Effective portfolio management is vital for any investor, and there are a number of strategies that investment companies and financial advisors use to help investors evaluate their assets. One method is to use a style box. The style box helps investors understand the diversity of their assets by positioning those assets on a simple box grid.
Here are two examples of stock and bond style boxes.
Used to assemble and assess a portfolio of investments, a stock style box enables investors to see each investment’s position on the grid relative to the others and how their portfolios are positioned overall. It’s a simple, clear representation, and is commonly employed to help investors diversify their assets. Investors should, however, be wary of limiting their investment options based on the dictates of the style box, particularly during a market crash when out-of-the-box thinking is often required.
What Is a Style Box?
The style box, popularized by Morningstar, Inc. in 1992, is a visual representation of the investment characteristics of an investment portfolio (containing either stocks or bonds).
Market Capitalization Represented by the vertical axis, this criteria divides stocks based on company size: large, medium, and small.
Investment Style Indicated by the horizontal axis, this measure of valuation classifies stocks based on whether the company displays value, blend (value and growth), or growth characteristics.
Together, the axes generate nine categories:
- Large value
- Large blend
- Large growth
- Medium value
- Medium blend
- Medium growth
- Small value
- Small blend
- Small growth
Applications and Limitations of the Stock Style Box
The stock style box has a number of strategic uses. Investors aiming to diversify their portfolio can use the style box to identify stocks or investments for each category. Investors with specific financial goals can use it to target positions of a particular style; for example, investors with a high risk tolerance and desire to attempt earning higher returns can use the box to zero in on more aggressive small growth investments.
Unfortunately, the box methodology of ranking and averaging based on the diversified performance of stocks falls short during a market crash when all stocks are moving in one direction: down. This is called correlation. An example of this extreme correlation of 1, which means everything is moving in the same direction at the same time can be found in a chart of the asset classes during the crash of 2007-2009. In minor corrections it’s often the case that one investment style can compensate for the problems in another. In major crashes and panics this is not the case. Only another assets types such as gold or cash, which people sometimes don’t have, helps. When stocks decline across the board, over-diversification of stocks does little to help mitigate losses.
To us it’s simply best to find and invest in the best companies, period.
Which companies do we focus on?
Small, growth companies that show a revenue trajectory rising from $100 million to $2 billion over a period of four to 10 years, even better if it’s over 5 years. It’s not to say you can’t make money other ways, we’ve just found this to be a particularly sweet spot. A company going from 2 billion to 100billion will have the same effect, there are just a lot fewer of them.
Why growth companies?
Consider the reality: If revenues are going up, profit generally goes up, and where profit goes up, stock prices usually follow. When revenues decline, the opposite occurs. During a market crash, most companies see some level of revenue decline, but growth companies may feel the impact less than those operating in mature markets, if they have the hottest current products.
Why target the small growth companies instead of larger, more established companies that show or moderate growth?
Think of companies, or stocks, as naval vessels. A large aircraft carrier is undoubtedly powerful, well defended, and a key piece of a navy's arsenal. It's also so large that its maneuverability is limited—an easy target. It’s hard to move out of the way of an oncoming problem. The same holds for big companies. The larger they are in terms of operations and consumer market, the more likely they are to be hit in some significant way by a market crash for example commodity or dollar declines.
On the other hand, a small, nimble cruiser is fast-moving and harder to hit. Small growth companies may be so niche that they find themselves insulated from a particular market crash, or so innovative that they’re able to re-orient and adapt their operations to the new market climate.
Of course, there are no guarantees. Even small ships that sail below the radar can be hit by a competitor. Naval warfare, like stock trading, is risky. Either way, investors should clearly be looking for ships that are sailing, not sinking.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing involves risk including loss of principal. No strategy assures success or protects against loss.
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