Improving on Morningstar Style Boxes

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No one would ever confuse a short man with dark hair and a tall one with light hair.  But this is precisely what investors do when they categorize stocks as either growth or value.  Those style definitions, championed by Morningstar and others, are flawed, and I have a way to fix them.

To illustrate, consider the following hypothetical conversation:

“I just got a new car. I love it.”
“That’s great. What color is it? Red?”

“No, it’s a station wagon.”

The investment community’s version of this flawed logic:

“I just invested in this great fund.”
“That’s great. Is it a growth fund?”
“No, it’s a value fund.”

The general consensus is that value and growth are opposites of each other, as if those two qualities were as mutually exclusive as, say, hot and cold, dark and light, or shiny and dull.

The familiar, traditional style box has a horizontal axis that goes from value on the left to growth on the right, with a middle, catchall section, called core or blend depending on your vendor of choice. Typically, stocks that have a low price-to-earnings ratios fall into the value bucket; stocks of companies with high earnings growth rates fall into the growth bucket.

The problem with this framework is that these two variables don’t have much to do with each other. The first is a measure of market price to current earnings, while the second measures earnings growth without factoring in the market price at all. These are measurements of different, unrelated things. It’s as if someone making a style box to describe people put tall on one end of the axis and dark hair on the other.

By positioning these two styles as opposites of one another, you inevitably end up with categorizations that don’t make sense. Companies with high growth rates and low P/E ratios end up in the same bucket (blend/core) as companies that have low earnings growth and high P/E ratios — two stocks with the exact opposite features that the style box is trying to segregate. Short guys with light-hair end up in the same middle category as tall guys with dark hair. Maybe we’d call them both “blend.”

Let’s take a step back and think about the goal of a style box. A useful categorization system is one that gives an investor a quick, objective method to evaluate a manager’s investment style.

Roughly speaking, there are two basic approaches to investing. One school of thought is value investing, which is simply buying a security for less than its worth. A value investor tries to calculate the value of a business, typically by attempting to predict how much it will earn in the future. The growth rate of those earnings, however, is just one variable in determining value.

The alternate school of investing attempts to predict future movements of stock price based on a various extrinsic factors – e.g., a change in ratings by a sell-side analyst, a news event, macroeconomic developments, shifting investor sentiment, the announcement of quarterly earnings better than the consensus of sell-side analysts (“beating earnings”), new product releases, etc. Earnings growth is only one aspect of this style of investing. This investment philosophy is better described as “momentum.”

Read more articles by Stephen Dodson