It’s not unfair to suggest that until recently, pretty much every aspiring young fund manager was told to go away and read the bible of “traditional” investing – The Intelligent Investor by legendary US investor Ben Graham. This eminently readable book is as close as you can get to the holy scripture of investing, and it describes what most of us would view as a common-sense idea.
When you buy a share, you buy a stake in a business. To have any hope of making a profit, you need to understand how that business works; and whether or not its shares are overpriced or underpriced, relative to certain “fundamental” measures such as cashflows, the state of the balance sheet, and earnings. But scrub away all the technical language, and you end up with a contrarian philosophy which says buy low (cheap) and sell high (expensive). This is what most people are referring to when they use the term “value” investing.
The evolution of value investing
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One of Graham’s most famous acolytes is a certain Sage of Omaha – Warren Buffett, one of the world’s richest men – who took Graham’s ideas and used them in building his giant investment portfolio, Berkshire Hathaway. But along the way, Buffett discovered that finding really cheap, Graham-style value stocks was becoming increasingly difficult. Valuations kept increasing as US stocks boomed in price, and it turned out that too many of the apparently “cheap” businesses being left behind were actually deeply flawed, with perhaps too much debt, or more importantly, no real prospects for long-term growth in profits.
So over time, Buffett developed a new mantra, which one could describe as “growth at a reasonable price (GARP)”. This involves looking for businesses and shares with growth potential that isn’t quite recognised by the market as yet. In other words, the shares aren’t necessarily cheap in the classic value sense (i.e. relative to current fundamentals), but they are cheap relative to their likely future fundamentals.
Over time this approach has paid off handsomely, and it wouldn’t be unfair to say that the single largest group of equity fund managers in existence today probably follow some form of GARP style. A modern variation is to target “quality” businesses – those with strong balance sheets, high profit margins, some form of advantageous intellectual property or brand protection (a “moat” in the parlance).
Growth or bust
But in recent decades, even this way of thinking has been critiqued by those who think that Buffett has lost his touch (often citing underwhelming share price returns for Berkshire Hathaway in recent years). Forget value, they say – instead, look at what the share price is telling you, and pick businesses in fast-growing sectors (usually, though not always, in technology).
These growth-oriented investors are less worried about whether a stock is cheap or expensive, but whether its business franchise is growing quickly and dragging along a share price that is also rising faster than the wider stock market. This group of growth enthusiasts have scored huge gains in recent decades as more money has flooded into technology stocks, especially in the US and to a lesser degree Europe, where the quoted tech sector is now worth more than the entire market capitalisation of all Europe’s banks.
Different styles for different environments
In the long term, historical data suggests that value has won out, though in more recent decades, both quality and growth styles have produced far superior numbers. But these studies also point to other historically successful strategies. For example, investing in smaller companies comes with extra risk, but evidence clearly shows that a fund invested in US or UK smaller cap equities over many decades, has beaten the wider market by a decent margin.
There is also a more curious anomaly. Stocks with the lowest day-to-day volatility – simply put, share price ups and downs – have also tended to beat the wider market. This has been called the “low” or “minimum volatility” premium, and seems to suggest that investors can succeed by avoiding the most turbulent sectors. Unsurprisingly, many funds based on this strategy have emerged, and more than a few managers using the “quality” style have incorporated it.
Step back from these debates around investment styles and a key point emerges – different styles work best at different times, and within different markets. In recent months growth and especially tech-based growth equities have massively outperformed, and value underperformed. But in recent weeks, cheap, contrarian stocks have bounced back.
What’s the lesson for investors? Many fund managers say they use multiple strategies, but in reality, many are best at one particular style. Understanding how your fund manager thinks, and how they then implement that thinking, is critical for investors. So look for a manager who is transparent about their strategy, competent at communicating what they are doing, and who knows their own strengths.
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