Investing – Common Stock Strategies

Accountancy Resources

Investing – Common Stock Strategies



Investing Author: Admin

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Buy and Hold

The “buy and hold” approach to investing in stocks rests upon the assumption that in the long term (over the course of, say, 10 or more years) stock prices will go up, but the average investor doesn’t know what will happen tomorrow. Historical data from the past 50 years supports this claim. The logic behind the idea is that in a capitalist society the economy will keep expanding, so profits will keep growing and both stock prices and stock dividends will increase as a result. There may be short-term fluctuations, due to business cycles or rising inflation, but in the long term these will be smoothed out and the market as a whole will rise. Two additional benefits to the buy and hold strategy are that trading commissions can be reduced and taxes can be reduced or deferred by buying and selling less often and holding longer. Some proponents of the buy-and-hold strategy of investing often believe in the Efficient Market Hypothesis or the Random Walk Theory.

Market Timing

Market timing is essentially the opposite of buying and holding. Market timers believe that it is possible to predict when the market, or certain stocks, will rise and fall. It, therefore, makes sense to buy when the markets are low and to sell when they are high in order to maximize profits. Market timers can use any number of different methods for timing the market – technical analysis, fundamental analysis, or even intuition.

  • Most experts agree that market timing is incredibly difficult if not downright impossible. They also warn against it because:
  • It’s hard to say when the market or a particular stock is “high” or “low”; often a seemingly high stock will go higher, and a seemingly low stock will go lower.
  • Commissions eat away at your profits when you trade frequently, especially on small transactions.
  • The bid/ask spread also eats away at your profits, especially for thinly traded stocks.
  • In the long run, the market goes up. Unless you’re a superb timer, you’ll do better staying fully invested at all times. For example, in the last 40 years, the market returned about 11.3% annually. If you were fully invested the whole time but got out completely for the 40 best months, your annual return would’ve dropped to 2.7%. If you miss the big moves it hurts, and no one really knows when they’re coming.

Growth

Growth investors focus on one aspect of a company: it’s potential for earnings growth. They believe that companies with high earnings growth will see their stock price continue to increase since investors will want to own profitable companies that can pay large dividends in the future. The number that they pay the most attention to is earnings per share, especially how it changes from year to year, although they sometimes look at revenue growth as well. Some investors also compare the price/earnings ratio with the annual earnings growth, to get a feel for how much the market is willing to pay for a given rate of earnings growth. Growth stocks tend to be from young companies, so they are often riskier than the average security. They have the potential for large gains, but they also have the potential for large losses. In the 1990s technology stocks were the most commonly purchased stocks by growth investors, although growth stocks can exist in just about any industry.

Value

Value investors look for stocks that are selling at an attractive price; in other words, they are bargain hunters. This does not mean that value investors buy stocks because they are “cheap” (such as penny stocks); value investing utilizes several measures of a company’s value to identify stocks that can be purchased for less money than they’re worth, regardless of whether they’re worth $10 or $100. Although it’s possible that a growth stock could represent a good value, growth investing and value investing are usually considered opposing strategies. This is because value investors tend to focus on traditional valuation metrics such as the P/E ratio, looking for low ratios which are typically not found in growth stocks. Value stocks often are ones that have fallen out of favor with the investment community for one reason or another, perhaps because they are in a slumping industry or because they reported poor earnings.

GARP

If you’re torn between the growth approach to investing in stocks and the value approach, then you might want to consider trying the GARP approach. GARP stands for “growth at a reasonable price” so, as you might expect, GARP investors look for companies with growth potential whose stock price is undervalued. That can be a difficult task since growth and value stocks tend to have opposing characteristics, but it’s not impossible. Most GARP investors look at the price-to-earnings-growth ratio (PEG) ratio in order to find bargain stocks with growth potential that are selling at a reasonable price.

Warren Buffett and Quality

Some investors prefer to consider themselves not ‘value’ or ‘growth’ but ‘quality’. This is a sort of hybrid approach in which the investor is searching not for questionable companies at bargain prices or exceptional companies at outrageous prices, but good companies at good prices. This strategy relies on a combination of quantitative and qualitative factors.

Warren Buffett is often cited as a classic example of a quality investor. Buffett relies on a fairly simple investment strategy that can benefit any investor interested in identifying good values. He looks for great stocks, then buys them and holds them for several years or more. Buffett is a long-term investor who plans to hold onto stocks for many years from the time of purchase. He thinks of his investment as buying a piece of a business, not just shares of its stock. In this sense, the management of the underlying company is an important criterion in the investment decision.

Buffett determines the value of a business by totaling the net cash flows he expects to occur over the life of the company and discounting them by the appropriate interest rate. He may add a premium based on the risk involved in the particular investment. He focuses on return on equity, operating margins, debt levels, and capital expenditures to identify the best investments.

Interestingly, Buffett challenges some of the traditional notions regarding diversification. He believes that diversification is less necessary for those able to confidently choose a select number of stocks they are confident will significantly outperform the market. For him, identifying a few good values is far more important than spreading invested money across a typical diverse portfolio.

Income

Income investors practice a very straightforward strategy: they buy stocks with the highest dividends. Income investors focus primarily on securing a steady income stream, instead of worrying about capital gains (although they obviously hope that the shares will increase in value). The stocks of large, well-established companies usually qualify as income stocks. Income investing is one of the more conservative stock strategies, yet there are still the usual risks involved in investing in equities. In some respects, this strategy is closer to bond investing than stock investing, even when stocks are used.

Dollar-Cost Averaging

Dollar-cost averaging is a good strategy for beginners that involves regular contributions of a fixed dollar amount to a portfolio or specific investment. At each interval, the chosen amount is invested, removing any emotional motivation to react to short-term changes in the value of the investment. Of course, dollar-cost averaging does not guarantee a profit, but it does encourage consistent investing and prevents short-term movement from leading investors to make emotion-based decisions that could harm their long-term strategy.

Because the investment is purchased at a range of prices over time, fluctuations in price are evened out and the initial price has a far smaller impact on the returns at the time the investment is sold. The average price paid trends toward the current price at each interval. As a result, the gap between the value of the money paid in and the current value of the investment decreases. However, the average price does not move fast enough to completely eliminate the possibility of profit or loss. Although dollar-cost averaging can prevent a large negative gap from growing between the price paid and the current price, it limits the potential for a positive gap in the same way.

Essentially, dollar cost averaging is ideal for investors who wish to eliminate the risk associated with timing the price of an investment and reacting to short-term results at the expense of limiting themselves to a decidedly conservative strategy. Some investors believe dollar-cost averaging is most effective when a stock is underperforming because more shares can be acquired for the same regular investment amount. However, better performance is not guaranteed and that aspect should not be the primary motivation for adopting this strategy.

DRIPs and DSPs

Some stock strategies focus on reducing brokerage commissions in order to boost overall returns. Direct Stock Purchase Plans (DSPs) let you buy shares of stock directly from the company, without the use of a brokerage (and without the commission they charge). DSPs are a good way to invest since you don’t even have to be a current shareholder in order to purchase the shares. The company will not charge you a commission, but they may charge you a small fee in order to set up a stock purchase account.

Dividend Reinvestment Plans (DRIPs) are also a good way for you to bypass a broker and save on commissions by investing your money directly with the company; however, with DRIPs, you must purchase the first share you buy in the company through a brokerage. After that, though, you’re free from the broker. The company will take whatever dividends it would normally send to you as a check and instead it will reinvest them to purchase more shares in the company for you, all without charging a commission. The only drawback is that you have no control over when your money from the dividends is used to purchase new stock in the company, which means you might be buying new shares at sub-optimal times.

Note that DSPs and DRIPs are only offered by some companies, although there are hundreds of well-established blue chips offering such programs.

Dogs of the Dow

This is a very simple strategy in which you find out which ten of the Dow Jones Industrial companies currently have the highest dividend yield and then you purchase those stocks. These stocks are called the “dogs” of the Dow because they tend to have lower prices than the other Dow components, which means that they could experience substantial price increases in the next year. If you decide to use this strategy, it’s important for you to remember to reallocate your portfolio every year, since the dogs will change over time. Historically this approach has been successful, but there’s no compelling reason to believe it will continue to be.

CANSLIM

CANSLIM is a strategy for investing that was pioneered by William J. O’Neil, who later went on to found Investor’s Business Daily. The strategy is a mixture of fundamental analysis and technical analysis. Each of the letters in the acronym describes a different metric used to pick a stock:

  • C – Current Earnings: current earnings growth for the stock must be at least in the 20%-25% range
  • A – Annual Earnings: average annual earnings growth for the stock over the past five years should be substantial, around 25%.
  • N – New Things: the company should be involved in developing new services or products; this can sometimes even refer to new highs for the stock price.
  • S – Shares Outstanding: the company should have less than 30 million shares outstanding so that it has the potential for good growth.
  • L – Leading Stocks: the company should be a leader in its industry.
  • I – Institutional Ownership: the stock should have at least a couple of institutional shareholders (e.g. pension funds, endowments, etc.).
  • M – Market Conditions: the market should be moving upward or ready to move upward.

Most of the principals involved in CANSLIM investing make sense to experts. Of course, figuring out whether or not a company meets these seven criteria is a whole other story.

Contrarian

Contrarian investing is a strategy that relies on behaving in opposition to the prevailing wisdom; for example, buying when others are pessimistic and selling when they’re optimistic, or buying out-of-favor stocks and selling them when they’re popular again. In an extended bull market, the term contrarian can begin to mean someone who is bearish or prefers value stocks to growth stocks, although this is really just a subset of contrarian investing.

Insider Activity

Another strategy for investing involves looking out for what insiders at a company are doing with their stock. Keeping an eye on insider trades can be useful because it allows you to see what the people who have a large stake in a company are doing with their stock. These insiders are often the ones who know what is going on at the top levels of their company, and so they may have the best information about whether a company’s stock is actually worth more or less than the current price. Insiders can be either individuals or corporations. They are required to report both direct holdings (which are held in the name of the insider) and indirect holdings (which are controlled by the insider but are held by a family member, trust, company plan, or corporation with which the insider is affiliated). Note that we’re not talking specifically about illegal insider trading (that is, insiders who are trading based on privileged information), but instead about all types of insider trades, including when no such privileged information exists, but the insiders are just generally confident about the company’s outlook.

Other Investing Strategies

  • Constant Ratio System: Unlike the constant dollar system, the same percentage of funds is divided between different assets. When the balance is upset, it is periodically restored by moving money from overperforming assets to underperforming ones. This system prevents one asset class from dominating the portfolio. This is one way to maintain a desirable asset allocation.
  • Variable Ratio System: This is a variation of the constant ratio system that relies on market timing to shift the proportions of the various asset classes contained in the portfolio. Buying low and selling high is built into this strategy, but, like the constant dollar system, prolonged movements in a given direction will harm returns.
  • Bottom-up Analysis: This is a name for an investment strategy that focuses on the fundamentals of individual securities as opposed to the state of the overall economy.

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