Style Based Investing
What is “Style Based Investing”?
Style based investing refers to a form of investment philosophy used by virtually all investors to set a framework (usually asset allocation or building a portfolio of individual securities) in order to achieve their investment goals. The investment style helps to formulate firm investment objectives and categorize what the investor is looking to achieve from their portfolio. This simplifies the investment goals and makes it easier for investors to select and weigh up opportunities and risks.
The main components required to determine the investment style of an investor include: risk tolerance, company size, time horizon, and investment objectives – income, growth, or a mixture of the two. The most common investment styles for equity investors are: growth investing and value investing. The chosen investment style usually then determines the investment universe, selection criteria, and individual security (or portfolio when selecting collective investments) features required for the implementation strategy to realize investment goals.
Key Learning Points
- Style based investing is centered on choosing an investment goal and then selecting simplified components from the investment universe which will support this investment objective
- There are two distinct styles of investing – growth investing and value investing
- Risk-averse investors tend to prefer large-capitalization stocks, while stocks of small capitalized companies are more suitable for less risk-averse investors
- There is an equity style box that can assist investors in managing their own investments and portfolio and creating it is relatively straightforward
Understanding Growth vs. Value Investing
Growth investing and value investing are the two most popular and distinct investment styles today.
Growth stocks are likely to grow at a significantly higher rate than the market due to underlying business benefits such as a unique sales product or company positioning in the market. An investor would likely be willing to pay a higher price in terms of ratios such as price-to-earnings, price-to-sales, and price-to-free-cash flow for growth stocks as they are expected to outperform the market (and therefore more expensive). Since growth stocks offer higher potential returns, they tend to be riskier and more volatile than value stocks. There is also a downside risk associated with growth stocks as they may not continue to outperform the market. Value stocks do not tend to pay dividends as the cash generated from the business is usually reinvested back into the company.
Growth investing is about searching for the companies that are expected to grow more rapidly than the market. These types of companies are usually disruptors in their sectors and are considered to have a competitive edge in their sector – for example, certain information technology companies such as Apple Inc. Great growth stocks can be found in the technology sector where newer companies can enter the market and gain a competitive advantage without requiring years of heavy investment.
Value investing is a long-term strategy involving identifying companies with stock prices lower than their intrinsic (or fair value). Usually, these stocks are trading on lower P/E or P/Sales multiples than their peer groups and are considered ‘unloved’ by the market. Value investing focuses on buying stocks of such companies, and holding them for a long period of time (i.e. it is a buy and hold strategy), and exploiting any ‘inefficiencies’ in the market where stocks are not deemed fairly priced.
Typically value stocks can be found in cyclical and more economically sensitive sectors such as Financials and Energy. Further, value investing tends to focus on companies that have a record or pay consistent dividends which can be attractive for income-seeking investors.
Large Cap vs. Small Cap
In terms of risk, the size of a company’s market capitalization (current market price of a company’s stock multiplied by its total number of shares outstanding) is a key measure that could give investors some idea about the potential risk/returns associated with a company or portfolio in question.
Risk-averse investors tend to prefer investing in large-cap companies, which are perceived as less risky than small-cap investments. Large-cap companies (i.e. have a market capitalization of $10 billion or more) are usually well-established “blue-chip” companies that tend to be more mature and stable and have a strong market presence in their sector. Although large-caps tend to grow more slowly than small caps, they are usually less volatile and could offer some downside protection features in a well-diversified portfolio. The FTSE 100 and S&P 500 are two of the most popular market indices that consist of such companies.
Small-cap companies (market capitalization ranging from $300 million to $2 billion) are usually nimbler and have the ability to embrace innovation, grow more rapidly and adapt to change more quickly. They are typically at earlier stages of development and can therefore offer higher growth rates and returns. However, this usually comes with higher associated risk as the companies are less well established.
Smaller companies usually have lighter resources and less diversified income streams compared to their large capitalized companies, which can also cause higher share price volatility. Therefore, small-cap stocks are generally more suitable for investors who are less risk-averse.
Style Matrix – Equity Style Box (Example)
Given below is an equity or stock style box, which can help an individual or retail investors manage their own investments and portfolios, without external or professional guidance. Creating such a style box for a portfolio is relatively straightforward. The vertical axis of this style box is divided into three categories, which is based on market capitalization, while the horizontal axis, which is divided into three categories, is based on valuation.