Investment Selection Styles: Portfolio Construction Implications
Classic equity portfolio management of mutual funds, insurance product subaccounts and separately managed accounts predominately utilize either a growth or value style investment selection process, or a blend of the two investment styles. This discussion of equity investment selection styles relates only to the portion of a portfolio which is deemed suitable for an individual investor’s personal circumstances. During periods of market volatility, the differences between growth and value investing become more pronounced, which tend to increase the benefits of rebalancing investment allocations between equity portfolio manager styles. Generally speaking, the greater market volatility, the greater the benefits from rebalancing allocations which may reduce overall portfolio volatility over time. So what are the differences between investment selection styles and what are the implications for constructing an investment portfolio’s equity allocation?
What is Equity Value-Style Investing?
Equity value-style investing was first articulated by Benjamin Graham and David Dodd, who in the 1930s published their seminal work entitled, Security Analysis. Graham and Dodd argued that superior long-term investment returns can be realized by investing in stocks that sell below to their true, intrinsic value. Warren Buffett is the legendary equity value-style investor of the modern era who personally amassed billions of dollars through long term buy-hold investments in under-priced companies made by his holding company, Berkshire Hathaway.
Equity value-style portfolio managers scrutinize financial fundamentals of a prospective investment to determine the value of the company, to determine whether it is correctly valued. The investment selection process is considered to be similar to bargain hunting. Portfolio managers as a measure of valuation look for indications as to whether a company’s stock is trading below its true, intrinsic value. The equity value-style investment selection process will scrutinize financial indicators such as a stock’s price-to-earnings, price-to-book value, and price-to-cash-flow ratios to help determine valuation. The premise of value investing is stocks which are selling below their true worth should generally rise, over the long run, as other investors perceive their true value. Equity value-style investing is considered by some to be a more conservative investment selection process.
What is Equity Growth-Style Investing?
Equity growth-style portfolio managers’ investment selection process is based on the premise that a stock’s earnings potential instead of current valuation, is a better indicator of potential stock performance. Equity growth-style portfolio managers tend to look for companies, based on their research, which can provide above-average future earnings growth. Equity growth-style portfolio managers look for financial indicators of accelerating growth, such as price-to-earnings ratios, or upward revisions in quarterly earnings over successive quarters. Similar to value-style portfolio managers, growth managers use fundamental research to identify trends for a company’s growth, such as new products, new global markets, or increased capital expenditures.
Compared to value-style equity portfolio managers, most growth-style equity portfolio managers are not as price-sensitive when making investment decisions. The growth-style selection process analyzes whether a company can grow its earnings in the near future. If the company is successful, a seemingly high price today may prove to be a bargain in the future, if the company’s stock price rises. The growth-style equity investment selection process is generally considered more aggressive, with portfolio managers less patient with their holding periods. If a stock does not continue to grow, the portfolio manager may sell it promptly. The upside is that successful growth investing can generate substantial returns. The downside to growth-style equity investing comes swiftly when the company fails to meet its expected growth rates.
Portfolio Construction Implications
Market research has found that value-style funds typically earn higher returns than growth-style funds over the course of an entire market cycle, and small-cap funds earn higher returns than large-cap funds, with greater expected volatility. Empirical research has found that this pattern changes during economic slowdowns, when large-cap and growth-style funds earn significantly less negative returns than small-cap and value-style equity funds. During the course of a market cycle, market expansions last longer than market contractions. These insights point to the need for building wealth through a portfolio construction process which requires both value and growth style equity portfolio managers. Furthermore, portfolio rebalancing throughout the market cycle should adjust the allocations between both equity investment-style selection methods.
The use of an Investment Policy Statement (IPS) establishes the parameters and criteria by which investment decisions are made to determine the appropriate asset allocation model. The asset allocation model specifies the suitable allocations for an investor’s investment portfolio amongst asset classes and investment selection styles. This investment process determines amongst many factors the allocation percentages for growth and value style portfolio managers across small, mid and large market capitalizations. For fixed income securities, credit risk, bond duration and cash needs are all considered when the asset allocation model is determined, monitored and rebalanced.
A fee based investment advisory service can help implement an asset allocation strategy based on your investment objectives, risk tolerance and investment time horizon. True North Financial Advisors provides fee-based financial planning and investment management services through the help of a Certified Financial Planner® professional to individual, trusts and closely-held business in Boca Raton and throughout Palm Beach County.
