We have found that there are roughly twelve major, or most popular, ‘styles’ of investing. Our own style is closest to a combination of:
- Overall: Valuation
- Within portfolio:
- For efficient asset classes: Beta/ Index (i.e. most of our portfolio)
- For inefficient asset classes (i.e. micro-cap): a mix of Competitive Position, Future Growth, Momentum, Quantitative, and Opportunistic
Our style has the least in common with:
- Top-Down Macroeconomic
- Technical
1) Valuation
Valuation-based, or value, strategies focus on finding cheap securities that are undervalued relative to other securities, usually according to a number of the following metrics: low P/E, P/B, P/CF, or the manager’s assessment of the securities’ intrinsic worth. Typically, value managers employ detailed fundamental research to determine what he believes is the “true” worth of a security. A primary risk of this strategy is that even if a manager’s assessment of undervaluation is theoretically correct, the market may not soon recognize it. Therefore, the security does not converge to true value. Also, since the style is by nature contrarian, it goes against popular or market beliefs. A value security, and even the entire value style, may be out of favor for extended periods of time, so it requires investor patience. Valuation strategies need not necessarily fall into the popular Morningstar Value style boxes. Ex: Dodge & Cox, Davis, Buffett.
2) Deep Value / Distressed
Following in the style of Benjamin Graham, these strategies utilize an extreme or absolute definition of value. Managers typically insist on large market discounts (usually greater than 30%) to their calculation of “true” value of a security, in order to achieve a comfortable margin of error cushion. Assets of interest typically sport very low valuation measures (i.e. P/B below 1.0 and/or P/E below 7) and may have lower liquidity. Often, these investments are either 1) in “sunset” industries with low growth and low investor interest; 2) distressed assets of companies undergoing bankruptcy or restructuring, 3) exhibit high business or credit risk which warrants a lower valuation; or 4) perceived to be of lower quality. The primary risk to a deep value strategy is business risk and liquidity risk. Managers need to be wary of the “value trap”– assets that are cheap because they deserve to be cheap, not because they are mis-priced, and sufficient liquidity to trade or hold on to the positions if forced to do so. Ex: Third Avenue, Hotchkis & Wiley, Mutual Series.
3) Future Growth
These strategies focus on companies that exhibit growth, usually in a number of the folowing metrics: growing revenues, margins, earnings, or sales. These companies typically have high return-on-assets (ROA) or return-on-equity (ROE) ratios. There are a variety of risks with growth strategies, depending on the particular investment style, but two of the main risks are price risk and business risk. As growth assets are normally well-recognized and popular in the marketplace, managers must be careful not to “overpay” for anticipated growth. Future growth strategies need not necessarily fall into the popular Morningstar Growth style boxes Also growth companies may not achieve the height of growth as originally anticipated. Ex: T. Rowe Price, Janus, Wasatch.
4) Aggressive Growth/ Momentum
These strategies focus on companies or securities undergoing spectacular growth or exhibiting high relative strength to its peers. This typically manifests in high and accelerating earnings growth or high momentum in price. Often these securities are in popular sectors, and there is a catalyst (e.g. exciting new product or positive industry change) driving the surge. Managers will often sell the company or security as soon as growth is reversing or decelerating. There may be a behavioral science aspect to the security’s popularity. The risk of these strategies is price risk and timing risk. As growth assets are normally well-recognized and popular in the marketplace, managers must be careful not to “overpay” for anticipated growth. Also managers have to be diligent in monitoring earnings announcements/ revisions and general market conditions to better manage the timing of purchases and sales. Ex: Driehaus, Turner, Brandywine.
5) Competitive Position
These strategies invest in companies with strong management, healthy financial condition, attractive business models, and defensible competitive positions versus their peers. Managers typically seek wide moat businesses with financial statement strength (e.g. low debt capital structures) that have a history of innovation and profitability. Since the companies are high quality, the investments tend to have low business risk. They also tend to distribute a larger share of their income. However, they may have high price risk, as these traits tend to be well-recognized in the market. Ex: Jensen, Primecap, Sequioa.
6) Beta/ Index
These often simple strategies seek to provide “systematic” risk exposures or provide a return pattern that matches very closely with a given market index. Alternatively, they may seek to make minor adjustments to incrementally outperform the exposure or market index. More recently, fund providers have used creative financial engineering to produce leveraged and inverse strategies on popular market indexes. The goal of these strategies is to provide pure “beta”, and it seeks to do so at a low cost and minimal tracking error to the index. These strategies are consequently very well diversified (at least within the market segment of the index it is replicating). The risk with these strategies are obviously the market risk of the particular market segment of the index, magnified market risks with leveraged strategies, and performance risk– the risk of active strategies consistently outperforming them in less efficient markets. Ex: Vanguard, DFA, iShares.
7) Concentrated
These strategies take a high conviction and focused approach to investing. The managers typically devote a lot of time and resources to uncover the most attractive securities or sectors, and devote a large portion of their portfolio to a limited number of holdings. They are typically buy-and-hold investors who trade infrequently. The primary risk with this style is idiosyncratic risk, the risk that the concentrated holding or segment of the portfolio experiences weakness due to unforeseen, “unsystematic” reasons, and these by themselves can drag down the entire portfolio. These strategies are also susceptible to performance risk, the risk that the strategy will perform differently than its peers or benchmark. Ex: Clipper, Fairholme, Oakmark.
8) Top-Down Macroeconomic
These strategies are predicated on top-down macroeconomic or thematic forecasts. To the extent that bottom-up security selection is utilized, it is a secondary consideration. Managers make forecast on interest rates, currencies, global geo-politics, and/or themes related to global economic developments. Managers adept at identifying and forecasting macro trends have a tremendous advantage in some market segments. However, the risk is that historically, correctly forecasting the occurrence of macroeconomic events or the level of macroeconomic variables are exceedingly difficult, let alone timing them accurately. Guessing wrong on macro trends could have powerful negative consequences, so effective risk management is important. Ex: PIMCO, Soros.
9) Opportunistic/ Event-Driven
These strategies constantly scan the markets for special opportunities. Often, these opportunities are created by “one-time” events that cause temporary supply/ demand imbalances, including forced sellings, reclassifications, disasters, and earnings surprises; or that cause excessive complexity or uncertainty, including mergers, acquisitions, spin-offs, privatizations, and management changes. These strategies require opportunistic managers who are diligent in uncovering deals and have a particular expertise in fundamentally analyzing these deals that other market participants choose to bypass. Ex: Cramer Rosenthal McGylnn, Baupost.
10) Capital Conservation/ Risk-Focused
These strategies are forcused on minimizing risk and permanent capital impairment, with capital appreciation a remote secondary consideration. Manager are typically highy risk-averse and strive for absolute (rather than relative) returns, and manages to tight and disciplined risk parameters. These stratgies are subject to performance risk: since these stratgies are lower risk, they naturally tend to be lower return, and can lag their peers and benchmark badly in strong bull market environments. They appear less consitent on a relative performance comparison basis, but typically are more consistent on an abolute basis. Ex: Gateway, Hussman, FPA.
11) Quantitative
These strategies are often labeled black-box processes, because the investment strategy is programed into a computer box and is typically opaque to the investor. Since they are methodically programmed, the strategies tend to be well-defined. Managers use advanced mathematical and statistical modeling, and typically pay no attention to bottom-up individual security fundamental analysis. The main weaknesses with quantitative strategies are that they are based on patterns in historical data that may not repeat, and they will react slowly or poorly to suddenly and dramatically changed market conditions. Ex: First Quadrant, Renaissance Technologies, D.E. Shaw.
12) Technical
These strategies rely principally on statistical modeling of market trading data (such as price and volume) in the investment process. They differentiate from pure quantitative strategies in that they often have a focus purely on market trading data and a heavy component based on charts. The primary risks of these strategies are that the efficacy of charting is questionable and use of high-frequency data typically leads to high turnover and trading costs. Ex: Leuthold, Ned Davis.