Chapter Five

Is There a Right Way to Invest?

Comparing Investment Styles

I can still recall how much grief I received in 1999 from various investment critics when I refused to pay exorbitant prices for technology stocks. The share prices were unreasonable, making valuations extremely expensive and unjustified. There was a clear disconnect between earnings and stock prices. Yes, the funds I managed suffered some short-term underperformance, but over the long term, it paid off when those technology stocks crashed. It pays to look (or in this case, study) before you leap. I must say that I wasn’t surprised when the bubble burst in 2000, when investors punished companies that failed to deliver expected profits by dumping their stocks. Investors who withstood the pressure and temptations of investing during those times of “irrational exuberance” were rewarded.

Too much time has been used up over the years by trying to determine which investment style is the most successful. All kinds of terminology have sprung up to describe the strategies employed: “technical,” “fundamental,” “active,” “passive,” “bottom-up,” “top-down,” “value,” and “growth.” Instead of rehashing the debate, I’ll outline my personal investment approach and explain why I think it makes sense for any equity investor.

Value versus Growth Orientation

Sir John Templeton once said that there was a tendency for too many investors to focus on “outlook” or “trend.” It was his belief that more opportunities could be uncovered by focusing on value and I agree with that.

Studies have shown that over the long term, stock market prices tend to be influenced by the asset value and earnings capabilities of listed shares. Also, share prices tend to fluctuate much more widely than real share values.

The value approach to investing was first and best defined by Benjamin Graham and David Dodd in their 1934 book Security Analysis. In that book, they articulated the system of buying value shares whose price was cheap relative to factors such as earnings, dividends, or book assets. But studies have also revealed elaborations on the application of that fundamental value orientation. For example, one study showed that investing in shares with a low ratio of share price to cash flow was a better strategy than buying shares with a low ratio of share price to book value. Others indicate that price-to-earnings (P/E) ratios were the best determinant of future price. Needless to say, despite what individual value criteria are used, those indicators that give investors insight into the earnings power and assets of a company are the best paths to finding value.

Many investors speak of “value investing” but few actually diligently apply the value investing principles and perform the hard work necessary to find real value. Those investors who do work hard at it are inevitably rewarded. The investor who purchases a stock that is selling below its intrinsic value can enjoy a certain peace of mind. If, after purchasing a stock at a low price in relation to value, the price continues to decline, then it is simply a better bargain than it was before. A number of studies have shown that dividend-paying companies perform better.

On the flip side, growth investors generally believe in buying stocks with above-average earnings growth without great regard for whether the stock is a bargain. In general, growth investors are more willing to pay a premium for such companies because they expect them to continue growing at such high rates. As a result of their high growth, such companies tend to have higher price-to-earnings and price-to-book value ratios than value stocks. In addition, growth companies tend to have low or even no dividend payouts, as profits tend to be invested into the company to further boost earnings. The main risk here is that the expected growth and profits may not occur. After all, just look back to 1999 when the technology sector was booming and investors were picking up stocks at astronomical prices with little regard for their current value but counting on their high growth to yield good value at a future date. However, when those companies failed to meet the high expectations placed on them, investors dumped their shares faster than you could say “technology crash,” which led to the bursting of the 2000 technology bubble.

Historically, growth and value investment styles often do not move in tandem. While the growth market was strong in 1999, investors ignored the benefits of value investing. However, after the technology crash in 2000, the market shifted and value investing began showing signs of strength and dominance. Understanding how an investment is likely to perform under different market conditions can help you avoid selling a fund or stock because its style is temporarily out of favor.

You may now be wondering which strategy is for you or which one makes more sense. I strongly believe that value investing is no doubt the way to go, especially for investors with a long-term horizon in mind. And here’s why.

History has taught us that when we buy value stocks, which are trading at low valuations despite strong fundamentals, over time the market will uncover the bargain and yield higher returns. In general, value investors tend to avoid paying unreasonable prices for stocks. However, growth investors tend to pay more attention to high market expectations and are more willing to pay higher and sometimes unreasonable current prices. (Here I must emphasize “current” since a price may seem high now but with high earnings growth that price may appear very cheap in the future.) In cases where expectations fail, value investors have less to lose as the stock has already been trading at low prices. However, in the case of the growth investor, the stock price would plummet and result in heavy losses, as seen with the technology sector in 2000. As a result, growth investing tends to involve greater risk than value investing.

I’ve been writing this as if there is a clear differentiation between value and growth. The reality is that you as an investor must always be looking to the future, and even when you are seeking value based on current earnings and current prices, you must always have your eye on the future since you expect a value company to at least do as well as it has done in the past and, hopefully, even better. You don’t want to buy companies that are not growing, even if they look cheap at current valuations.

Short versus Long Term

Another issue about which I have been particularly concerned is that of evaluation or measurement of returns. Over the years, I have consistently emphasized a long-term investment approach. I have had to write many letters to individual investors in funds I manage who have expressed concern when we have not taken opportunistic short-term positions. Another way observers forget or ignore the long-term approach is obvious when they ask questions like: “Why have the funds experienced a poor performance over the past six months?” I must continually remind investors and commentators that this is the wrong question, and that there is no “poor” six-month performance because sometimes it is necessary to underperform in the short term to outperform in the long term. If you are buying cheap stocks, they are cheap because they are unpopular and they could remain unpopular or even become more unpopular in the short term before the market wakes up and realizes that the stock is undervalued.

One problem facing the world today is the tendency for people to think in shorter and shorter time frames. A study undertaken in the 1990s indicated that stocks in U.S. companies were held for an average of two years, whereas in the 1960s they used to be held for seven years. Some shareholders look for a quick return on their investments, and thus business executives are increasingly driven by the same mentality. This short-term philosophy is detrimental to the health of the company and the investor. Unless companies and investors take a longer-term view, growth prospects are limited and planning becomes stunted. Taking a long view of emerging markets will yield excellent results for the investor prepared to be patient and willing to apply sound and tested principles in a diligent and consistent manner.

The approach we take is not that of a three-month, six-month, or even one-year period, but at least a five-year period. Over the many years that Templeton funds have been investing, I have found that striving for short-term performance increases the risks to shareholders and actually results in poorer returns. Only by taking the long view will investment managers be able to do the best job for investors.

Bottom-Up versus Top-Down Investment Strategies

There is continuing controversy over the optimal research approach strategy to apply to emerging markets portfolio management, or for that matter any equity portfolio. On one side of the fence is the bottom-up investment school of thought, and on the other side are the top-down investors. Let me make clear from the outset that I think the arcane debate over the merits of narrowly defined investment strategies is often not very productive. Any good fund manager applies all the investment information he or she can obtain to make a good decision, and is unlikely to satisfy pure patterns that are merely convenient definitions.

When beginning our investment research we tend to take a “bottom up” approach by studying individual companies wherever they may be located in the world and in whatever industry they may be in. In this sense, the “bottom-up” research focuses on the details of each and every company: What the nature of their business is, how profitable they are, what the value of their assets is, and so on. The “top-down,” or macroeconomic and political information, is then used to place the “bottom-up” information in context. No company can exist in isolation, and the economic and political conditions of the country or countries in which it operates will impact profitability and long-term planning. We need to be concerned with macroeconomic and political conditions to the extent that they may hinder or help a bargain company achieve its objectives. Bottom-up investors allow country and sector allocations of their portfolios be determined by bottom-up stock selection while taking into consideration the wider picture.

If an investor wants to take a strictly top-down approach, he or she will first select the countries in which he or she would like to invest, through the analysis of the economic and political environment in those countries. He or she may also study industry sector characteristics to determine which sectors are best. Only after those studies will he or she begin to select individual stocks within those markets and sectors finally looking at value as well as such considerations as liquidity and market capitalization, factors that would influence the manager’s ability to enter and exit the market easily. Of course these categorizations of bottom-up and top-down investment styles are gross oversimplifications, and it is difficult to find managers who neatly fit those descriptions. The subject is fraught with dangers, simply because definitions of investment styles tend to pigeonhole particular managers and leave them with fewer options. More often than not, some managers would tend to emphasize stock selection whereas others would tend to emphasize country allocation, but both would at all times be considering macroeconomic and political situations as well as individual stock differences. It is difficult for any manager to ignore matters regarding earnings, growth, and dividends that are inherent in the evaluation of companies while ignoring such macro factors as exchange rates, interest rates, currencies, and other such factors and their impact.