In my previous article in this series, I looked at the role of investment styles in how asset management firms pick stocks and shares. I also delved into the pros and cons of the value investment style. In this article, I’ll briefly look at some of the other popular investment styles.
The minimum volatility style aims to reduce portfolio risk and the possibility of capital losses by investing in stocks that show low volatility in their price movements and earnings. Hence, a minimum volatility portfolio will be largely comprised of solid blue-chip companies that show steady rather than stellar growth, pay a reliable dividend, and are reasonably resilient in market downturns.
There is evidence that a well-constructed minimum volatility portfolio can deliver market-related returns with less risk than some of the other styles. The downside is that investors who stick to these steady performers without also investing in some growth stocks could be forgoing the opportunity to outpace the market. This approach is particularly well suited to market slowdowns and economic contractions.
Momentum investing follows the trader’s adage, “The trend is your friend”. In other words, stock prices that are currently climbing are likely to remain on their upward trajectory.
Momentum investing portfolios work especially well in bull markets, where success breeds success. Once a stock starts to soar, more retail investors and funds will buy into it, causing its value to rise further, attracting more investors to what seems like a safe bet…until there is some bad news about the stock or the economy.
The danger in momentum investing is that the trend is your friend — until it’s not. High-flying stocks can plummet to earth quickly if there’s some negative news from the company, such as a missed quarterly earnings target. The subsequent repricing of the stock can lead to severe losses for investors who buy into a stock as its value is peaking.
Some asset managers who have a mandate to pursue higher risk, higher reward strategies favour investing in smaller companies over the well-established and reliable S&P 500 or FTSE/JSE Top 40 stocks. The thinking is that smaller companies will often outperform larger ones because they are more agile, have more headroom for growth and may be less well analysed and covered.
Smaller companies can be riskier bets—their stock prices are more volatile and more vulnerable to market movements, they are more likely to go bankrupt, and they are less liquid than larger listed companies. This strategy works best when the market is recovering from a downturn or is already doing well.
This investment style focuses on maximising capital growth, with a focus on investing in companies that are expected to outpace the rest of the market in earnings growth. Investors might identify such companies by factors such as higher than average historic earnings growth, rising return on equity, and projected forward earnings growth.
As is the case with the size style, growth investment is a high risk, high reward approach. It can deliver excellent capital growth. Capital losses can be steep, however, when a stock is priced to deliver earnings targets it never meets, as was the case with many stocks in the dot-com era. It’s also a research-intensive process to identify growth stocks and shares; what’s more, growth stocks often reinvest profits in the business rather than distributing dividends.
My next column will discuss the advantages and disadvantages of focusing on quality and look at the Dynasty approach to portfolio construction.