Within the world of investing there are a number of schools of thought or styles that managers tend to follow. This article will look at the most common manager styles, along with the strengths and weaknesses of each.
Value Investing
The value manager attempts to determine the intrinsic worth of a company and then buys it when it is trading well below that value. They will use a variety of tools to measure this worth, paying special attention to strategic indicators they believe the market is ignoring. Warren Buffet is perhaps the most successful (and certainly the most famous!) value investor of all time. He recommends that the most important things to look at are companies that are hard to replicate, have strong management teams, little to no debt and can weather all types of economic cycles. As an added bonus, the company should be involved in a business that is currently out of favour with the wider market, leaving it underpriced.
When talking to a value investor you will hear them using buzz words like “price to earnings”, “price to book value” and “positive cash flow”. Value mangers try to buy companies that are trading below the market average in each of these assorted metrics and sell them when they reach above market levels.
Classic examples of companies that fall into this category include: banks, insurance companies, utilities, railways and dominant brand names in consumer goods (think Coca-Cola and Dairy Queen).
This style is typically most effective when the markets are struggling through a downcycle, the economy is weak, or we are coming out of a market downturn. It tends to struggle as a bull market grows longer or the economy is growing very rapidly.
Growth Investing
Growth managers are near opposite of value managers. Growth investors are seeking the “next big thing” and want to get in early. This typically means the investor is looking for companies that make relatively little or no profits but are early entrants or market distruptors and therefore dominate new parts of the economy. Current examples would be companies like Netflix and Amazon, as well as many start-ups and industry pioneers.
The objective of a growth manger is picking companies that will continue to grow at very high rates. The risks tend to be higher because the stocks typically trade at a high premium to the market and if significant returns don’t meet the market’s expectations, the stock price can fall very quickly and dramatically. Think of Blackberry, the creator of the first smart phones.
Interestingly, many of today’s value companies were at one time major growth stories. For example, Walmart was once a major growth stock but today is viewed as a value story. Apple is a more recent example of this same trend. It is worth noting that when a stock moves from being a growth to a value categorization, the price can often experience significant declines until the market adjusts to the new reality.
Growth at a Reasonable Price (GARP)
GARP managers try to find a balance of both the value and growth narratives. Like value managers, GARP focuses on cash flow, profitability and a competitive advantage as key metrics in deciding if a stock is worth buying. And like growth managers, a GARP investor wants their companies to be growing a rate that is better than average. In short, these managers seek stocks that are a blend of both value and growth. As a result, this type of investor is willing to pay a premium to market price for their companies while avoiding both speculative growth and mature industry players.
Current examples of GARP type companies would be Google, Facebook and Mastercard, as well as many of the most successful smaller to medium sized companies in the stock market.
This type of manager tends to outperform during prolonged bull markets but can drop more quickly when the market gets bearish. In addition to the above average volatility, a GARP manager needs to be careful about buying either too early or too late in the company’s life cycle. If a manager is too early to purchase, the company may not have sufficiently solidified its market share or price advantage over competitors. The company then get caught in a competitive squeeze and see its profits drop. If the manager is too late she may find herself owning a stock where the company is no longer growing at its historical pace, and the market will discount the company’s future growth potential.
Momentum Traders
This style looks at market trends to determine which sectors are in favour and which are out of favour, then only invests in the in favour sectors. For this style to be successful the manager needs to be ahead of the market curve and entering a sector just as it is starting to gain attention and attract new investors. As an analogy think of a surfer hoping to ride a large wave.
This strategy is most commonly found in hedge funds as the manager must be given great latitude and discretion in his trades. As a result, both the potential risks and returns (and corresponding losses) can be much greater than the market average. Fundamental analysis such as profitability, cash flow, market share, book value and the like will have little relationship to the price of the stocks. Instead, the manager attempts to get sector and specific stock picks right, and combines it with exceptionally good market timing.
Two very recent examples of momentum trades were Bitcoin in 2017-2018 and Canadian marijuana stocks in 2018-2019. Investors who got in early enough on each of these stories, AND also sold at the right time could make dramatic profits. The danger was buying in at the tail end of a boom cycle and then being caught when the market finally goes bust.
Conclusion
Clearly one can have a number of investment styles or biases when picking stocks. The key to choosing the right style will depend on personal tolerances for risk, as well as an expected rate of return. Finally, the manager needs to have the disciple and skill to properly evaluate the companies they might invest in both when they buy, and when they sell.