On to a winner?

Some investment professionals have strong beliefs in certain styles of investing, but the jury’s out about which is best, writes John Redwood

There are those who say you need to seek out value. Look for companies that are out of favour but can deliver good profits and dividends, and in due course you will be rewarded with an above average uplift in value. Critics say this is difficult to do and depends on being able to identify those market turnarounds and good managements that can overcome the problems that led to the shares falling the first place. You might think a difficult market is about to improve, but it could be a long term bad trend. There was no point in backing blackberries once the smartphone arrived. A management which promises improvement may not deliver.

There are the growth investors, who say it is usually a good idea to pay a premium to get into companies that have a proven track record of growing faster. They say you will outperform by backing fast growth, as the higher dividends and profits come in and pleasantly surprise the market. Critics say the premium you pay for such shares shows the market already knows about their faster growth. If the company stumbles you will lose more. The shares will go down both because the profits fell, and because without growth investors will pay a lower multiple of the profits to buy the shares. A growth company share might sell on 25 times the per share earnings if people expect fast growth. If profits fall, it might only warrant 15 times earnings, so it could be a big decline.

Some say you should concentrate on the dividends. After all, around one half of the typical return on shares over time comes from the running income they pay, and the other half from capital gains reflecting the growth in the asset value and earning power of companies. An Income manager buys shares that offer an above average dividend. Critics say many companies offering a high yield are about to cut the dividend or will struggle to put it up, making it a less good investment. Some income investors impose a discipline to try to avoid buying into high payers who will be forced to cut their dividend, or companies that cannot ever increase the dividend because it is high. Yield based investing is a variant of value investing. Of course, if you can find shares offering a 4% income when the market as a whole offers 2% and if the companies then grow you should do well.

Some investors argue that smaller companies as a whole will grow faster than larger companies. After all they tend to be the challengers with the new ideas, and they have more flexibility to exploit market conditions even when the markets are difficult. Over some long time periods in some markets this has been established. Others say small companies will get hit more by a recession or point out the population of small companies includes larger companies on the way down as well as smaller companies on the way up. Smaller companies as a whole can go out of favour for a bit. Some say they want to stick with larger companies as they have more pricing power in markets, can adapt to costly changes more easily, and can attract the best talent. This is a variant of the growth-oriented approach. Critics point out that there will always be a lot of larger companies that allow costs to get too high and become complacent about emerging threats to their business model.

Which of these is right? The answer is all these methods of investing have their good runs and their bad runs. As many of them rely on judgements, some managers can make good money out of a strategy which itself is not having a good time. Let’s say small companies are having a good run. Smaller companies’ funds on average should outperform larger company funds. An active manager however, could choose poor smaller companies and not join in the gains or could select a few very good larger companies and buck the adverse trend.

The answer is there is no guaranteed way of winning in capricious fast moving and complex markets. There are growth managers and value managers who beat an index over some years because they do well or are lucky. There are small company and large company managers who both underperform an index owing to their selections. The index itself has a style. It reinforces success and cuts out failure by putting shares into an index like the FTSE 250 or the S and P 500 when they reach a certain size and cutting them out when they are no longer large enough. There are strategies which will beat this, but at any given time it is a difficult judgement which strategies they will be. The nature of investment means that certainty is hard to come by and investors would be best placed to consider these various approaches, including their pros and cons, before making a decision. The Index often turns out to be one of the most successful investors.

There are many other strategies you can adopt. If you are doing it yourself you need to be aware that there are no guaranteed answers, and you need to do plenty of research to try and understand what is going on. That’s why many do end up backing a professional or a fund which has a particular style they believe in.