” Stock Z is cheap. Therefore, sooner or later, hopefully sooner, it will go up in price. So I’ll buy it now and make money by already being there when others discover the undervaluation and bid the price up.” This is absolute value investing. It’s about the intrinsic value of a firm’s assets and growth prospects, either in the hands of current management or, more often than one might think, with the idea that someone more capable will take over.
On the other hand,
” Stocks A and B are both in the Consumer Discretionary sector of the S&P 500, and each represents, say, 1% of the overall S&P 500 index. I think that A is cheaper than B, based on PE, earnings and/or assets, and also has better growth prospects. So I won’t hold any B and will instead have 2% of my portfolio in A. Other than this one difference, I’ll make my portfolio look exactly like the S&P.” If I’m correct in this judgment, my portfolio will outperform the S&P. This is relative value investing. (In the real world, I would do this with a number of individual names. I would most likely also over/underweight industries and sectors based on my assumptions about how the world economy is going to play out. In my own real-life active portfolio, for example, I own no oil and gas stocks at the moment.)
Framing this slightly differently, an absolute value investor is more highly convinced about what will happen and has less of an idea about when. In contrast, as earnings reports come, they will establish the correctness of believing in the superior growth of A and/or the turkeyishness of B. So the relative value investor is more highly certain of when the strength of A that he thinks will be revealed in earnings reports than what the actual revelation will be.
Relative value investing is what I mostly do, although I did spend a decade in an absolute value shop where I was the lone relative value voice. The main virtue of relative value, as I see it, is that the judgments I need to make are simpler. It’s usually much clearer that A is more attractive than B than whether either is good or bad in the absolute.
To some degree, however, my decision to buy A and not B can also be influenced by how I perceive macroeconomic conditions. I may, for example, choose to hold Walmart or dollar stores and not luxury goods firms if I think the economy is going to be weak, and dump the former for the latter if I think a strong upswing is likely.
What I’ve called absolute value investing is what is known in industry jargon as value investing. What I’ve been calling relative value is known as growth investing. There’s also a middle ground between the two called GARP (growth at a reasonable price).
Value investing came into prominence during the Great Depression of the 1930s, formulated by the father of value investing, Benjamin Graham. Until the 1970s it was the dominant method used by professional investors. It continues to work well today as a way of approaching special situations–think of Robinhood when it was trading at/below book value a year ago. But it hasn’t worked particularly well in the US stock market as an overall method during the last third of a century.
Growth stock investing has worked a lot better in the US, at least in part due to the explosive potential for earnings gains in the technology sector.
Note: S&P has “style” sub-indices that it labels Growth and Value, based on elements it perceives as the important characteristics of each investment style. Especially in the case of value stocks, it’s not clear to me that the Value sub-index matches up much with what a professional value investor might hold.