Morningstar has been enormously successful in popularizing its style-box approach to analyzing mutual fund portfolios. Professional and individual investors alike now tend to make asset-allocation decisions based on the growth vs. value stock-selection style and on whether a stock's market cap is small, medium or large compared with other stocks.
It seems the whole investment community has accepted as an unspoken operating premise that a common stock-with a total market value falling between $5 billion and $20 billion-shares a set of business or investment characteristics with other stocks that have market values falling between these same parameters.
Even sophisticated investors seem to accept that mutual funds whose analysts and portfolio managers pay for high estimated earnings growth ("growth" funds) form a distinct peer group-one in which members' results ought to be compared only among themselves. Corralled into a separate group are those mutual funds whose operatives pay a great deal of attention to the price they are willing to pay for securities ("value" investors).
By making this particular segregation, it is implied that price-sensitive managers are apples, while those focusing on earnings-growth estimates are oranges, and they cannot be compared. Never mind that in any given year, some value managers will outperform the least-successful growth managers and vice versa. To have performed well in one's style class is evidently more important than absolute returns. And not just the style class, but the style class subdivided into capitalization brackets!
Small, Medium Or Large?
I wonder how differently advisors would make asset-allocation and stock-selection decisions if Morningstar had not developed its style grid?
Why do we believe it is important to divide the stock universe into three groups based on the market value of each stock at a point in time? Do we think it is important because in the past there have been some years when the average appreciation of the small group was greater than the return for the giants and other years when the mid-cap group outperformed both small and large caps? Do we infer from this group data that there is some cause-and-effect relationship between cap size and market performance? Or do the numbers lead us to believe that after some period of relative outperformance by one group we ought to shift to a different cap size in the expectation that every dog has its day? Or do we think that a careful advisor should own some of each because we do not know which will do best?
Do style distinctions actually help us better manage our clients' money?
Let's pretend that Morningstar had never come on the scene with the nine-box grid we have come to know and love. Let's say that a new company, "Eveningstar," developed and popularized a different approach to dividing up stocks and mutual funds. Suppose, for example, Eveningstar's extensive research had determined that companies whose executive car fleets are purchased from the Big Three tend to be run by insular, unimaginative and protectionist managers. Yet these companies' workforces have been loyal, honest and hardworking. Hence these buy-American businesses, as a group, tend to have fewer surprises, higher ROEs and larger dividend payouts, but their growth over the years has been modest. Eveningstar calls this group of companies the Domestic Fleet (DF) group.
Eveningstar then grouped together those companies that always purchase their executive car fleets from foreign auto manufacturers. Research shows that these companies tend to be headed by managers who are more hip to changes going on in the economy. They are willing to break with the pack to achieve quality and cost-effectiveness. They are more decisive and more comfortable with change. But these companies also tend to have a younger, more mobile workforce, which sometimes produces costly turnover. They tend to use stock-option incentives more aggressively, and it is not unheard of that their auditors have been willing to accommodate aggressive reporting tactics to appease the option holders and investment bankers. As a group, they grow faster but have more train wrecks. This group of companies has been designated the Foreign Fleet (FF) group.
But not all companies have standardized their buying of vehicles from Detroit, Tokyo or Frankfort. Some have decentralized their car-purchasing decisions, resulting in less homogenous executive fleets. Research has shown that, as a group, the 2,000 or so companies with Blended Fleets (BF) do have characteristics that make them unique from the DFs and the FFs. Academics are not in complete agreement on this, but most suggest that this culture of decentralization tends to result in businesses that are more opportunistic and adaptive.
So, eschewing market capitalization as a way of dividing the securities universe, Eveningstar evolved three categories that it believes are more indicative of business characteristics than the market-cap approach: DF, BF and FF.
I don't think we'd be surprised to learn that over the past 25 years, there were periods when the FF stock, as a group, outperformed the BFs, and other times when the DFs did much better than either of the others. That being the case, I wonder whether dividing stocks by their auto-fleet characteristics and separating mutual funds according to which of these groups were most prominent in their portfolios would be any more or less useful than the cap-size breakdowns with which we have become so comfortable.
"Growth" According To Murphy
What are we indicating when we make an effort to diversify our clients' portfolios by owning some mutual funds that operate in the "growth" style and some that operate in the "value" style?
Are we saying that sometimes a value style produces better results, and other times, the less-price-sensitive style does better? Are we saying that either a) we can figure out which will do better, so we will emphasize that one, or b) that we do not know which will do better so we will own some of each? Do we think this way because of the Morningstar style boxes, or do we really believe this is an intelligent way to make investment decisions?
I found myself getting a little confused as I wrestled with these difficult questions, so I decided to call on one of the most outside-the-box investment thinkers I know, my old friend George Murphy. Remember him? He's the blustery, self-taught fellow in his seventies who got his start in a wirehouse back office during the Eisenhower administration. He's got an opinion on everything, so I thought I'd quiz him on the growth vs. value thing.
Murph's disorderly office occupies a southeast corner of 120 Broadway, a grand, 1920s-style brick skyscraper two or three blocks from the New York Stock Exchange. It was just after 4 p.m. when the receptionist opened the door to Murph's inner sanctum. I heard his computer making that "boing" sound it makes when it shuts down. "Damned market," he barked at me as though I had something to do with the lousy close. "Can't make up its mind whether strong consumer numbers are good news or bad news. Drivin' me nuts."
"Yeah. This market has a very different feel to it," I offered as I settled into the old brown leather swivel chair that serves as a guest seat. I tried to swivel, but I bumped into a stack of magazines piled on the floor. "Do you ever read these things or do you just save them?" I asked. Murph made some sort of buzzing sound with his lips and dismissed my comment with a wave of his big hand. "You come to talk about magazines?"
"No, actually I have been doing some thinking about investment styles; you know, growth vs. value, and whether it makes sense to look at the world that way. I know you use mutual funds to supplement your own stock picks. Do you think growth is a style? How does it differ from value investing? Do you think style drift is a sin? Does style make any difference to you?"
"Mike, as long as you've been around, I'm surprised to see you wasting brain cells on that malarkey." Murph was never one to mince words. I smiled as I sensed a sermon coming on; that's what I came here for.
"Investing is always about value," Murph went on with building enthusiasm. "It's a simple matter of evaluating a share of a business the same as if you were buying the whole business. You estimate how much cash the business can earn, make some projections about the trend of those profits in the next 10 years, do a present value of the estimated cash flow and compare it with the market price. OK, it's a little more complicated than it sounds because getting the future right is tricky. You've got to weigh competitive forces, technology cycles and all that. But the basic process is pretty straightforward.
"The important point is that growth is just a part of the value calculation. If your research tells you the earnings can grow 8%, you get a certain present value. If you think they can grow 15%, you get a higher present value. But experience teaches us that the higher and longer you project a growth rate, the more likely you are to be wrong. It's a lot easier to estimate 30% growth than it is to deliver it in the real world of competition."
"Well, if growth is just a part of the valuation process, why do you suppose growth has come to be considered a style?'" I asked. "Why is it contrasted with value investing?"
"You can probably lay that one at the feet of Thomas Rowe Price," Murph opined. "He pioneered the idea that companies have growth cycles, and that by focusing your research in what he called 'fertile sectors,' you can spot companies in the take-off stage of their life cycle. Not only does a company's cash flow grow rapidly in this situation, but as its business grows, other investors notice it and start making more optimistic projections of future earnings. This tends to create a higher present value (a higher P/E on current earnings). So by spotting the business growth before the P/E takes off, an investor has the potential for a double whammy. Mr. Price called it growth-stock investing.
"There are two big risks, of course," Murph says. "First, the growth you bet on may never develop. Second, even when you latch on to a strong grower, at some point, the cycle of rising earnings and rising P/Es runs out of steam. If earnings just flatten out, the falling P/E can hurt you badly; think Coke and McDonalds. If earnings actually collapse, as often happens in technology-based businesses, then you get the reverse of the double whammy you were hoping for. Think Cisco.
"Estimating growth cycles is a dangerous game," he continued. "True believers think that diversifying across a hundred stocks eliminates some of the risk. But when the whole market environment has been on fire with optimism, or when most growing businesses are tied to technology, growth mavens are exposed to an overall market risk that's more emotional than rational. That's when the distinction you want to make is between investing and speculating, not between value style and growth style.
"You know what's the worst part of the style-box mania? It's assigning a growth label to a manager and insisting that he stick to owning companies that strive for fast growth even if the stock prices are insane. He is forced to make bad investments to remain in his box, or risk losing investors because of style drift.
"You'll never find me paying 50 times earnings for a business that's supposed to grow 40% for the next five years. The companies that actually experience that kind of growth are so rare that, to me, it's not worth the risk.
"You want to buy a good mutual fund, find a team that ignores the style boxes and focuses on buying a reasonably predictable stream of future cash earnings at a price that is attractive compared with a 10-year Treasury. See that they own businesses that are not all driven by the same macros. And be sure that the managers have been able to deliver results over the past 10 years, because it's always easier to talk the talk than to walk the walk.
"Speaking of walking, I have a train to catch. Granddaughter has a soccer game in Ridgewood at seven o'clock. Always nice to talk with you."
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.