In these turbulent times, it's key to understand difference between the three investment processes
What next for your portfolio: growth, value or momentum investing?
Investing has its fair share of jargon, most of which private investors can cheerfully ignore, but sometimes a little technical knowledge can go a long way towards making you richer.
Three fundamental investment processes are worth knowing, because they help investors choose the stocks, funds or markets that they believe are going to outperform in future.
They are called growth, value and momentum but don’t panic, they are surprisingly easy to understand.
Tuan Phan, a board member of SimplyFI.org, a non-profit community of UAE investment enthusiasts, says these three investment “factors” can point towards future stock movements. “Many investors believe that by focusing on either growth, value or momentum, you can beat the market over the long term.”
As the global stock sell-off triggers another bout of investor nervousness, it pays to keep a cool head. The following three factors could help you survive whatever markets throw at you next.
So without getting too technical, what do they actually mean for your portfolio?
Growth investing is the simplest of the three to understand, as it is what most private investors instinctively do. It involves investing in companies whose earnings are expected to grow at a faster rate than the rest of their sector, or the overall market, in the hope of banking larger capital gains when their share prices rise as a result.
The so-called Faang stocks – technology heroes Facebook, Amazon, Apple Netflix and Google owner Alphabet – have been the big growth story of recent years. Earlier growers include emerging markets after the millennium, dot.com stocks in the 1990s and the “Nifty 50” - stocks such as General Electric, Coca-Cola, and IBM that investors were told to buy and hold - in the 1960s.
Growth stocks are expected to keep boosting their earnings even when the wider economy slows. “Investors may buy even if the share price appears expensive based on traditional measures such as their price-to-earning or price-to-book ratios," Mr Phan says.
You can invest in a spread of growth stocks through specialist exchange traded funds (ETFs) and Mr Phan singles out Vanguard Growth ETF Portfolio (VGRO), which invests in US, Canadian and international equities.
Tom Anderson, senior investment manager at Killik, who has clients in the UAE, picks out another growth ETF, the Lyxor Russell 1000 Growth UCITS ETF (RUSG).
The downside of going for growth is that if a stock grows at a slower pace than hoped, disappointed shareholders may bail out, bringing the share price crashing down.
Growth stocks may also struggle when share prices are falling, the global economy is slowing and investors are feeling cautious, as many are at the moment.
Sam Instone, director of UAE-based investment advisory AES International, says growth investors tend to focus on sectors such as technology but also smaller company stocks, which may grow at a faster pace than larger blue-chips. “They mostly operate in rapidly expanding sectors and have a competitive edge or first mover advantage,” he says.
If they can establish a strong brand and customer loyalty, the growth story could keep rolling, Mr Instone adds. “Modern growth success stories would be Uber or Airbnb."
Value investing involves buying stocks, funds or markets that appear to be unjustifiably under priced, or below their intrinsic value, in the hope that the rest of the market wakes up to their real value at some point in future, when their share prices will recover.
It takes courage to go against the crowd, and patience while you wait to be proved correct, but great rewards await those who get it right.
Warren Buffett, the world's second richest man and most famous investor, is a renowned value investor, Mr Phan says. "Over the last 25 years, Mr Buffett and Charlie Munger have successfully applied this principle to turn their vehicle Berkshire Hathaway into the $544 billion conglomerate it is today.”
Again, there are ETFs targeting value and Mr Phan picks out Vanguard Global Value ETF (VVAL), which invests in a global spread of stocks whose prices are low relative to their fundamental measures of value.
Mr Anderson says value as a style tends to outperform the wider stock market over very long periods. “However, out of favour value stocks can be more sensitive to economic conditions and you may have to put up with extended periods of underperformance.”
Mr Instone says the danger is that there may be very good reasons why some stocks have seemingly low valuations. “Disappointing sales, a company scandal, or a business strategy that shareholders no longer believe in are just some of the threats.”
Investors also need to avoid falling into a “value trap”, he adds. “This happens when you invest in a company that you think will rebound … but never does.”
Momentum investing involves buying stocks that have delivered high returns over a certain period of time, say three to 12 months, while selling those that have performed poorly. “The idea is that stocks that have done well recently will continue to do well," Mr Phan says.
This reverses the old stock market maxim: buy low, sell high. In effect, you are buying high, with the aim of selling even higher.
Mr Anderson says momentum investing aims to turn herd behaviour to your advantage. “As individual investors mimic the wider market reaction, this should drive yet further momentum.”
If tempted by this theory, he tips ETFs iShares Edge MSCI World Momentum (IWMO), Vanguard Global Momentum Factor (VDMO) and iShares Edge MSCI USA Momentum (IUMO).
Mr Phan says the three investment strategies perform differently depending where you are in the economic cycle. “Growth stock tends to perform best in a growing economy and have dominated during the bull market of the past decade," he says. "However, that may change when the market reverses.”
Buying value stocks during a market downturn can deliver better results in the longer run. So if markets slow, you may wish to switch from growth to value.
This suggests that now could even be a good opportunity to go hunting for value stocks, taking advantage of the recent stock market meltdown.
However, Mr Phan says there are dangers in following any of these three factors, as you are effectively taking a bet on the performance of a certain sector or style, and may call it wrong. "You may need a long-term outlook, because your chosen factor could underperform the market for a decade.”
Instead, you could invest in a combination of different factors, through the iShares MSCI Multifactor Global ETF (ACWF), he suggests.
Mr Phan says investors should limit single or multi-factor ETFs to no more than 10 per cent of their portfolio.
Don't worry if this jargon sounds too daunting, Mr Phan says there is a simpler way. “For most investors, a much better strategy involves using a broad, global index such as the Vanguard FTSE All-World ETF (VWRD) or Vanguard FTSE All-World UCITS ETF (VWRL), which contains all the factors by default.”
Just buying a single fund will cut your trading costs and be easier to manage, with no risk of underperforming the market, Mr Phan adds.