We had some consultants come visit us
recently at Fool HQ. And I think we all know that joke about consultants, and consultants
make this joke about themselves, and it’s that they always have their own framework.
Generally, they have a matrix, it's usually a 4-box matrix. 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 are high or low on the x-axis and high or low on the y-axis. So, that's
the old joke about consultants. They make it themselves. They always have that matrix-like
framework. And that's what style-boxing is. Morningstar, the mutual fund and advisory
service company, is credited with inventing the style-box that drives a lot of the mutual
fund industry. And Morningstar's classic style-box, here's an example. Generally, these are 9
boxes you can be in, so we're talking about a 3 x 3 matrix. The y-axis, the vertical one,
you have large companies, medium companies, and small companies. Their 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 a blend of the two.
So, large-medium-small companies, value-to-growth. And every mutual stock fund is plotted in
one of those 9 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're probably 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 -- those 9 boxes. This is the reason it's
popular with consultants, you can quickly see where you are, whatever the context is,
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 style-box framework is so
ubiquitous, if you can't clearly fit within one of those 9 boxes, a lot of the rest of
the industry, the financial advisors and planners who are picking funds for clients, they just
won't recommend your fund if you are not clearly owning and living within one of those 9 boxes.
Now, this is the Rule Breaker Investing podcast -- the Rule Breaker Investing podcast -- so
you can imagine, while I respect and, in some ways, admire the Morningstar style-box, and
style-boxing of anything. It also sometimes makes me 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 on this particular podcast. And at the end, I'm going to ask you whether
you have one 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 5 or 6 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 that his parents were first-generation Russian-Americans, and he was here at The
Fool. We have about a dozen summer interns here 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 is, 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 a 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 19-20 year-old
was as thoughtful, as smart, and really wise beyond their years about investing in money
as you." I wish everyone could be Igor. So, I asked him, "How'd you do it?" He said, "Oh,
my mentor who got me started in investing?" I said, "Yes." He said, "Sure, yeah, it was
a guy a year ahead of me in college." And I said, "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 that long-term,
that's what investing is. He was getting all that. And he had a mentor, somebody who wasn't
much older than he was, but this particular fellow was quote-unquote "no longer" investing.
So, here's how it went -- and this is going to lead to a style box. It's going to be 4
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 do 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 his friend had
about these companies that led to him wanting to teach others about investing. He really
loved the 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 he liked and 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 in just a second -- as I thought about that, I could see why
is 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 forward 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 think and 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 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 the 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."
Too many of us who come new to the game of investing are in one of the wrong boxes in
that simple little 4-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 that I just mentioned, mature companies and diversified. But if you
don't, it's not easy, necessarily, to intuit yourself into the right spot to be.
And I will say, 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 #1. That's different from the Morningstar style-box. 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 (laughs) mentor who was about 20 or 21 was no longer investing.