Utterly Styleless

As in a number of other disciplines, investors groups themselves according to some (often arbitrary) criteria. It goes with the in/out tribal nature of humanity. Are you a liberal or a conservative, a frequentist or a Bayesian, a value investor or a growth investor?

Value investing means buying stocks that appear cheap on current multiples and growth means buying those that seem cheap on future multiples. Regardless of which so-called “style” an investor follows, the objective of active management – to outperform passive alternatives – remains in tact. So why do investors pitch their tent in one of the two camps?

The origin of the distinction between growth and value can be traced to a paper written over 20 years ago by two of the most respected academics on the topic of asset pricing. Fama (a 2013 Nobel prize recipient) and French argued that the CAPM failed to accurately price the risk on smaller companies (the “size effect”) and those with low price to book (the “value effect”).

This gave a boost to an already-blossoming line of literature examining various anomalies, or breaches of the predictions of the CAPM. Some demonstrated that buying stocks in January and selling in May outperformed, others showed that buying stocks just before they reported results paid off over time. But the most pervasive, from the point of view of the design of the asset management industry as we know it today, is the idea that most stocks fall into one of two categories, value or growth, and managers should behave differently depending on the category they are involved with.

Commentators like James Montier have argued that investor overpay for growth and that value is the only discipline the sensible investor should follow. This line of reasoning extends an approach to investment analysis that can be traced to Graham and Dodd’s Security Analysis textbook. Published in 1934, well before the formulation of the CAPM, the approach advocated by Graham and Dodd has been spliced with the results from Fama and French to give an ostensibly credible lineage to value-investing. But Graham and Dodd neither coined the term “value-investing” nor did they draw a distinction between two styles of investing. Graham and Dodd simply laid out analytical tools for determining whether a stock was cheap given the risks – this is what investing is and should be about, regardless of style.

Value investors expect a specific trajectory in earnings (or cash flows) much the same way as growth investors. Getting this right is more important than being in the right camp to start with. More often stocks don’t fall cleanly into either category and crude criteria such as price to book and price to earnings brush over accounting differences, leverage and the organic sustainability of earnings at the expense of the efficient pricing of risk.

So, there’s nothing fundamental to the style distinction. The two categories exist due to the flaws in a now-debunked theoretical framework, the CAPM. If the theory was better to start with, Fama and French would not have found these exceptions. But we would still stick to the principles laid out by Graham, Dodd, Buffett, Marks and a host of other successful investors – we would just call it “investing” and we would do it without style.