Is your portfolio built to weather all market conditions, or is it tailored to thrive only in specific scenarios?
Investors often debate the merits of various strategies—growth stocks, value investing, quality stocks, or dividend-focused approaches. Opinions can vary widely depending on who you ask and when.
In this article, we break down the strengths and weaknesses of these investment styles, helping you understand how each performs under different market conditions. More importantly, we’ll explore how blending multiple styles can create a resilient, adaptable portfolio. By diversifying across strategies, you can position your portfolio to navigate the ups and downs of the business cycle, enhancing potential returns while managing risk effectively.
Growth Style
A growth strategy aims to find high-growth companies in terms of potential future revenues and earnings. Some companies may be trying to develop potential innovations, but most rely on a breakthrough business plan, technology, or specialized expertise.
The growth strategy is often associated with more significant uncertainty for two main reasons. First, since strong profit growth is expected, future profits carry much weight in calculating 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, growth companies’ business plans often involve a new way of doing things, whether it is a new technology or a new way of addressing a market. This strategy is, therefore, associated with an even higher level of uncertainty.
For growth strategies, it is often said that we are looking for the next Microsoft, which is an image that sums up this approach. Its main advantage is that it opts for a superior return by maximizing the chances of owning companies with 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.
Prices can suffer significant corrections in a bear market or when headwinds affect growth sectors. 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 Style
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 a company’s intrinsic value. We also rely on earnings ratios, book values and other valuation ratios to determine if a stock is trading below its actual theoretical value, which interests 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 restricting significant drops, which often means a less volatile portfolio that still offers an excellent expected return.
Value investing requires 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 access quality securities trading at a good price.
When the economy favours earnings growth, it becomes challenging 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 and could be duped by companies that appear cheap but have an abysmal outlook.
Quality Style
Quality investing involves investing in companies with superior operating and financial characteristics. The quality investor looks for companies with strong balance sheets, high-profit margins, and high profitability.
Investors will greatly emphasize the quality ratios 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 also show stability and growth in profitability. We also make sure to invest in optimally managed stocks 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 long term and demonstrate excellent business plan sustainability.
This strategy seems trivial and obvious, but we face the fact that the shares of companies that meet these quality criteria are often very expensive.
Dividend Style
In the mid-1900s, companies used to pay out a more significant portion of their profits as dividends than today, as investing styles dictated that people wanted a cash flow supported by the tax environment. Even today, dividends are a way to return capital to shareholders. Many investors are attracted to dividends because they provide a tangible income stream. The dividend style is simply choosing companies that pay dividends and preferring those with a high dividend relative to the share price.
Like other strategies, the dividend style has strengths and weaknesses. One benefit is that dividends can be used 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 has its own strengths and weaknesses. Style diversification is an essential 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. Our research at Claret has shown us that we obtain better returns when we combine several strategies.
There are complicated formulas for building a balanced portfolio that considers 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 strategies have recently become popular. Remember: When performance numbers seem too hot, they may indicate that the biggest portion of the strategy’s upside potential may already have been realized.
