Investment goals may differ from individual to individual, but one objective is considered fundamental - that of making your money grow. Serving as a guide to investor’s financial decisions by taking into account goals, risk tolerance and future objectives, investment strategies are crucial to building your portfolio.
From seeking rapid growth by focusing on capital appreciation to centering on wealth protection, there are several investment strategies to choose from. Some investors stick to one, others use several different ones over time depending on the conditions in the wider market.
So how can you narrow down the ideal one for you? Here we explore three strategies you may want to master before you begin trading.
What is value investing?
Value investing is a strategy that involves selecting undervalued stocks of strong, quality companies and holding them over a long period of time. These stocks appear to be trading for less than their intrinsic value, in other words, the measure of what an asset is worth. Investors watch out for market overreactions since they believe that the market overreacts in certain events which in turn results in irrational stock price movements. Although these price movements don’t correspond to a company’s long-term fundamentals, this overreaction offers an opportunity to profit since stocks are bought at discounted prices. As a result, investors’ decision to purchase any particular stock is based on what is known as strong fundamental analysis.
Investors need to be wary that cheap stocks may be cheap for a reason. The trick in value investing is about deciphering what is cheap but fundamentally sound which provides for an investing opportunity, and cheap but fundamentally weak which provides for potential investment losses in the long run.
To simplify things even further, think of value investors as bargain shoppers. Although a company’s stock price may change, the company’s value remains the same. So, like a top-notch smart TV with all the works can be bought at a lower price during say a Black Friday sale, the same applies to stocks. The so-called sale wouldn’t have changed what you’re getting for your money. The main difference is that unlike products, stock prices are not discounted at specific periods of the year nor are these price changes advertised prior to their occurrence.
Warren Buffet is known as the ultimate value investor, however, there have been others. David Dodd, Benjamin Graham, billionaire hedge-fund manager Seth Klarman and others have all been in favour of this investment strategy.
How does value investing work?
One way of identifying undervalued stocks is by using the price-earnings ratio (P/E) tool, which determines a single number that derives from dividing a stock’s share by its earning per share (EPS). A lower P/E ratio means that you’re paying less for €1 of the current earnings per share, so as expected, value investors are particularly attracted to companies with a low P/E ratio. Another simple measure to identify value trades is the dividend yield (ie. annual dividend per share divided by share price). Usually, a value company is more mature and provides stable cash flows which means that it pays a dividend to shareholders. Value investors are intrigued by the dividend distribution component to generate long term return.
Although serving as a good start, you should always use this tool together with comprehensive research to identify underpriced securities. In addition, in order for this strategy to work to your favour, you must take the time to analyse and truly understand the company you are investing in before buying its stock. Try to determine its long-term plans, its business principles and financial structure and focus on companies that pay consistent dividends. And remember that with this strategy you’re in for the long haul. Your choices should be based on decades of trends and with future performance in mind.
What are the pros and cons of value investing?
Let’s face it, everyone likes a bargain and seeking stocks that sell at a discount to their intrinsic value will help you get a good deal. But there are other benefits. For instance, the strategy aims to reduce risk. The margin of safety provided by a stock that is bought for less than what it’s worth means that any inevitable share-price declines will be less dramatic should they take place, yet at the same time, good value stocks can offer you the potential to cash in when their true value is recognised.
However, you must remember that value investing requires perseverance and patience, while it doesn’t provide instant gratification. You may have to wait years before your stock pays off while you still run the risk of losing your money from time to time. You must also beware of stocks that appear to be cheap but aren’t. Known as value traps, some such stocks include those in cyclical industries that experience a substantial rise in earnings during boom times but diminish considerably when industry conditions cool off.
What is growth investing?
Also known as capital growth or capital appreciation strategy, growth investing is focused on maximising an investor’s capital gains. As a result, growth investors centre on companies that operate in rapidly expanding industries and which are marking strong profit growth. To determine this factor, investors look for features like a solid history of earnings, expanding revenue and profit margins. Profits through capital appreciation is ultimately the gains they will achieve when they sell their stock, as opposed to the dividends they receive while they owned it.
Often impressed by the strong earnings growth and the expectation for this to continue, many investors consider growth investing as a highly attractive strategy, however it’s important to keep in mind that despite their excellent potential, these companies tend to be small and newly established so they may pose more risk. For instance, back in the late 1990s, many investors rushed to purchase high-growth technology stocks but following the dot-com bubble, many were left with losses.
How does growth investing work?
Investors look at a company’s potential for growth. To establish whether a particular stock is a growth stock, they must look at its valuation and that its price-to-earnings multiple is high in comparison to the broader market and its industry competitors. On the other hand, a company’s potential growth can be calculated using certain methods or criteria that take the following key factors into consideration:
- Historical earning growth – companies should demonstrate a track record of strong earnings growth, typically during the past five to 10 years. Firms that have displayed good growth in recent years are most likely to continue doing so in the near future.
- Forward earnings growth – companies often publish their quarterly profits in what is known as an earnings announcement that showcases the company’s profitability for that specific period. These announcements come following earnings estimates issued by equity analysts and it is these estimates that growth investors pay close attention to as they attempt to determine which companies are likely to grow at above-average rates.
- Profit margins – this is an important metric to consider because if a company has strong growth in sales but poor gains in earnings, it could be an indication that the management is not controlling costs and revenues appropriately.
- Return on equity – known as ROE, this measures its profitability by showing how much profit a company generates with the money shareholders have invested. ROE is calculated by dividing net income by shareholder equity. A stable or increasing ROE is a good indication.
- Stock performance – here investors look at a stock’s growth rate. If a stock can double in five years, then this reflects strong stock performance.
What are the pros and cons of growth investing?
Perhaps one of the greatest pros of this strategy is the fact that it could potentially lead to wealth accumulation in no time since it serves as an excellent opportunity for an investor to capitalise on a company's momentum. By investing in companies that have great potential to making it big means that you can ride with them to the top, eventually realising this potential.
Broadly speaking, growth investing is considered a risky strategy mainly due to the fact that much of a growth stock’s value is based on future gains. Any change in investors’ perception of this potential could have a great impact on the share price. Another drawback is that often these company don’t pay any dividends. When a company is growing, it often needs capital to sustain this expansion which leaves no funds for dividend payments.
What is momentum investing?
As the name implies, momentum investing involves capitalising on a continued market trend, which means that investors purchase securities that have been showing an upward price trend or short-selling securities that have been reflecting a downward trend. The reasoning behind this strategy is that once a trend has become well-established, then in most likelihood it will continue trending for several more months.
American fund manager and businessman Richard Driehaus is considered as the father of momentum investing for taking the practice and turning it into a strategy. When running his funds, Driehaus let the winners ride while sold the losers and reinvested the money in other stocks that were about to start picking up – a technique that served as the basis of momentum investing.
How does momentum investing work?
Unlike other strategies whereby investors focus on a company’s performance, momentum investors use technical indicators to analyze a security, identify trends and their potential strength. By making use of a data-driven approach to trading and looking for patters in stock prices that will eventually influence their purchasing decisions, momentum investors also attempt to analyse and possibly anticipate the behaviour of other investors.
Some technical indicators used include trend lines, moving averages and specific momentum indicators like the average directional index (ADX). As the trend identified strengthens and gains momentum, the trader either buys an uptrend or sells a downtrend. Other investors also use short-selling as a way to boost their returns, which allows them to profit from a drop in an asset’s price.
What are the pros and cons of momentum investing?
There are several benefits to momentum investing. For starters, it can be a profitable strategy most especially thanks to the potential for high returns over a short period of time. Also, investors have the opportunity to leverage the market’s volatility to their advantage. By purchasing stocks which are on their way up and selling them before prices start to go back down, investors can maximise their ROI. At the same time, trends can keep on rising for years, so as long as an investor sticks with a specific upward trend, they are set to gain.
As expected, there are also risks involved. With downside risk due to short-selling, an investor’s possible loss is limitless. If the share price keeps on increasing, repurchasing shares to return them to the lender may prove to be too expensive. What’s more, momentum investors have to monitor the markets daily since they need to jump in early and get out fast.
Boasting both pros and cons, investing strategies require time to understand and adequate preparation before executing them. Skilled traders are adept at understanding when to take action, how long to hold an asset and when to exit, while they can also react to short-term and news-driven spikes or selloffs. Make sure you can handle the risks involved and that you can stick to a particular strategy. Here are some additional tips for successful trading.
Ready to try your hand at one of these strategies? To access Moneybase Invest and start trading download the app from either the Android or App Store. Alternatively, visit https://live.cctrader.com from any browser.
Moneybase Invest is brought to you by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business by the MFSA under the Investment Services Act.
Moneybase Invest offers direct market access and speed of execution and is intended for knowledgeable and experienced individuals taking their own investment decisions. The value of investments may go up and down and currency fluctuations may also affect investment performance.
The contents of this article are not intended to be taken as a personal recommendation to invest but strictly based on research and for information purposes only. Retail investors should contact their financial adviser for a suitability assessment prior to taking any investment decisions.
