Is your portfolio well-constructed? Is it flexible enough to perform well in most environments or is it better suited to specific, rigid conditions?
Whether it’s a focus on growth stocks, value investing, quality stocks or dividends, specialists may differ on the best investing strategies. It may well depend on who you ask, and when you ask them.
Here we demystify the different investment styles by assessing their strengths and weaknesses. Most importantly, we’ll explain how combining multiple investment styles can build a more robust portfolio that can adapt well to different phases of the business cycle. The result is a multi-style portfolio, which can increase expected returns while minimizing risk.
The objective of a growth strategy is to find high-growth companies in terms of potential future revenues and earnings. Some companies may be trying to develop potential innovations, but most of them are companies that are relying on a breakthrough business plan, technology or specialized expertise.
The growth strategy is often associated with greater uncertainty, for two main reasons. First, since strong profit growth is expected, future profits carry a lot of weight in the calculation of the company’s valuation. As a result, the further out in time the profitability assumptions are, the more likely they are to be inaccurate. The valuation calculation of growth companies is therefore more uncertain.
Second, the business plan of growth companies is often based on a new way of doing things, whether it is a new technology or a new way of addressing a market. The strategy is therefore associated with an even higher level of uncertainty.
It is often said for growth strategies that we are looking for the next Microsoft, which is an image that sums up this approach. Its main advantage is to opt for a superior return by maximizing the chances of owning companies that have strong stock market momentum.
The growth style tends to be more volatile. The likelihood of overpaying for securities is an important factor to consider. Investors often get carried away by the high return prospects and forget to consider the chances of it occurring. Much like buying a lottery ticket, there is a lot of emphasis on the value of the jackpot, but very little on the odds of winning. One must, therefore, be prepared to pay a premium to invest in growth stocks.
In a bear market or when headwinds affect growth sectors, prices can suffer significant corrections. While the performance numbers are excellent when the strategy is on the upswing, it does not work in all phases of the market cycle, and corrections are usually painful for your portfolio.
Value managers seek to invest in stocks at bargain prices. Its pure definition is investing in companies whose market value is lower than their intrinsic value.
With this strategy, the discounted cash flow method is used to find the intrinsic value of a company. We also rely on earnings ratios, book values and other valuation ratios to determine if a stock is trading below its true theoretical value, which is of interest to the value investor.
This strategy is the basic approach of the all-star investor Warren Buffet.
For value managers, the price of the stock (or more precisely, the weakness of the price) is what matters. You’re looking for assets at a discount. One of the benefits is that this strategy limits the purchase of pricey securities in the hope of limiting major drops, which often means a less volatile portfolio that still offers an excellent expected return.
Value investing requires an iron discipline. While there are times when this approach is appropriate and greatly reduces the risk of incurring large losses, this is not always the case. In fact, when the economy is growing strongly, there can be long periods when the investor cannot get his hands on quality securities that are trading at a good price.
When the economy favours earnings growth, it becomes very difficult for the value style to focus on tangible things like the balance sheet and earnings history. Since this philosophy is reluctant to pay for future earnings growth, many good investment opportunities can be missed.
Also, there is often a reason why a stock trades at a low cost. Companies can face significant headwinds that will eventually prevent them from reaching their profitability potential. Investors who insist on putting too much emphasis on price and neglect to analyze the quality of a company risk acquiring stocks with poor prospects and performing accordingly.
While it’s true that some periods in the market cycle are conducive to value style investing – and that many good companies can be found at low cost – the value investor may have difficulty establishing a proper value strategy for long periods of time and could get duped by companies that appear cheap but have a very poor outlook.
Quality style investing involves investing in companies that have superior operating and financial characteristics. The quality investor looks for companies with strong balance sheets, high profit margins and high profitability.
The investor will place great importance on the quality ratios that can be calculated from a company’s financial statements. Attention will be paid to profitability ratios to demonstrate operational quality such as profit margins, self-generated cash flow, EBITDA ratios and net profit margins. Preferred companies are not only highly profitable but show stability and growth in profitability. We also make sure to invest in stocks that are optimally managed with a strong balance sheet and reasonable capital expenditures while investing for the future.
The analysis is completed by ensuring an above-average return on capital employed. Therefore, great importance is placed on the ratio of profits to assets, the ratio of profits to equity and the return on equity.
We seek to invest in companies that maximize their chances of remaining profitable over the very long term and that demonstrate excellent business plan sustainability.
This strategy seems trivial and obvious, but we come up against the fact that the shares of companies that meet these quality criteria are often very expensive.
In the mid-1900s, companies used to pay out a bigger portion of their profits as dividends than they do today, as investing styles dictated that people wanted a cash flow, which was supported by the tax environment. Even today, dividends are a way to return capital to shareholders. That’s why many investors are attracted to dividends, because they provide a tangible income stream. The dividend style is simply choosing companies that pay a dividend and preferring those with a high dividend relative to the share price.
Like other strategies, the dividend style has strengths and weaknesses. First, one of the benefits is that dividends can be used as a basis to help judge whether a company’s stock is expensive or cheap. Often, the higher the dividend rate, the cheaper the stock. Second, the dividend paid to the investor can be used to buy back other securities or as liquidity.
On the other hand, the tax system now favours capital gains over dividends, which is not to be overlooked. Furthermore, when looking for companies that pay a high dividend, there is a greater risk of finding mature or declining companies. Also, companies that return too much capital to their shareholders risk not reinvesting enough in their development and end up with obsolete facilities. These companies can therefore fall prey to better-equipped competitors, lose market shares over the long term and mortgage their profitability.
Each investment style comes with its own set of strengths and weaknesses. Style diversification is an important element to consider when building a portfolio. By doing so, you can build a robust portfolio that performs better through all phases of the economic cycle. In fact, at Claret, our research has shown us that we obtain better returns when we combine several strategies.
There are complicated formulas for building a balanced portfolio, taking into account many factors. However, an astute investor can combine different proportions of a value, growth, dividend and quality portfolio to find a mix that meets his or her investment objectives.
Be wary of some investments offered by financial institutions, as they tend to promote funds whose strategy has been in vogue recently. Remember: When performance numbers seem too hot, it may indicate that the biggest portion of the strategy’s upside potential may already have been realized.