10.1 Investment Styles

Investment style refers to the approach used to select securities and construct portfolios. Understanding different styles helps advisers match strategies to client needs and market conditions.

Growth vs. Value Investing

The growth-value distinction is one of the most fundamental in investment management.

Growth Investing

Definition: Investing in companies with above-average earnings growth expectations, even at higher valuations.

- P/E Ratio: High (typically 25-40+)

- Dividend Yield: Low or none (earnings reinvested)

- Revenue Growth: 15%+ annual growth expected

- Industries: Technology, healthcare, consumer discretionary

- Volatility: Higher

Growth Investor Mindset:

- Willing to pay a premium for future growth potential

- Focus on revenue growth, market share expansion

- Less concerned with current profitability

- Expects capital appreciation, not income

Typical Growth Metrics:

- Price-to-Earnings Growth (PEG) ratio

- Revenue growth rate

- Earnings growth rate

- Return on equity (ROE)

Value Investing

Definition: Investing in companies trading below their intrinsic value, often identified by low valuation ratios.

- P/E Ratio: Low (typically 10-15)

- Price-to-Book: Often below 1.0

- Dividend Yield: Higher (company returns cash)

- Industries: Financials, utilities, industrials

- Volatility: Lower (typically)

Value Investor Mindset:

- "Margin of safety" philosophy (buy cheap)

- Patience - wait for market to recognize value

- Focus on fundamentals vs. market sentiment

- Often contrarian (buy what others are selling)

Typical Value Metrics:

- Price-to-Earnings (P/E) ratio

- Price-to-Book (P/B) ratio

- Dividend yield

- Free cash flow yield

Growth vs. Value Performance

- Bull market/expansion: Typically Favored Style: Growth

- Bear market/recession: Typically Favored Style: Value

- Rising interest rates: Typically Favored Style: Value

- Falling interest rates: Typically Favored Style: Growth

- Low inflation: Typically Favored Style: Growth

- High inflation: Typically Favored Style: Value

Important: Neither style consistently outperforms - they cycle. A diversified portfolio often includes both.

Active vs. Passive Management

Active Management

Definition: Attempting to outperform a benchmark through security selection and/or market timing.

- Goal: Beat the benchmark

- Approach: Research-driven stock selection

- Trading: Frequent (higher turnover)

- Expense Ratio: Higher (0.5% - 1.5% typical)

- Tax Efficiency: Lower (more taxable events)

Arguments FOR Active Management:

- Skilled managers can identify mispriced securities

- Can avoid overvalued stocks

- Flexibility to respond to market conditions

- May add value in less efficient markets

Arguments AGAINST Active Management:

- Most active managers underperform over time

- Higher fees compound negatively

- Tax inefficiency hurts after-tax returns

- Difficult to identify winning managers in advance

Passive Management (Indexing)

Definition: Matching the returns of a market index by holding its constituent securities.

- Goal: Match the benchmark

- Approach: Buy and hold index components

- Trading: Minimal (only for rebalancing)

- Expense Ratio: Lower (0.03% - 0.20% typical)

- Tax Efficiency: Higher (fewer taxable events)

The Evidence on Active vs. Passive:

- 1 Year: about 60% of Active Large-Cap Managers Underperforming S&P 500

- 5 Years: about 75%

- 10 Years: about 85%

- 15 Years: about 90%

The Cost of Fees

- Expense Ratio 0.10% (passive): $100,000 After 30 Years (7% return): $745,000

- Expense Ratio 1.00% (active): $100,000 After 30 Years (7% return): $574,000

- Difference: $171,000 lost to fees

Market Capitalization Styles

Large Cap (greater than $10 billion market cap)

- More established, stable companies

- Greater liquidity and analyst coverage

- Generally lower volatility

- Dividends more common

Mid Cap ($2-10 billion)

- "Sweet spot" of growth and stability

- Less analyst coverage than large cap

- Moderate volatility

Small Cap (less than $2 billion)

- Higher growth potential

- Less liquidity, more volatility

- Less analyst coverage

- Greater risk of business failure

Geographic Styles

- Domestic: Home currency, lower complexity

- Developed International: Europe, Japan, Australia - diversification benefits

- Emerging Markets: Higher growth potential, higher risk, currency exposure

In Practice

Most portfolios blend multiple styles:

- Core-satellite: Passive core + active satellite positions

- Style diversification: Growth AND value exposure

- Cap diversification: Large, mid, and small cap

- Geographic diversification: Domestic and international

On the Exam

Series 65 frequently tests:

- Distinguishing growth (high P/E, low dividends) from value (low P/E, higher dividends)

- Understanding active vs. passive management trade-offs

- Knowing that most active managers underperform over time

- Recognizing which styles may outperform in different market conditions

Key Takeaways

1. Growth stocks have high P/E ratios; value stocks have low P/E ratios

2. Growth tends to outperform in bull markets; value in bear markets

3. Most active managers underperform their benchmarks over time

4. Passive management has lower costs and greater tax efficiency

5. Fees compound negatively - a 1% fee difference costs significantly over time

6. Diversification across styles reduces timing risk