Most wealth and asset management firms have a set of overarching philosophies that guide how they pick assets and securities in which to invest. There are several dimensions that they will consider when they choose securities or assets on behalf of their clients – the active versus passive debate, local versus offshore, and tolerance for risk among others.
But in this series of articles, I will be looking at the dimension commonly known as the equity investment style, which is the method and philosophy a fund manager uses to pick equities.
Some common equity investing styles are:
- Growth: Investing in companies that are expected to deliver strong growth in earnings.
- Minimum volatility: Investing in companies that deliver slow and steady returns without sharp jumps and dips in their stock price or earnings.
- Quality: Investing in great companies at a fair price.
- Value: Investing in good companies that are trading at a discount to their intrinsic value.
- Momentum: Buying up stocks that are trending higher and selling those that are falling.
The series will focus on all of the above styles, but before I delve deeper into the topic, it is worth noting that these investment styles do not necessarily exclude each other. Some fund managers might, for example, lean into momentum investment at a time when the economy is expanding and share prices are rising, and then focus on minimising volatility in a slump.
The diagram below sourced from Blackrock illustrates which management styles have tended to work through a typical economic cycle:
Different investment styles may also be better suited for clients or funds who have different investment horizons, goals and tolerance for risk. That said, let’s take a closer look at the pros and cons of value investing. This approach is underpinned by the belief that the value of a stock can be objectively quantified and that it should—despite fluctuations over time—eventually be priced correctly.
Warren Buffett of Berkshire Hathaway is one of the world’s most famous value investors, though he has of late shifted more towards quality under the influence of his business partner, Charlie Munger. A key idea behind value investment is that equity prices are often skewed in the short term by emotional responses to company news and market events.
Taking advantage of oversold and undervalued equities
For example, a company’s stock price might soar or collapse in response to a great or poor set of financial results. The stock price movement may be overdone in either direction, but should, in time, revert to a level that reflects the true value of the company. Value investors aim to snap up a stock at a time when it is most undervalued relative to its intrinsic value.
It is, of course, rather complex to tell apart a company that is undervalued from one that is cheap for good (if not immediately obvious) reasons. The would-be value investor needs to have an intimate understanding of the business and industry to be able to identify the real bargains. Investors such as Buffett have shown value investment can be profitable over time.
What’s more, value investment can often reduce the risk of downside if the professional investor has sound valuation models and a good understanding of the business. With today’s advances in technology, a value investment style can be replicated and implemented relatively cheaply and effectively via quantitative methodologies or smart beta.
So, what are the downsides? One of the challenges is that it can take a long time for an undervalued stock to return to its intrinsically fair price—this is an approach best suited to the patient, long-term investor. It’s also difficult to set aside one’s biases to accurately estimate the intrinsic value of a stock—the value investor needs to do his or her due diligence carefully.
Finally, even though I mentioned earlier that value investing should not offer too much downside, many value funds are quite volatile in practice. Because it is difficult to assess to what extent the discount to intrinsic value may be reached, many fund managers will pile into a stock before it has reached its bottom and remain there for a ride down before it recovers.
So, even though the likes of Warren Buffett have reaped handsome rewards from value investing, many other investors have burnt their fingers. Indeed, there has been a shift away from value over time, as investors lose patience with the time taken for the strategy to reap rewards.
My next columns will discuss the advantages and disadvantages of focusing on the other investment styles and Dynasty’s approach to selecting which styles are appropriate for our clients.