Why style matters in stock selection

At one end of the spectrum are those who believe that one style or other delivers better returns over the long term. At the other are those who, as pure pragmatists, regard themselves as uninterested in style. In the middle many combine elements of both styles such as the so-called Garp (Growth at a reasonable price) managers.

To assess the importance of style, it is necessary to go back to first principles. The origins of growth and value and growth investing both go back to the Great Depression of the 1930s. Investors, understandably traumatised by the experience of the 1929 Wall Street crash, were concerned with how best to minimise the risk of losing their capital.

The approach of growth investors was to look for companies with strong earnings potential in the future. Since shares were essentially claims on future earnings, those firms with a strong profits outlook were likely to perform better. This approach was first outlined by John Burr Williams in his Theory of Investment Value in 1938.

In contrast, value investors sought shares that were cheap by various measures such as price to earnings or price to book ratios. If shares were cheap, it was more likely they would perform well and certainly less likely that they would fall. Benjamin Graham and David Dodd outlined this approach in Security Analysis in 1934, and Warren Buffet is its most famous advocate.

Growth investing became closely associated with the technology sector during the TMT boom of the late 1990s. But such sectoral generalisations should not be taken too far. It is true that, on average, technology firms are more growth-orientated than, say, utilities. However, within each sector there are firms that are more growth-orientated and others that are more geared towards value.

Style is a useful tool for investors concerned with achieving a diversified portfolio. Being aware of style is not the same as having to follow growth or value under any circumstances. Style is one of several variables of which investors should be conscious, but it is a useful factor to monitor.