One of an investor’s most important tasks is deciding how to allocate his or her capital among various types of investments. Studies have indicated that as much as 90% of a portfolio’s return is determined by the way you divide your money among major “asset classes” such as stocks, bonds, and cash.
That’s not the end of the diversification road, however. Important subgroups exist within each asset class that are ignored at an investor’s peril. Within the stock category, at least two major divides exist: small vs. large companies, and value vs. growth styles of investing.
Company size is fairly easy to understand — add up how much it would cost to buy all of a company’s stock at the current price. Businesses worth many billions of dollars are “large” companies (such companies are found in SMI’s Risk Category 1 and 2 funds — see the Fund Upgrading Recommendations page). Those whose worth is measured in the hundreds of millions of dollars, rather than billions, are considered “small” (Risk Categories 3 and 4). The cutoff between the groups shifts over time, but the concept is easy to grasp.
“Growth” and “value” styles are not as easily understood, but they’re important terms because of their frequent use. What do they mean, and which of the two styles should you favor?
First, understand what is meant by the term “style.” There are many ways to make money in the stock market, but one key is figuring out a successful approach and sticking with it. Most fund managers have discovered a specific approach that works for them. That approach, whatever it may be, is the manager’s style. While every manager would like you to believe his or her approach is unique, in reality most fit into one of two broad camps: growth or value.
Growth investors look for companies that have above-average growth in earnings. There’s little doubt that as a group, the companies whose earnings grow the fastest will see their stocks appreciate the most in the short-term.
The market rewards growth. There are many ways a company can grow faster than its peers — through superior technology, better products and/or marketing, being the first player in a new business niche, or by being the low-cost producer (or enjoying other efficiencies its competition does not). Often, a successful growth company may have more than one of these attributes (Amazon is an example of a company that clearly enjoys multiple advantages).
If the market is so enamored with growth, why doesn’t everyone rush to buy these same companies? The answer is simple: price. The companies that exhibit these qualities are invariably more expensive. Because higher growth leads to higher stock appreciation, the price investors are normally willing to pay for that growth is higher. That’s where the concept of value comes in: is a stock a good buy, taking into account not only its future prospects but the (possibly high) price being paid for it as well?
Value investors understand that every stock has an intrinsic “fair value.” Whether a company is an industry leader or in an exciting niche is secondary to value investors. What matters more is if the stock is trading at a price higher or lower than what the investor believes its fair market value to be.
As you might expect then, being able to determine the appropriate fair value price is central to success as a value investor. Calculations such as price-to-earnings ratios, price-to-book-value, and many others are used in this process, although most value managers dig quite a bit deeper than these widely used measures. Value investors often invest in companies whose shares are selling at bargain prices due to earnings problems or other bumps in the road. Often, years go by before the market recognizes the hidden value in these out-of-favor companies. It takes courage to buy a particular stock when everyone else is selling, and patience to wait for companies to right themselves sufficiently to again attract greater investor interest. These are two hallmarks of successful value investors.
In short, growth-fund managers tend to favor stocks on the basis of their superior future prospects, while value-managers look for bargains in relation to what they see as a company’s true value. When all the factors align, growth stocks can really soar. On the other hand, any disappointments hit growth stocks hard because they’re priced for success. Value stocks generally offer lower risk in down markets, since less is expected out of these companies to begin with.
This is clearly demonstrated in the nearby table. In 1998-1999, growth stocks boomed along with the economy while value stocks were dormant. The tide quickly turned in the early 2000s though, as value stocks outperformed in four of the next five years.
So which style works better overall? Surprise — they both work! As the summary at the bottom of the table shows, over the last 40 years the cumulative difference between the two camps has been extremely small. (Growth and Value each led in 15 of the 30 calendar years shown in the table.) The truth is, both styles tend to generate similar returns over time. They just get there differently.
Neither approach is inherently superior to the other, and you can benefit by owning funds from both groups. That’s a chief virtue of diversification — as the value portion of your portfolio zigs, the growth portion can zag, and vice versa. Over time you get roughly the same type of returns either style would have provided independently, but with much less volatility — and anxiety — along the way.