Choosing an investment style

The question that is often asked by investors is, “What types of stocks should I buy?” Should you rush to buy the small-cap growth stocks that have outperformed large-cap growth stocks or should you look for value stocks? The question relates not only to the investment type but also to the size of the company stocks. Some investors feel comfortable going after the winning categories, whereas the more patient investor is content to invest in the lagging categories, which will rise over time.

Studies have shown that stocks can be classified into categories that have similar patterns of performance and characteristics. In other words, the returns of the stocks within the categories were similar, whereas the returns of the stocks between the categories were not correlated (Farrell, 1975, pp. 50–62). Farrell found four categories for stocks, namely, growth, cyclical, stable, and energy. Other studies measured stocks by their market capitalization or size, which was then translated into small-cap, mid-cap, and large-cap stocks. What portfolio managers found was that they could enhance their performance by moving their money into the different categories of stocks from time to time.

From these categories of stocks, two investment styles have emerged, namely, value and growth investing. Figure 13–1 illustrates the common styles of equity investing as developed by Morningstar Mutual Funds for mutual fund investing, but they also can be used to determine individual equity portfolio holdings.

Investors can use this style box to determine if the bulk of their equity investments suits their investment style, as determined by their investment objectives. Value stocks have different financial characteristics and returns than growth stocks. Value stocks generally have low P/E ratios that are less than their expected growth rates. Growth stocks generally have high P/E ratios and are expected to experience high sales growth for a period of time. Ablend includes a mixture of growth and value stocks. The size of the company is measured by market capitalization, which is the market value of its stock multiplied by the number of shares outstanding. Small-cap companies are riskier than mid-cap or large-cap companies, but as the Ibbotson study showed, the returns over longer periods for smallcap stocks generally have exceeded the returns of large-cap stocks. Small-cap value stocks have outperformed large-cap growth stocks quite handily over the 21⁄2-year period 2003–2005. Consequently, stock picking becomes extremely important for individual portfolios, particularly when the investment style is to time the markets.

Figure 13-1
Types of Equity Investing Styles. (Morningstar Mutual Funds.)


The style box in Figure 13–1 illustrates the choices in terms of investment styles and sizes of companies. Investors can choose the current winners (2006), which happen to be small-cap value stocks, in which to invest more money. Alternatively, some investors might not want to pay high prices for these types of stocks and instead would look for the quadrants of stocks that have not participated in the recent rally (large-cap growth stocks, for example). Some investors might want to have a combination of growth and value stocks in the different size categories. This style box also can be used with international stocks.

Research has shown that value and growth stocks do not perform in the same manner within the same time periods. This is evidenced recently by the spectacular performance of large-cap growth stocks in the late 1990s, during which time large-, mid-, and small-cap value stocks underperformed the market. Since 2000, small-cap value stocks have outperformed large-cap growth stocks. One investment style (growth versus value) is dominant at a given point in time. Some investors choose to invest all their funds in the stocks that are performing well and then shift to other investment styles when they perceive that things are about to change. This style of investing would be more conducive to an active management style, as opposed to a passive management style, where investors would allocate their stocks among the different categories and then hold them for long periods. Active managers are more likely to be market timers and are more inclined to be fully invested in stocks when they perceive the market to be going up. The opposite occurs when they think that the market is about to decline; they exit the market. Passive investors tend to stay fully invested in stocks irrespective of the state of the markets.

Investors need to decide ultimately whether they choose value or growth stocks and whether they will be active or passive managers of their portfolios. The selection of individual stocks can be made easier if direction is provided through an asset allocation model, which breaks down the different style categories of investment by the asset class. Table 13–1 lists a few examples of the different portfolio possibilities. Investors might invest in a mixture of value and growth stocks, which could be allocated among domestic U.S. stocks and international stocks. Investors then would decide on the amounts to allocate to the different stock sizes, large-, mid-, and small-cap (Example 1 in Table 13–1).

Example 2 illustrates a value stock portfolio and Example 3 a growth stock portfolio. Diversification within the stock sector of an investor’s portfolio offers protection against the downside risk of being fully invested in only one sector, such as large-cap value or growth stocks, for example. If the tide turns against stocks in one sector, investors would be protected by being able to participate in any price improvement in other sectors should the stock market rally become more broad-based.

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