Investment Strategies
You can go your whole life without ever buying a single stock. But until you do, you won't really understand the full potential of investing -- and the rewards that come with it.
For beginners, mutual funds give you a great way to get your feet wet. The diversification that comes with broad-based mutual funds brings with it a measure of security. You may still lose a lot if the whole market goes down, but if one particular company gets hurt, it won't have a huge impact on your overall portfolio.
Conversely, you can earn far greater returns from individual stocks than you'll ever find from mutual funds, if you pick the right stocks.
So how should you pick?
Investing, like most other things, requires that you have a general philosophy about how to do things in order to avoid careless errors. Before you dig deeper into some specialized investing strategies, you should first understand the various methods people use to analyze stocks. You certainly need a considered plan before investing your hard-earned savings.
Fundamental Analysis -- Buying a Business (Value, Growth, Income, GARP, Quality)
Many people rightly believe that when you buy a share of stock you are buying a proportional share in a business. As a consequence, to figure out how much the stock is worth, you should determine how much the business is worth. Investors generally do this by assessing the company's financials in terms of per-share values in order to calculate how much the proportional share of the business is worth. Some knows this as “fundamental” analysis, and most who use it view it as the only kind of rational stock analysis.
Although analyzing a business might seem like a straightforward activity, there are many flavors of fundamental analysis. Most investors come up with an approach that is a blend of a number of different approaches.
1) Value. A cynic, as the saying goes, is someone who knows the price of everything and the value of nothing. An investor's purpose, though, should be to know both the price and the value of a company's stock. The goal of the value investor is to purchase companies at a large discount to their intrinsic value. - What the business would be worth if it was sold tomorrow. In a sense, all investors are "value" investors, in that they want to buy a stock that is worth more than what they paid. Typically, value investors are focused on the liquidation value of a company, or what it might be worth if all of its assets were sold tomorrow. However, the idea of intrinsic value is not specifically limited to the notion of liquidation value. Novices should understand that not all who use the word "value" mean the same thing.
These value investors tend to have very strict, absolute rules governing how they purchase a company's stock. These rules are usually based on relationships between the current market price of the company and certain business fundamentals. Examples include:
· Price-to-earnings ratios (P/E) below a certain absolute limit.
· Dividend yields above a certain absolute limit.
· Book value per share at a certain level relative to the share price.
· Total sales at a certain level relative to the company's market value.
Growth. Growth investing is the idea that you should buy stock in companies whose potential for growth in sales and earnings is excellent. Growth investors tend to focus more on the company's value as an ongoing concern. Many plan to hold these stocks for long periods of time, although this is not always the case. At a certain point, "growth" as a label is as dysfunctional as "value," given that very few people want to buy companies that are not growing.
Growth investors look at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries, and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year.
Income. Although common stocks are widely purchased today by people who expect the shares to increase in value, there are still many people who buy stocks primarily because of the stream of dividends they generate. These individuals often entirely forgo companies whose shares have the possibility of capital appreciation in favor of high-yielding, dividend-paying companies in slow-growth industries. These investors focus on companies that pay high dividends, although many times they may invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is consequently very high.
GARP. GRAP, stands for Growth at a reasonable price. The world according to GARP investors combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a "double play" as earnings increase and the price-to-earnings (P/E) ratios at which those earnings are valued increase as well.
One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected.
Quality. These investors are looking for high-quality businesses selling for "reasonable" prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at the company's valuation and at the inherent quality of the company -- measured both quantitatively by concepts like return on equity (ROE) and qualitatively by the competence of management.
Arguments against fundamental analysis. Those who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. The second is that much of the fundamental information is often up to the person looking at it to interpret its significance.
Quantitative Analysis -- Buying the Numbers
Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although even fundamental analysis requires some numerical inputs, the primary concern is always the underlying business, focusing on things like management's expertise, the competitive environment, the market potential for new products, and the like. Quantitative analysts view these things as subjective judgments, and instead focus on the incontrovertible objective data that can be analyzed.
That's a radical departure from fundamental analysis. "Quants" will often mix in ideas like a stock's relative strength, a measure of how well the stock has performed relative to the market as a whole. Many investors believe that if they just find the right kinds of numbers, they can always find winning investments.
Company size. Some investors purposefully narrow their range of investments to companies of a certain size, measured either by market capitalization or by revenue. The most common way to do this is to break up companies by market capitalization and call them micro caps, small caps, mid caps, and large caps, with "cap" being short for "capitalization." Different size companies have shown different returns over time, with the returns being higher the smaller the company.
Momentum. Momentum investors look for companies that are not only doing well, but also that are flying high enough to get nosebleeds. Momentum companies often routinely beat analyst estimates for earnings per share or revenue, or have high quarterly and annual earnings and sales growth relative to all other companies, particularly when the rate of this growth is increasing every quarter. This kind of growth is viewed as a sign that things are really, really good for the company. High relative strength is often a category in momentum screens, as these investors want to buy stocks that have outperformed all other stocks over the past few months.
Arguments against quantitative analysis. Because quantitative analysis hinges on screens that anyone can use, many of the pricing inefficiencies quantitative analysis finds are wiped out soon after they are discovered. If a particular screen has generated 40% returns per year and becomes widely known, and if lots of money flows into the companies that the screen identifies, the returns will start to suffer.
Technical Analysis -- Buying the Chart
Some investors have taken an alternate route, attempting to create a set of tools that might tell them what other investors thought about a stock at any given time, particularly looking for the footprints of large institutional investors that tend to cause the most extreme price changes. Investors who focus on this kind of psychological information call themselves technical analysts and believe that charts can sometimes provide insight into the psychology surrounding a stock. Although there are plenty of pure chartists, some investors use charts just to time investments after looking at them from a fundamental or quantitative perspective.
There is no set of clearly defined approaches to technical analysis, but there are a number of different tools. The most important indicators seem to be specific chart formations that show certain price movements at times when trading volume is at a certain level. The most common kinds of charts include point and figure charts, logarithmic charts, and Japanese candlesticks.
Trading -- Doing What Works
Traders normally use a hodgepodge of fundamental, quantitative, and technical techniques with a short-term orientation. Trading tends to be a highly charged experience where one looks to make a few percentage points from each trade.
Many novice investors, lulled by the apparently easy casino-like gains possible in trading, tend to lose a lot of money before they realize that when there are thousands of other traders out there looking for the same things, it is often those who are fastest, have the most experience, and own the best equipment that make money, and that's normally not the people just starting out. All traders emphasize that successful trading requires careful attention, discipline, and a lot of work.
Arguments against trading. Trading is clearly a time-consuming adventure. Although there are a number of very famous and successful traders, many individuals ignore the fact that these traders are well equipped to trade and have all day to do so. Given the time and effort most successful traders put into their trading, the potential for amateurs to reap the same rewards with less effort and fewer resources is very low. With so much money competing in the one-day to one-year investment time frame, an individual with a minimal amount of time will probably be more successful finding businesses to own for the long term and not trying to engage in almost gambling-like behavior.
Summary
We've run down the basics on fundamental, quantitative, and technical approaches to picking stocks. Chances are, like most investors, you'll find elements of several that suit your investing style. As your education continues, you'll develop your own investing philosophy that targets your needs and goals with bull's-eye precision.
Before you buy, do your own research. I can't stress this enough. There are many experts out there, who could give you helpful advice, but there are also many people out there who think they are experts, and their advice may not be as solid.
So, if a friend gives you a tip and urges you to buy because such and such a company is hot, make sure to not blindly follow their advice.
I would recommend any beginner to start off with stable stock. Choose a company that has been around for a good while, and read up on them. Check out how the company of your choice is doing, and what the state of the market is like in general. This will help you make your decision.
