Frameworks – especially those that can be explained in a matrix – are common in investing, but what should rule-breaking investors think about them? David Gardner discusses the pros and cons of those ubiquitous style boxes, and shares a couple of his own.
Rule Breaker Investing
Styleboxing
It's the Rule Breaker Investing Podcast with Motley Fool Co-Founder, David Gardner. And welcome back to Rule Breaker Investing Style Boxing. That's our topic this week. And this is not the kind of boxing that is presently on offer in the silver screens and sounds like Creed has gotten a really good critical reception, not a movie I've seen yet. I did enjoy that first Rocky. There's that kind of boxing. But I'm talking about more the framework-y style boxing. And we're going to talk about that this episode. But first, I just want to mention that this is a framework. And frameworks are of enduring interest to me. And I think a lot of Rule Breakers, in fact, the October 7th podcast, the Rule Breaker Investing podcast entitled "How Investors Should Think About Thinking," is very much about frameworks and how we use them. I really encourage you, if you're new to our podcast, to go back and listen to that October 17th. And so we're going to be talking about frameworks here. We had some consultants come visit us recently at Fool HQ. And I think we all know the joke about consultants, and consultants make this joke about themselves. And they've always got their own framework. Generally, they have a matrix. It's usually like a four box matrix, right? There's an x-axis and a y-axis. And each one is going to lead into one of four quadrants that everybody fits into depending on whether they went high or low on the x-axis and high or low on the y-axis. And so that's the old joke about consultants. They make it themselves. They always have that matrix-like framework. And that's what styleboxing is. Morningstar, the mutual fund and advisory service company, is credited with inventing the stylebox that drives a lot of the mutual fund industry. And Morningstar's classic stylebox. Here's an example. Generally, these are nine boxes that you can be in. So we're talking about a three by three matrix. And the y-axis, the vertical one, you have large companies, medium companies, and small companies. They're market caps, the size of the company. And then the x-axis, you go on the left from value, so-called value, whatever exactly that means, right through to the far end of the x-axis, which would be growth. And in the middle, that's kind of a blend of the two, right? So large, medium small companies, value to growth. And every mutual stock fund is plotted in one of those nine boxes. So as an example, if you are a large cap value stock fund, then you're in one box and maybe the exact opposite of that would be a small cap growth fund and you're in the tic-tac-toe box on the exact opposite side. So that's style boxing and you probably are already familiar with it if you're an investor, especially if you're a mutual fund investor, you may well know this, the style boxing of the funds industry. And there's a real strength to it, certainly, that you can quickly understand where you are among, for any stock fund among those nine boxes. This is the reason it's popular with consultants. You can quickly see where you are, whatever the context is that you're of the four quadrants, where are we today? So it's great pattern recognition, it's a great way to place things quickly. At the same time, it's a little bit of a curse to the fund industry as well, because many companies find that they'd like to invest slightly differently or do something different with their fund, but because the power of the Morningstar Stylebox framework is so ubiquitous, if you can't clearly fit within one of those nine boxes, a lot of the rest of the industry, the financial advisors and planners and who are picking funds for clients, they just won't recommend your fund if you're not clearly owning and living within one of those nine boxes. Now this is the Rule Breaker Investing Podcast, the Rule Breaker Investing Podcast, you can imagine, while I respect and in some ways admire the Morningstar Stylebox and the style boxing of anything, it also sometimes makes you want to have my own matrix or my own axes or things that break the style box. I like to think in terms of the gaps or the spaces or what's the matrix that isn't out there that should be. And I'm going to share two of those with you, this particular podcast. And at the end, I'm going to ask you whether you have one that you'd like to share yourself. So let's get to it. I have two for you this week. The first one comes by way of a story. About five or six years ago at the Motley Fool, we had a summer intern named Igor. I haven't seen Igor since. He was an excellent summer intern. Igor, if you're hearing this, hi there. I'm about to tell the story that I remember from you. Igor was an American, but with a strong Russian accent, I think I gather his parents were first generation Russian American. And he was here at the Fool. We have about a dozen summer interns every year at the Fool, usually a very talented bunch. The bad news for any prospective summer interns is that we get a few hundred applications. The good news, if you happen to be one of them, you got through a lot of other people to get to be a summer intern at the Motley Fool. So Igor was one of this very talented smart guy about investing. And I asked him during an intern lunch that summer, "Hey, how'd you get started, Igor?" Because I wish every 19 to 20 year old was as thoughtful, as smart, and really wise beyond his years about investing in money, I wish everyone could be Igor. So how'd you do it? He said, "Oh, my mentor who got me started investing?" I said, "Yes." He said, "Sure. That was a guy you're ahead of me at college." And I was like, "Oh, that's great. I'd like to hear a little bit more about that." He's like, "Well, the funny thing is he's not still investing anymore." And that was funny to me because Igor clearly understood long term, and that's what investing is. And he was getting all that. And he'd had a mentor, somebody who wasn't much older than he was, but this particular fellow was, quote, "No longer investing," end quote. So here's how it went, and this is going to lead to a style box. It's going to be a four quadrants. Get ready. What Igor said about his friend was that his friend had two things going on in his mind about investing. The first was he loved to find very early so-called development stage companies. These are companies, not only did they not have profits, in some cases they didn't even have revenues yet. These are very early stage companies. And his friend loved this kind of company. And it was part of the passion that his friend had about these companies that led to him wanting to teach others about investing. He really loved development stage of companies. So that was one of the two traits that marked his approach to investing. The second was he loved to go almost all in when he invested. He was a so-called focused investor. He had very few companies. And so when he found something that he liked and he believed in, he would pile what you and I might think of as an alarmingly high percentage of his money into those few ideas. And as I thought about that, and we're going to talk about that style box framework and just a sec, as I thought about that, I could see why his friend might not still be in the game anymore. Because it doesn't really take a long time or that many iterations if you play that system for it a little bit to see what's going to happen. You might get it right a few times, but if you get it wrong, you lose a lot of your money. And when you're specifically targeting early stage development stage companies, it seems fairly likely that a few of those aren't going to play out so very well. And so from my standpoint, and I hope Igor agreed with me, I was like, I'm not surprised that your mentor is no longer still in the game. So here's the style box. Here's the matrix. Let's just call it on the Y-axis vertically, we've got mature companies at the top right down to early stage development stage companies at the bottom. And then along the X-axis, the bottom, you've got the all in focused investor on one side, and then it goes all the way out to the highly diversified investor on the other. And if you can follow me, and I realize this is a podcast, I don't have big visuals for you, but I know you're smart. I know you've got this in your head. If you're following me, you can see that one of those four boxes says development stage companies all in investing. And that for me seems a recipe for disaster. The exact opposite is probably what's going to lead to people like Igor succeeding over the long term and people like his mentor staying in the game over their only term that counts, which is the long term. And that is the box that says mature companies, and I like to be diversified as an investor. You know, too many of us who come new to the game of investing are in one of the wrong boxes in that simple little four box quadrant. And it's generally because we haven't had that much coaching or experience. We may not have had a mentor who's done this well. In my own case, I was very fortunate to have a father who totally understood this. He had me in the right one of those four, the one I just mentioned, mature companies diversified. But if you don't, it's not easy necessarily to intuit yourself into the right spot to be. And I will say that over the course of time, I have had more and more love for emerging companies. I do like some development stage companies and I somewhat shun highly mature, sometimes to me less interesting companies. So I've progressed a little bit from where I started, but I think there's no substitute for starting in a very conservative way, thinking about finding really good companies that we all know and having a nice diversification across those companies. So that's style box number one. That's different from the Morningstar Stylebox. It's a little simpler, but it was the one that I heard in my head as I listened to Igor tell me the story of why his mentor who was about 20 or 21 was no longer investing. And now I want to share with you my style box. I don't want to oversimplify what I do, say, or think, and I wouldn't do the same for you either. So anytime we're talking about frameworks, whether it's a four box or a nine box, it's always going to oversimplify. Other frameworks like the Myers Briggs, or these are always a course somewhat oversimplified. But what we're doing is we're typing, and we're getting quick pattern recognition as our minds fly over. If you ever watch golf, they'll sometimes have to fly by the whole hole and you just get zoom. You have a drone, takes you from the tee right out to the 18th green. It's that kind of fly by that these things that good frameworks can give us. So I don't want to oversimplify what I'm doing, but I'm going to share with you something that I think I hope you'll understand and I hope is illuminating. So I myself see two more axes. I'm going to call the Y axis long term at the top and short term at the bottom. And across the X axis, we're going to go with predictable on the left, right through to innovative on the right. So what am I talking about here? Well long term and short term is the term over which you and I are playing the game of investing or trading. If you are thinking long term, I would say you're an investor and you're investing. And so that's at the top of the Y axis. If you are thinking or acting short term, I would say you're not investing. Let's say you're trading. So maybe I should have just said investing or trading, but it's the same either way to me. It's the time frame that you are putting your capital into the markets. Along the bottom, we have the types of companies that you are investing in. And it's not a perfect yin and yang here, but I would say that most companies either fall in the bucket of predictable, rote, going through the motion, doing that business. They might be an oil operations company or they might just be dunking donuts. It's going to be a company that is staying within what you'd expect it to do. And it might be innovative in its own way, but for the most part, you and I wouldn't point out and say that's a real innovator there. And then of course, right out on the far side of that X axis, it are the innovators. The companies are less predictable and there's more risk associated with them, but there's also much more opportunity associated with them as well. By the way, if you've ever worked with consultants along these kinds of frameworks, you know that it's always good of those four boxes. You always want to be in the upper right box. Any of the other three isn't quite so I've set it up that way. And so you can see where I think I am or my approach or our approach that we practice here at the Motley Foolish, specifically we as rule breakers. We're invested for the long term and we're investing in the most innovative companies. So ultra long term, ultra innovative. And here's why I think that works. The reason is that there are very few other people playing in our box. Very few other kids playing swimming in the same pool. And it's understandable because for a lot of people, when they think about innovation and technology, they're thinking it's all fly by night. In fact, great investors like Warren Buffett have said in the past, "I don't invest in that area. I don't swim in that pool because it's so unpredictable. I can't know 10 years from now who's really going to win the battle for leadership in drones or internet of things or cloud computing. It's just too hard to predict." And so this type of a person says, "I don't even invest there." And so those who do, those who really enjoy technology, innovation, bleeding edge, they're often taking a lot of risk and thinking much shorter term. And so when you hear this kind of people talking about tech stocks on CNBC, often it's very short term oriented. And it sounds crazy to allow yourself to lose 20% on one of those stocks. People like William O'Neill, an otherwise very good investor, talk about how you want to sell before you ever lose more than 7% on an even second. It's just very short term. By contrast, often the people who are long term with their investing shun these innovative companies because we can't predict them, they tend to find mature, very predictable, road businesses, often they're called so-called value stocks or they pay a good dividend. And they tend to just, there are a lot of people swimming in that pool. There are a lot of people in that style box. The long term, investing in mature and more predictable companies. So one thing that I've learned about games and game theory over the course of time. And Malcolm Gladwell's great article turned into a book, "How David Beats Goliath Makes This Really Clear." By the way, you can search the New Yorker, "How David Beats Goliath," and reread Malcolm Gladwell's great article of five or six or seven years ago now, it turned recently in the last couple of years into a book. How David Beats Goliath is the David while he's playing the same game, in this case we'll say David Goliath warfare, he's taking a totally different approach than the way that everyone else is doing it. And for that reason, he's able to win. He's able to win in that context and Gladwell has lots of examples of underdogs that are consistently winning and the way that underdogs typically are winning. And I think we're underdogs and I think we're winning is by, on the same field, with the same rules, just taking a totally different stylistic style box approach. So I just share with you my matrix, which is that if you are really fascinated by innovation, and these are your kinds of companies, one of the best things you can do is invest for the ultra long term, because when so few other people are playing that game, they'll be the first to sell salesforce.com. If cloud computing has a bad month, they'll be the first to sell monster beverage when there's an alarming, but largely over reported, somewhat misleading story that energy drinks are killing people or under armor. When under armor has a slip up, the list goes on of these kinds of companies Tesla Motors. Remember, the batteries were catching on fire underneath the cars and it was going to be a big problem for these are the kinds of stories that pop up all the time for innovators. And they're not always great stories. I mean, it's sad thinking about the E. coli breakout for Chipotle, but at the same time, these are really very small stories in the grander scheme of these companies and our society and culture. They get highly over reported by media. They set a tone. And of course, you have the shorter term players all ready to sell. So when you take that ultra long term focus into these kinds of companies, I think you and I as rule breakers stand a better than average chance of beating the market. And that's why we've been doing that for years and why I hope we're enjoying that together as we enter the next year of rule breaker investing 2016. I'm very excited about that year, you and me together. But let me close by asking, what's your style box? What's your matrix? Each of us, it's a creative act. I've just shared with you kind of what I've realized was mine. I also gave you the story of Igor. I bet you have your own that itself can stand right by the Morningstar style box to explain your own style of investing or how you invest. So if you're on Twitter, we always love hearing from you. Maybe you could tell us the x axis and y axis and how they're labeled. I think you can do that 140 characters, but it's really for me, it's a real sign that you are progressing as an investor when you're able to see your quadrants for yourself and you're able to start demarcating where you fit within the grander scheme. And that goes for things, by the way, outside investing too, but the subject of rule breaker investing is investing. Well, that's it for this week's rule breaker investing. Thanks so much for joining me. Next week, I think I'm going to open up my book of quotes. I asked you a couple months ago to vote, did you want to do A or B with our next podcast and you voted for B. I don't even remember what B was right now, but I can tell you what A was, A was some of my favorite quotes about investing. So I'm going to go over those next week and illustrate a little bit, provide a few examples of them. And that's something that I'll probably do from time to time. By the way, speaking of time to time, we had a lot of success with our November mailbag. So I'm already looking forward to our December mailbag later this month. Ask us on Twitter at RBI podcast is, of course, our rule breaker podcast investing Twitter handle and just share a question and I'll take as many of them as I can and fit it into that month's mailbag where we're going to try the last Wednesday of each month, which means this one is coming up. And because some of us are on vacation the last week, we're going to take this a little earlier ahead of time. So if you would in the next week or so, drop us your question at RBI podcast and I'll do my best to cover it in our month and close. That's all for now. I'm David Gardner, full on. As always, people on this program may have interest in the stocks they talk about and the Molly Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Learn more about rule breaker investing at RBI dot fool dot com. [MUSIC] [BLANK_AUDIO]