&P 500, these funds track more bespoke groups of stocks – pre-screened to include only companies that fit certain growth or value characteristics.
The only active decision being taken there is setting those parameters in the first place. By contrast, actively managed funds may, in addition to having an overarching style bias, employ stock-picking strategies that are less strictly formulaic – and instead rely more on the judgment of an investment manager. That idiosyncrasy could lead to unusually high returns compared to simply following the crowd – but the manager’s active services will usually command a higher fee…
Some of the largest growth funds available to investors like you include:
- Vanguard Growth exchange-traded fund (ETF) (passive)
- SPDR Portfolio S&P 500 Growth ETF (passive)
- Schwab US Large-Cap Growth ETF (passive)
- Fidelity Growth Discovery Fund (active)
- MFS Growth Fund (active)
And among the world’s biggest value funds are:
- Vanguard Value Index Fund (passive)
- iShares MSCI World Value Factor ETF (passive)
- iShares S&P 500 Value ETF (passive)
- Vanguard Selected Value Fund (active)
- Homestead Funds Value Fund (active)
- MFS Value Fund (active)
Conclusion
Conventional wisdom suggests that investing in a mix of styles – and thereby increasing the diversification in your portfolio – may be the way to go. Clearly, such an approach would have underperformed a purely growth-oriented strategy over the past ten years – but the next decade could well tell a different story, as the broader economic environment perhaps begins to favor companies that look like a better fit for the value bucket… 🤔
The takeaway: There are passive and active means of implementing your chosen style bias – but whatever you choose, keep an eye on the economy and adjust your approach accordingly.
In this Pack, you’ve learned:
🔷 Investors often adopt distinctive approaches – and growth investing, which involves seeking out stocks deemed likely to deliver progressively higher future sales and profits, is one of the biggest.
🔷 Value investing attempts to find companies that are undervalued based on what they own and/or how much they earn today – but while proponents claim it’s a lower-risk approach than growth investing, it’s also proved lower-reward recently.
🔷 Special situation investors take a view on how certain events will pan out for companies, while factor investing involves looking at stocks in light of particular characteristics.
🔷 There are passive and active means of implementing your chosen style bias – but whatever you choose, keep an eye on the economy and adjust your approach accordingly.
