Style-Boxing: An Investing Framework for Success

Frameworks are systems of thought that allow us to interact with information in meaningful ways.

In this clip from Rule Breaker Investing, Motley Fool co-founder David Gardner explains style-boxing -- an investing framework that mutual fund managers and consultants often use to organize companies into categories based on criteria such as size and risk. Tune in to hear how style-boxing can help you better understand investing, where it falls flat, and how to use a style box to evaluate your own investing strategies.

Click here to watch Part 2 of this series, where David Gardner presents his style box for Foolish long-term investing.

A full transcript follows the video.

This podcast was recorded on Dec. 9, 2015. 

David Gardner: 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 four-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 nine boxes you can be in, so we're talking about a three-by-three 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 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'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 nine 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 nine 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 nine 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 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 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 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 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 it 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 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 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 No. 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.