Which Investors Matter?  671 That said, we do not get much help from the common approaches to un- derstanding institutional investors. For example, sometimes investors are la- beled as growth or value investors, depending on the type of stocks or indexes they invest in. Most growth and value indexes, like that of Standard & Poor’s, use price-to-earnings (P/E) or market-to-book ratios to categorize companies as either value or growth: companies with high P/E and market-to-book ra- tios are labeled growth companies, and those with low P/E and market-to- book ratios are value companies. However, growth is only one factor driving differences in P/E and market-to-book ratios. In fact, as we discuss in more detail in Chapter 7, we have found no difference in the distribution of growth rates between so-called value and growth stocks.1 As you might expect, dif- ferences in market-to-book ratios derive mainly from differences in return on capital. The median return on capital for so-called value companies was 15 percent, compared with 35 percent for the growth companies. So the compa- nies whose shares were classified as growth stocks did not grow faster, but they did have higher returns on capital. That’s why a modestly growing com- pany, like the high-ROIC consumer packaged-goods company Clorox, ends up on the growth-stock list. Many executives mistakenly believe they can increase their share price (and valuation multiple) by better marketing their shares to growth investors, because growth investors tend to own shares with higher valuation multiples. But the causality runs in reverse: in our analysis of companies whose stock prices have recently increased enough to shift them from the value classifica- tion to the growth classification, what precipitated the rise in their market value was clearly not an influx of growth investors. Rather, growth investors responded to higher multiples, moving into the stock only after the share price had already risen. Investor Segmentation by Strategy A more useful way to categorize and understand investors is to classify them by their investment strategy. Do they develop a view on the value of a com- pany, or do they look for short-term price movements? Do they conduct ­extensive research and make a few big bets, or do they make lots of small bets with less information? Do they build their portfolios from the bottom up, or do they mirror an index? Using this approach, we classify institutional investors into four types: intrinsic investors, traders, mechanical investors, and closet indexers.2 These groups differ in their investment objectives and the way they build their port- folios. As a result, their portfolios vary along several important dimensions, including turnover rate, positions held, and the number of positions held per investment professional (see Exhibit 34.2). 1 See T. Koller and B. Jiang, “The Truth about Growth and Value Stocks,” McKinsey on Finance, no. 22 (Winter 2007): 12–15. 2 Palter et al., “Communicating with the Right Investors.” 672  Investor Communications Intrinsic investors take positions only after undertaking rigorous due dili- gence of a company’s inherent ability to create long-term value. This scrutiny typically takes more than a month. The depth of the intrinsic investor’s re- search is evidenced by the fact that such investors typically hold fewer than 80 stocks at any time, and their investment professionals manage only a few positions each, usually between five and ten. Portfolio turnover is low, as in- trinsic investors typically accept that price-to-value discrepancies may persist for up to three or four years before disappearing. We estimate that these inves- tors hold around 20 to 25 percent of institutional U.S. equity and contribute 10 percent of the trading volume in the U.S. stock market. Examples of intrinsic investors include the William Blair Growth Fund. In June 2019, it held shares in 57 companies and had a turnover rate of 38 percent. From the hedge fund world, Pzena and Hermes Capital are good ex- amples of intrinsic investors. One prominent hedge fund manager, Lee Ainslie of Maverick Capital, is proud that Maverick holds only five positions per in- vestment professional, and many of his staff members have followed a single industry for ten years or more.3 Traders seek profits by betting on short-term movements in share prices, typically based on announcements about the company or technical factors, like the momentum of the company’s share price. The typical investment pro- fessional in this segment has 20 or more positions to follow and trades in and out of them quickly to capture small gains over short periods—as short as a few days or even hours. We estimate that traders own about 35 to 40 percent of institutional equity holdings in the United States. EXHIBIT 34.2  Investors Segmented by Investment Strategies >200 20–50 Traders Intrinsic Turnover, % >400 <20 >500 • Indexers Mechanical 100–300 >1,000 • Quants 20–80 150–400 Closet indexers 50–80 Number of positions 20–100+ 200–500 50–300 50–100 5–10 Positions per professional 3 R. Dobbs and T. Koller, “Inside a Hedge Fund: An Interview with the Managing Partner of Maverick Capital,” McKinsey on Finance, no. 19 (Spring 2006): 6–11.