A common way in which professional investment managers describe their decision-making process is to define themselves as adhering to either a "growth" or "value" philosophy. What exactly does this mean, and is it relevant to individual investors who invest in mutual funds or ETFs?
When examining portfolios managed by growth and value managers, it is not unusual to find the same stocks in both. Given this overlap, is there any real distinction? In my opinion, the answer is a definite yes, and it all has to do with what is deemed to be the critical buy/sell criteria. In other words, although a stock may concurrently be in both growth and value portfolios, it was likely purchased at different times and for different tactical reasons.
Growth managers deal in future dimensions. Specifically, they focus on a company's future earnings power and what that translates into in terms of future valuations. To assess this, they examine various aspects of a company's historical growth record, and then evaluate whether its earning power is likely to accelerate or decelerate. Also important is an assessment of what the market's embedded expectations presently are. A growth manager will deem a stock attractive if his discounted future value (risk-adjusted) is significantly above that of today's price. As such, the growth manager is not particularly concerned about today's price if, in his estimation, the company's future earning power supports a much higher value. Of course, the process, in a similar way, also identifies sell candidates. The vulnerability of growth investing relates to the never-ending wall of unknown unknowns. Cynics point out that when one enters the realm of discounting rainbows, selecting an appropriate discount rate is speculative, at best.
Value managers live in the here and now. They do not make decisions based upon future expectations, including their own. They are interested in identifying under- and overvalued stocks, based on today's market prices. They do this by closely examining a variety of a company's historical financial metrics and how they collectively were valued in the marketplace. They also do a current-day comparison of the company's valuation relative to various benchmarks - i.e. its industry peers, overall market indexes and sub-indexes etc. What they are looking for is major valuation discrepancies, either in terms of a stock's historical norms, or relative to external comparatives or both. The objective is to buy cheap and sell expensive, based on today's market valuations. The vulnerability of value investing is the simple fact of life that things change. Because of a whole host of factors, historical valuation norms can become irrelevant. Notable examples are changes to a company's competitive environment and/or its moving on to another stage of its corporate life cycle, In the case of a "fallen angel", a stock may appear cheap, but that is simply because it fully deserves to be. Alternatively, a stock may appear expensive, but this is because the market is correctly anticipating an acceleration in its earning power.
Both growth and value investment philosophies have been around a long time. Despite each having inherent vulnerabilities, each is based on sound logic and practical methodologies. Both have aggressive and conservative adaptations of their respective disciplines. Both processes have high-profile managers that have successfully maneuvered numerous investment cycles and added value for their clients. Therefore, this brings us back to the question previously posed - is the growth versus value discussion of any meaningful relevance to individual investors? I believe it is relevant, and the reason is very fundamental.
The key takeaway for individuals investing in mutual funds and ETFs relates to how they evaluate the returns generated by their manager. Again, there is documented evidence that over the longer term, e.g. an entire investment cycle, both growth and value processes have generated value-added returns. However, it is also clear that within a cycle, it is highly unlikely that one specific style will consistently outperform. During the early stages of a cycle. when expectations are expanding and indeed accelerating, growth investing does extremely well. However, when the market rolls into the back end of a cycle and it becomes increasingly clear that expectations are overextended, investors retreat and become defensive. This is when a value approach thrives and outperforms on a comparative basis. Accordingly, it is important that investors recognize that their manager, whatever his investment style, cannot be a man for all seasons during all the ups and downs of an investment cycle.
Given this, what should an individual do? Firstly, a fund investor must do his homework and understand what exactly he is buying into. What is the manager's investment philosophy? Does he have a disciplined process that has been consistently applied and is evidenced by superior returns over several market cycles? Having satisfied himself on these criteria, it is critical that an investor not dump his manager during short-lived periods of underperformance. The underperformance most likely has more to do with the stage of the cycle than the manager suddenly becoming incompetent. If, however, poor results persist for an extended period relative to style peers, then it may well be time for a change. Finally, another strategy that could be deployed would be to diversify one's stock portfolio according to investment style. Potentially, this would serve to moderate performance swings during a market cycle. However, before diversifying managers, it is important to consider what additional management expenses would be incurred.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.