Use of Specialized Investment Concept

One of the approaches to achieve superior returns is to employ a specialized concept or philosophy, particularly with respect to investment in stocks. As Charles D Ellis put it, a possible way to enhance returns is to develop a profound and valid insight into the forces that drive a particular sector of the, market or a particular group of companies or industries and systematically exploit that investment insight or concept. Some of the concepts that have been exploited successfully by investment practitioners are:

1. Growth stocks
2. Value stocks
3. Asset rich stocks
4. Technology stocks
5. Cyclical stocks

The advantage of cultivating a specialized investment concept or philosophy is that it will help you to: (1) focus your efforts on a certain kind of investment that reflect your abilities and talents, (2) avoid the distractions of pursuing other alternatives, and (3) master an approach or style through sustained practice and continual self critique. As against these merits, the great disadvantage of focusing exclusively on a specialized concept or philosophy is that it may become obsolete. The changes in market place may cast a shadow over the validity of the basic premise underlying the investment philosophy. Given your profound conviction and long term commitment to your specialized investment concept or philosophy, you may not detect the need for change till it becomes rather late.

Two Popular Management Styles:

Two management styles popularly used by active portfolio managers are value management and growth management. Value managers typically buy stocks that have low price earning ratios, low price to book value ratios, below average earnings growth and high dividend yields. Such stocks are referred to as value stocks. Value managers are sometimes called contrarian managers as they often buy “out-of-favor” stocks.

Growth managers buy stocks that currently enjoy high rates of earnings growth and are expected to experience high rates of earnings growth in future as well. These stocks called ‘growth stocks’ or ‘glamour stocks’ typically have high price earnings ratios high price to book value ratios, average earnings growth, and low dividend yields

The characteristics of value and growth stocks are summarized below:

Value Stocks Growth Stocks

Low earnings per share growth High earnings per share growth
Low price earnings ratio High price earnings ratio
Low price book ratio High price book ratio
High dividend yield Low dividend yield
Betas tend to be less than one Out of favor Out of favor
Betas tend to be more than one Popular

Empirical evidence suggests that, in general, value stocks have outperformed growth stocks, in terms of both raw and risk adjusted returns. The value managers seem to have performed better in several different countries and over extended periods of time.

Passive Strategy:

The active strategy is based on the premise on the premise that the capital market is characterized by inefficiencies which can be exploited by resorting to market timing or sector rotation or security selection or use of a specialized concept or some combination of these vectors. The passive strategy, on the other hand, rests on the tenet that the capital market is fairly efficient with respect to the available information. Hence, the search for superior returns through an active strategy is considered futile.

Operationally, how is the passive strategy implemented? Basically, it involves adhering to the following two guidelines:
1. Create a well diversified portfolio at a pre-determined level of risk.
2. Hold the portfolio relatively unchanged over time, unless it becomes inadequately diversified or inconsistent with the investor’s risk return preferences.

Case for Active Strategy:

How can one reconcile active portfolio strategy with the notion of market efficiency? While most managers are not likely to outperform the passive strategy on a risk-adjusted basis, economic logic and some empirical evidence suggest that exceptional managers might realize superior risk adjusted returns.

Consider the economic logic first. If all investors pursue the less expensive passive strategy, funds will not be available for pursuing active strategies. Hence prices will no longer reflect sophisticated analysis. This will then generate profit opportunities that will attract active managers who are likely to earn superior returns.

Now, look at the following empirical evidence: (1) Some portfolio managers have produced superior returns on a sustained basis and it is hard to regard them as just lucky strokes. (2) Given the noise in realized returns, it is not possible to dismiss the hypothesis that some portfolio managers have outperformed the passive strategy by a statistically small, but economically significant margin. (3) The persistence of some anomalies in realized returns suggests that those who detected them early may have outperformed the passive strategy over extended periods.