Hello! I’m back from my short vacation. How is everyone doing? In my last article, I shared with you the distinction between long-only and long / short investing. This week I introduce you to various investment styles ranging from deep value to hypergrowth investing.
There are infinite ways to make money in the public market: Some trade, some buy-and-hold, and some do something between the two. One thing is for sure: you cannot influence how your future employer invests.
When you join the buy-side, you will either struggle to conform because of lack of belief in the investment style, or you will excel because of strong alignment. Therefore, it’s absolutely paramount that you assess your personal investment philosophy, which should help you narrow down your job search targets. Yes, your opportunity set will be smaller than if you want to be everything for everyone, but you can tell a more convincing story, have more tailored stock pitches and most importantly, have a better chance of landing the job.
Conceptually, when you buy a stock, you get paid in three ways: dividend / stock buyback, earnings growth, and valuation multiple expansion (picture below, source: Hayden Capital).
Every fund claims they invest just slightly differently from the other funds out there, because an investment fund, as a business, needs to differentiate. In reality and my opinion, all stock picking funds generally fall into one of the genres:
Deep value investors generally invest in non-growing or declining businesses operating in secularly challenged or heavily cyclical industries. The hard assets (equipment, manufacturing plants, oil rigs, etc.) for these companies can be utilized unproductively. Or, a free cash flow generating company in a mature industry with no growth or revenue decline. A deep value investor could make money by agitating for the sale of the company or for aggressive return of capital via dividend or share buybacks.
Traditional value investing centers around the idea of mean reversion. Businesses can have short-term issues and the bet is by owning them during their troubled times and gaining conviction on the business' ability to revert to normality. Traditional value investors usually get paid on reversion to normalized earnings power and the subsequent multiple expansion.
They are perceived to be glamorous because all the publicity and the success the high profile activists have achieved (think Bill Ackman of Pershing Square, Dan Loeb of Third Point, Paul Singer of Elliott Management and Jeff Ubben of ValueAct.) It’s really just another form of value investing.
Activists take stakes in public companies to become one of their top shareholders in an attempt to influence strategic direction or capital allocation because they disagree with how the company’s board of directors and the CEO are running the company.
I view activism to be the true “private equity approach to the public market”, which explains why activist funds favor candidates with elite private equity work experiences.
Activist funds typically invest concentrated (Pershing Square for example, currently owns 8 stocks) and take long time to analyze a business – Many activism presentations are 100+ pages long, think about the amount of work that goes into that.
Activism can get paid across all three dimensions: dividend / buyback, earnings growth, multiple expansion.
Select famous value investors: Seth Klarman (Baupost), Leon Cooperman (Omega), Michael Price (MFP)
Select famous activist investors: Bill Ackman, Dan Loeb, Paul Singer, Jeff Ubben, Carl Icahn
GARP, Growth at a Reasonable Price
GARP investing is a blend of value investing and growth investing. GARP investors buy businesses that can grow consistently above market growth without overpaying.
A variant style under this genre is wide moat investing. They invest in consistently growing businesses who exhibit sustainable competitive advantage. Similar to GARP, wide moat investors will not pay crazy price, but they are willing to pay a slightly higher multiple than what GARP investors would, knowing the quality of the businesses provides the qualitative margin of safety.
GARP investors mostly get paid on earnings growth without needing multiple expansion.
Well, they invest in high growth companies, no confusion there. The companies in this category are growing very quickly because of their enormous addressable market. Hyper growth companies tend to be unprofitable when they become public because of the need to spend on marketing to grow aggressively to achieve dominance as soon as possible due to typically winner-take-all nature of their industries.
The stock market is mostly efficient, so hypergrowth companies often have high valuation multiples. Ultimately, the sensible hypergrowth investors need to have valuation discipline (sadly even the successful practitioners in this genre clearly have forgotten that rule in recent years).
The bet is that by applying a reasonable multiple on the long-term earnings power of these businesses, the price paid today to own them can generate attractive IRR or internal rate of return (for example, $10 to $100 over 10 years would be a 26% IRR).
Of course, the math is the easy part. The hard part is the deep work it takes to gain conviction in a hypergrower’s long-term earnings power.
The hypergrowth investors ultimately are paid on earnings growth, but they could be well compensated by multiple expansion if one bought a company at a reasonable multiple and the business is just on the cusp of entering the hypergrowth phase of their industry’s S-curve (shown below).
At such entry point multiple, the market was underestimating the earnings growth acceleration, which also underestimated the multiple the business can fetch during its hyper growth phase.
To learn more about hypergrowth investing: Read Alex Sacerdote of Whale Rock Capital
Select famous GARP / wide moat investors: Warren Buffett, Charlie Munger, Peter Lynch, Chuck Akre, Terry Smith.
Select successful hypergrowth investors (yes, some of them are blowing up as we speak): Tiger Global, Coatue, Whale Rock, Altimeter, Aterides, Shawspring.
Special Situation / Event-driven
Special situation investing relies on company-specific events to drive investment return. Aside from quarterly earnings releases, many events can have material impact to the value of a business and therefore its stock price.
One example would be a spin-off of a division within a conglomerate, where the market will appreciate the spun-off segment more with a higher valuation multiple when its economics are no longer masked by being within a sleepy conglomerate consisting of other inferior businesses. Examples of other events include: debt paydown, asset sale, rights offerings, etc.
Special situation investors get paid primarily through multiple expansion. This investing style has the advantage of generating near-term to medium-term returns that are uncorrelated to the broader market performance due to the dependence on company-specific events (also known as catalysts.)
Recall my discussion last time on pod shop / multi-managers generate returns based on company-specific events uncorrelated to overall market movements? So pod shop also falls under this genre. Most hedge funds prefer to invest with a catalyst in sight.
Another sub-genre with special situation investing is Merger Arbitrage: Merger arbitrageurs aim to make money by buying (and/or shorting) the acquirer and acquiree company based on assessment of probability of a merger transpiring.
The most famous special situation investor is Joel Greenblatt, whose book You Can Be a Stock Market Genius is a must read on special situation investing.
There is no right or wrong way to invest, you just need to be very clear on what situations and businesses resonate with how you invest, which will help you target the right funds to work for so you can perform and grow as a professional investor.
If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:
Don't know where to start to research and value a company? Have trouble generating stock ideas and differentiating on stock pitch? I can help you. Let's meet!