"Buying above-average businesses at average prices is just as much value investing as is buying average business at below-average prices." -- Bill Nygren   HAT'S THE BEST INVESTMENT strategy for the long-term investor? Ask three "investment professionals" or "financial advisors" and you'll probably get four different answers. Fact is, most investors don't have a specific strategy. Even professional money managers switch approaches as market conditions change. (Just look at the "style boxes" in Morningstar and notice how many mutual funds with "value" in their names are really growth funds, and vice-versa.) Besides the method used by most investors (technically known as "Seat of the Pants"), there are several primary strategies: Momentum, Growth, Value, and Core. Here's a look at each. Momentum Investing Momentum investing doesn't really get the respect that it probably deserves. Many investors look down on it as a mindless "follow the leader" approach while others blame it for the 1990's bubble. Few money managers openly admit to employing a momentum approach. That's really too bad because in and of itself, there's really nothing wrong with a consistently applied momentum strategy. In fact, many investors do this without really knowing it. More about that in a moment, but first let's get an idea of what momentum investing entails. The theory here is that the trend will continue and will propel the share price As is the case with many general approaches, momentum investing can involve several different but related strategies. The two most popular are earnings and price momentum. Investors apply earnings momentum by creating portfolios of stocks of companies have have had steady or rising earnings growth over the recent quarters. The theory here is that the trend will continue and will propel the share price. Price momentum is just what the name implies. It's a strategy of buying stocks with share prices that have been steadily increasing. Again, the underlying belief is that the trend will continue. Mindless or Mind Less? It's this adherence to the trend that gives momentum investing its name and what many feel gives it its bad name. After all, you don't have to spend a lot of time analyzing ratios or spotting chart patterns to simply follow the leaders. What a mindless approach! Those following the 1990s' herd were riding the market momentum, but they weren't really momentum investors. But momentum investing really isn't that simple -- at least for the successful investor. While it's true that anyone could build a portfolio by buying the latest hot stocks, not everyone is able to hold onto the resulting profits. You see, trends -- especially in the stock market -- can be powerful and long-lasting, but they do eventually reverse. The successful momentum investor not only has to spot a trend, he or she has to have a sense of when it will end in order to hang onto profits and avoid possible losses. With this approach, being a day or two late can be ruinous. That's why many blame momentum investors for both the excesses of the 1990s as well as the devastating aftermath. They believe, large stocks -- particularly tech and telecom shares -- were driven to absurd valuations by traders blindly buying on momentum. When the bubble burst, they fell over one another running to get out, sending shares crashing down. There may be some truth in this reading, but investors' greed and overconfidence were the true culprits. Any strategy used to excess -- whether it be momentum or any other -- will ultimately end this way. Those following the 1990s' herd were riding the market momentum, but they weren't really momentum investors. The true momentum investors weren't just mindlessly buying what everybody else was but instead were seeking stocks of companies with a history of above average earnings growth or price appreciation. Funny Little Secret Before leaving momentum investing, it's worth noting that some of the very investors who look down on this approach are actually using it themselves. In fact, millions of investors are using it and don't even know it. Indexing has become a popular investment strategy. Many investors who don't have the time to research and construct their own stock portfolios or those who have tired of trying to beat the "market" have decided to be the market. Studies have shown that the majority of actively managed mutual funds fail to beat their benchmarks, so why not just own the benchmarks? Index mutual funds and exchange traded funds (ETFs) closely track the performance of most major indexes, and do so with relatively low expenses. By using a combination of these vehicles, an investor can efficiently construct a portfolio to match any desired asset allocation. This is appealing to many who wouldn't be caught dead chasing momentum, but that's exactly what they end up doing when they invest in equity index funds. The secret is lies in the way most of the major indexes commonly used as investment benchmarks are constructed. Most stock indexes like the well-known S&P 500 are capitalization-weighted rather than equal-weighted. As an equal-weighted index, it would apply the same weight Since major indexes -- and the index funds that track them -- are cap-weighted, they tend to act like momentum portfolios. to each of its 500 stocks, but instead as a cap-weighted index each stock is weighted by multiplying its share price by the number of shares outstanding. As a result, larger companies' shares carry more weight and have a greater impact on the index. Does this make a difference? You bet it does. In 1999, for example, the S&P 500 rose over 21% yet over 50% of the stocks in the index posted losses. The top 50 companies accounted for all of the gain while the other 450 cancelled one another out. The shoe was on the other foot in 2003. Then, small companies outperformed their larger counterparts. As a result, the equal-weighted S&P 500 outperformed the cap-weighted version by 39.6% to 28.7%. Since index funds typically benchmark the latter, their returns were around 28%. Since major indexes -- and the index funds that track them -- are cap-weighted, they tend to act like momentum portfolios. They, like momentum investors, are overweighted in the fastest growing and oftentimes priciest firms. The irony of the situation is that many investors who wouldn't even consider applying a momentum approach are often the most comfortable investing in "safe" index funds. Like any strategy, momentum is as safe or risky as you make it. Growth Investing Growth investors focus on the fundamentals, looking for companies with above-average growth in sales, revenues, or most commonly, earnings. This makes a lot of sense. After all, investors who invest in successful companies are usually rewarded with rising share prices. Measures of growth are always relative, they're always compared to something else. Growth investors don't just look at this quarter's results, but how they compare to last quarter's, last year's, the performance of other companies in the industry, etc. They seek companies showing steady or accelerating growth. This improvement should ultimately translate into an appreciating stock price. At What Price? So if a company's sales, revenues, or earnings are consistently growing, you should buy its stock, right? Well, yes, according to some growth investors -- those who believe you buy growth at any price. In fact, that's what this strategy is called: growth at any price or aggressive growth. Those taking this approach don't even look at the stock's price when making their decision. For them, it doesn't In searching for the best investments, isn't it also reasonable to seek quality at the best price? matter where the stock's been or where it is now. All that's important is that the salient yardsticks show growth; because if they do, the stock's price will appreciate regardless of where it is now. These are people of conviction! They're willing to buy high in the hopes of selling even higher. You've certainly got to admire them for acting on their beliefs. But then again, you might also think a certain make or model car is well made and reliable. Nevertheless, if you're like most people, that still won't deter you from shopping around and negotiating the best price. (You don't pay sticker price, do you?) In searching for the best investments, isn't it also reasonable to seek quality at the best price? This is precisely what other growth investors do. While they still focus on growth, they make an effort to not overpay. What you're really buying is growth potential. If two companies have the same growth potential but one sells at a lower price than the other, isn't it the better buy? Don't you, in essence get more growth for your investment dollar? The trick is determining a fair price. There are a number of ways to do this based on sales, revenues, or earnings, but it takes a little work. It Works in Theory The most common growth valuation centers on the price-to-earnings ratio or P/E. To calculate it, you divide the company's annual earnings by the number of shares outstanding. This gives you the earnings per share. The P/E is the result of dividing this figure into the current share price. Some growth investors look for stocks with P/Es that are expanding. You might call this growth momentum. Others look for companies that are growing earnings, but have steady or falling P/Es. In this case, the company's share price hasn't yet caught up with its earnings growth so there's a REAL EARNINGS vs. REAL WRITE-OFFS Cisco Systems 2003 Source: Baseline In 2003, fully 65% of Cisco Systems' reported earnings were the result of write-offs. This is still better than its industry and the overall tech sector that saw 100% of reported earnings come from write-offs. The stocks of the S&P 500 were little better with write-offs representing 37% of reported earnings. Given this, growth investors have their work cut out for them. potential for additional gains when the P/E expands to its appropriate level. Another approach focuses on the so-called "PEG Ratio". This compares a company's P/E to its expected growth. In general, if a company's earnings growth rate is equal to or less than its P/E, it's a good buy -- you can purchase its growth potential at a fair price. On the other hand, if the P/E greatly exceeds the growth rate, it isn't a good bargain. Nailing Jell-O to the Wall Unfortunately, "earnings" may be a little harder to measure than you might at first think. This is critical when earnings (or sales, or revenues, or whatever) are the basis of your investment decisions. First, you need to make sure you're comparing apples to apples. If you want to compare companies' P/Es, you should calculate them yourself or at the very least, get them from the same place. You can get P/E figures from a number of different sources, but few are calculated in the same way. For example, The Wall Street Journal's P/Es are based on the trailing four quarters' actual reported earnings. The Standard & Poor's Outlook calculates theirs based on analysts' projected earnings for the coming year. The Value Line Investment Survey is a hybrid, using the last two quarters' actual reported earnings and their analysts' projections for the next two quarters. Lord knows what your local paper uses. To make matters worse, as we've learned all to painfully from the likes of Enron and WorldCom, even when earnings look good, they may not be. Back in the 1990s, companies went to great lengths to show earnings growth each quarter. As we're still discovering, much of that was simply smoke and mirrors. To be successful, you've got to have a consistent means of finding good companies and purchasing them while they're still growing. The pressure of today's markets encourages companies to find creative ways to report the numbers. The success of a growth investor's buy and sell strategy is determined by the accuracy of his or her projections. In today's environment, this becomes more and more difficult, sometimes like trying to nail Jell-O to the wall. This isn't to say that growth investing doesn't work -- it does. No one can deny the remarkable run growth stocks enjoyed in the decade of the Nineties. But contrary to the steadily upward sloping long-term stock charts, it isn't a straight shot. To be successful, you've got to have a consistent means of finding good companies and purchasing them while they're still growing. You've got to be willing to do your homework and dig into mind-numbing company reports and balance sheets. Just as successful momentum investing is more than just following the crowd, growth investing isn't just "buying growth". it's more disciplined than that -- at least for the successful growth investor. Value Investing Value investors are bargain hunters. They want to buy stocks that are "cheap" relative to a company's earnings or intrinsic value. Unlike growth investors who are willing to pay a premium for growth, value investors want to buy stocks that are down in price. While not possessing the glitz and glamour of momentum or growth stocks, value selections should offer appreciation potential with less downside risk. GROWTH vs. VALUE Annual Returns 1978-2002 Source: Ibbotson Associates The growth and value styles have taken turns outperforming throughout the last 25 years. Judging from annual returns alone, there's no clear winner. Value investors also have to be more patient since they must wait for their stocks to return to their appropriate value in order to recognize any profits. Unlike growth or momentum investors who often receive -- and expect -- instant gratification, value investors must be prepared to wait. Standards of Value There are a number of measures that can be used, but most value investors look at ratios such as P/E, price-to-sales, or price-to-book. For example, investors using P/E, compare a stock to its particular industry sector or overall market. If its P/E is less than that of the sector or market, the stock is a relative value. By purchasing this stock, you are paying less for its earnings than you would for those of comparable alternatives. Presumably, the further the P/E falls below the benchmark, the better the buy. This is relative value. Book value is a common measure of intrinsic value. A company's book value is roughly what remains when its liabilities (including preferred Not all low-priced stocks are bargains. Some are just dogs. stock) are subtracted from its assets. It's essentially the company's liquidation value. This is a base measure of value since the company should be worth at least this much. You can find the book value of the company's stock by dividing the company's book value by the number of shares outstanding. This is the book value per share. By comparing this to the stock's current price, you can determine if it's fairly priced, overpriced, or somewhere in-between. The search for companies selling at a discount to their intrinsic value is often referred to as deep value. What Value Investing Isn't OK, so to be a value investor, all you have to do is find some beaten-down stocks and buy them on the cheap, right? Well, no. While value investors are bargain hunters, they aren't necessarily bottom fishers. Not all low-priced stocks are bargains. Some are just dogs. A lot of stocks are beaten-down for good reasons. Value can't be simply captured by looking at one measure such as P/E or Price to Book. Other external issues must also be factored in. A cheap stock with a shrinking market share is no bargain. A cheap stock with poor management should also get a miss. Companies overburdened with debt are cheap because they are teetering on the verge of bankruptcy, not because they represent any sort of value. Some stocks are cheap because they ought to be, not because they're bargains. Value investors must work to separate the wheat from the chaff. Core Investing Core investors are often mistaken for having no real investment strategy. That's understandable since in building their portfolios, they use both value and growth standards. Offhand, they may appear to be undisciplined and simply blowing with the wind. Some investors are undisciplined, but not true core investors. Instead, they seek diversification by investing in a broad spectrum of stocks. Many design their portfolios to be weighted like their benchmark indexes. Often they hold issues from all 10 S&P sectors. That's why they have to blend elements of both growth and value styles. Different sectors of the market call for different approaches. SECTOR STYLE CHARACTERISTICS Sector Type Style Consumer Discretionary Cyclical Growth Consumer Staples Defensive Growth Energy Cyclical Growth Financials Cyclical Value Health Care Defensive Growth Industrials Cyclical Value Information Technology Cyclical Growth Materials Cyclical Value Telecommunications Cyclical Growth Utilities Defensive Value Think about it: Would you use the same metrics to pick a tech stocks as you would to find one in basic materials? Book value would be very important to the latter and almost meaningless in the former. More specifically, the materials sector tends to be a value sector while the tech sector is more of a growth sector. Core investors apply the appropriate style for each particular sector. The nearby table shows the 10 sectors and how they're usually classified. If done properly, core portfolios look a lot like those of an equal-weighted broad market index. This is the diversification and relative safety that many index investors think they're getting. Like growth and value investing, it takes a lot of homework to get it right. In fact, it may even take more since core investing requires the right combination of the other two styles. Comparing the Alternatives The value approach requires more patience than the alternatives. Momentum investors expect immediate results. If they don't get them, they're out of a stock as quickly as they got in. Growth investors don't have a lot more patience. As their name implies, they expect growth and if they fail to get RISK AND RETURN 1978-2002 Source: Ibbotson Associates Over the 25 years from 1978-2002, growth and value stocks have had roughly the same return, but value has achieved this with less risk. it fairly quickly, they move on. Core investors combine both growth and value styles and expectations. In general, value stocks tend to be less volatile. Since they're already depressed, they have much less to fall in a market swoon. (As a wise old broker once said, "You don't have far to fall when you're already lying on the floor.") Momentum stocks can fall as quickly as they climb, and nowadays growth stocks go through a period of turbulence every quarter when earnings are reported. Value investing may appear to be much better suited for the faint-hearted, but no investment -- especially equity investment -- is a one-way ride. Like growth or momentum stocks, value stocks can fall from favor and remain that way for quite some time. Although they tend to be less volatile, value stocks are still subject to substantial losses when the market turns against them. So given that no style is a sure thing, which has historically offered the best long-term performance? They all do. It just depends on the time frame you use for your measurement. During the bear market from 2000-2003, value stocks were the place to be. If you expand your time horizon a little further; growth investing has been the winner going back to 1990 and especially through the great bull market of the 1990s. GROWTH vs. VALUE Source: Ibbotson Associates Growth had a strong showing throughout the decade of the 90s. As a result, it finally moved ahead of value, only to fall back behind in the bear market. Even so, the returns from both are pretty similar over the past 25 years. Yet over the past 25 years, value has had the lead. Growth briefly pulled ahead in the late '90s, but quickly fell back behind when the tech bubble burst. Over that time, both had roughly the same return, but value had less risk as measured by standard deviation. These results are illustrated on the nearby graphs. The Spectrum The aggressive growth investor buys stocks that he or she believes have the highest growth potential regardless of price. But most growth investors aren't this aggressive. They don't want to overpay for potential growth so add an additional element of valuation -- a value element. This is usually called "growth at a reasonable price", GARP for short. Similarly, deep value investors seek stocks that are "cheap" relative to their intrinsic value. But if you stop there, you risk buying some real dogs. After all, if a stock is cheap there's usually a reason for it. Either its industry is out of favor or it has some company-specific problems. If it doesn't have the potential to turn around -- to grow -- then it could stay "cheap" for quite some time. Read: dead money. It's because of this that most value investors incorporate some screen for potential growth. As you might have already figured out, investing styles aren't purely black and white but instead fall along a spectrum. Deep value and aggressive growth anchor the ends. Moving towards the center, you find THE INVESTING SPECTRUM Few investors are deep value investors or pure growth investors. Most find themselves closer to the middle of the investing spectrum. relative value and GARP, respectively. Remember, these are dominated by their namesake style but incorporate elements of the other. Finally, at the center of the spectrum you find core, an approach incorporating both styles. Investors here apply growth screens for some stocks (e.g. technology) while using value parameters for others (e.g. utilities). They believe value measures are most appropriate for some industries while growth parameters are more suitable to others. Where do you fall? Probably not at one of the extremes, and that's OK. After all, growth without value is quite akin to gambling, while value without growth is dog catching. The important thing is to have a specific style and stick to it. Success in investing comes from consistency.   E-mail your comments. Search this site! 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