"Inflection points" and the Growth Stock Theory

The financial media is currently full of market watchers speculating as to whether or not we are passing through a major "inflection point."

Recent discussion has ranged from the broad question of whether now is the time to bring money off of "the sidelines" and into the equity markets, to narrower questions such as whether it is time to switch from "value" to "growth" or from small-cap stocks to larger-cap ones (see, for example, this recent article on that question).

Practitioners of the classic growth stock style of investing should understand that these sorts of questions arise from strategies which are diametrically opposed to the foundations of the growth stock theory. They arise because much of the investment community today follows strategies which attempt to find the right time to "overweight" one area or another, trying to call the inflection points at which one should shift from being overweight to underweight or underweight to overweight in any number of areas, from international securities, to small-caps or large-caps or mid-caps or micro-caps, to this sector or that sector, and on and on.

We have discussed the folly of this type of approach in many previous discussions, such as last August's "Drawbacks of sector rotation." One important observation that stands out in times like those we have experienced in 2009 thus far is a comment that growth stock investment pioneer Thomas Rowe Price made in his 1973 essay, "A Successful Investment Philosophy based on the Growth Stock Theory of Investing."

In describing the genesis of the growth stock theory, Mr. Price wrote:

"In the early 1930s, after 10 years experience in the investment business, several things were learned which helped to formulate my investment philosophy:

1. That I did not have the ability to correctly forecast the trends in the stock market.

2. That most other people, including various stock market services, were unable to predict the market over an extended period of time. The various systems usually failed at crucial turning points in the market.

3. That most of the big fortunes of the country were made by men retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

The phrase which stands out to us in looking back at 2009 thus far is "failed at crucial turning points in the market." It strikes us that Mr. Price's observation from the 1930s is certainly applicable to the situation today.

Back on March 2, 2009, we published a post entitled "Don't get off the train," in which we stated that "As unbelievable as it seems now, there will be a turn in what seems to be a never-ending bear market cycle." While we did not presume to predict exactly when that would be, we warned investors that getting on the train after it starts to move is a lot harder than most people think. As it turned out, a major turn was just seven days away, which can be seen from the market chart above.

The broader lesson, which applies not just to the markets of the past several months but to investing at any point in time, is that investment strategies (the "various systems," as Mr. Price calls them in his essay) that attempt to predict the market (or one sub-segment of the market, whether a sector, industry, geographic region, capitalization size, or whatever) usually fail precisely at these "crucial turning points."

Even if you meet someone who has correctly predicted one or two of them, the belief that someone or some system can do so correctly for the thirty or forty years (or more) that make up a typical investment lifetime is delusional.

Nevertheless, much of the "wealth management" industry follows just such an approach, even as they almost universally denounce "market timing." So-called "core-satellite" strategies, in which a "core" of supposedly conservative (often index-based) holdings is surrounded by a few "satellites" which attempt to overweight sectors or geographies or capitalization ranges that are about to produce outsized returns, are very common. Even those who use "only indexes" or "only ETFs" typically shade their index or ETF holdings to favor growth at one time and value another, or large-cap one year and small-cap another, or a few selected sectors at the expense of others.

All of these contemporary strategies are based on predicting markets, and are typical of what Mr. Price describes in point #2. The alternative, which he describes in point #3, is to base your investment upon ownership of successful businesses. This is a world away from the market guessing strategies that dominate the landscape today.

Investors should read Price's three points above very carefully, and be sure they understand the gulf between the approach in point #2 and the approach in point #3, and they should resolve to base their investment foundation on that described in point #3. Doing so will free them from having to guess the "crucial turning points in the market" on which market-timing strategies are dependent, and at which history suggests they usually fail.

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For later posts dealing with the same subject, see also:


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