Fifty years ago, there was a very limited set of philosophies of investment or in other words, styles of investing. In fact, the basic advice brokers gave their clients was nothing buying when a stock is going up and selling when it’s going down. That was about it. Over the past half-century, thanks to prescient thinking by some very smart people, there has evolved a range of investment styles. In this article, we’ll examine some of the most important ones. Before starting, you may want to check one of these things out:
- Bond Investment for Beginners: Types, How To Buy And Make Money
- Investment For Beginner: Basic Buying and Selling
- Stock Investment For Beginners: What Stocks Are and How To Buy Them
The Buffett Road to Wealth
Value investing focuses on companies rather than stock prices. As Warren Buffett, the leading practitioner of value investing, says, “The dumbest reason in the world to buy a stock is because it’s going up.” The movement of stock prices is largely irrelevant save for this important precept: Over time, the stock price tends to reflect the real value of the company. Value investors are on the prowl for bargains, and they’re more inclined than growth investors to analyze companies using such data as sales volume, earnings, and cash flow.
The philosophy here is that value companies are actually under-valued, so their stock price doesn’t really represent how much they’re worth. Value investors are often willing to ride out stock price fluctuations because of the extensive research they have done prior to committing to a particular stock. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” —Warren Buffett
Typically, value investors don’t glue themselves to computer screens, watching every flicker of the market as it rises and falls during the day. Instead, they concentrate on analyzing companies, determining—or attempting to determine—their intrinsic value.
Disagreements about Intrinsic Value
This is difficult since there’s no agreed-upon method for doing this. For instance, does “value” include both current assets and debts, or does it also include projected future growth? And if the latter, how do we accurately estimate that future growth? It’s these disagreements that lead to a variety of different formulas for calculating a company’s value. (After all, if there were a single “right” formula, all value investors would invest in exactly the same companies.) One number that many value investors look at closely is the company’s price-to-earnings ratio. This is the ratio between share price and per-share earnings, generally calculated over a year. For example, if Company A is trading at $30.00 per share and its per-share earnings during the past year were $1.35 per share, the company’s P/E ratio would be $30.00 divided by $1.35, or $22.22.
Value investors (and others) spend a lot of time on what is called fundamental analysis (as opposed to technical analysis, which is a very different kettle of fish). Fundamental analysis looks at such things about a company as:
- Revenue—is it growing and where is it coming from?
- Profits—are they growing?
- Debt—growing or shrinking?
- Who are the company’s competitors?
Analysts look at such questions both from the point of view of quantifiable numbers as well as the harder-to-calculate intangibles. For value investors, these questions all come down to the issue of valuing the company to determine if that value is in line with its stock price. As mentioned previously, one number analysts study is a company’s P/E ratio. Others include:
- Stock price highs and lows
- Market share
- Earnings per share
More intangible values include market leadership and how steady that leadership is; quality of the company’s leadership; its vision for the future; and how wide is the recognition of its brand.
Coke and Apple
We can see how this plays out in two iconic companies: Coca-Cola and Apple. Coke is among the world’s most important brands, with dominant market share in the area of soft drinks. More than that, it dominates the soft drink market in a way no other brand can come close to. Warren Buffett, who bought Coca-Cola stock beginning in 1986 and whose company, Berkshire Hathaway, currently owns approximately 400 million shares of Coca-Cola, famously said, “If you gave me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I’d give it back to you and say it can’t be done.”
Market dominance, in this case, is a pretty tangible intangible. On the other hand, we have Apple. The biggest intangible to hit the computer company was the death of Steve Jobs in 2011. It was not clear—and still isn’t—what long-term impact that will have on the company, Jobs’s role as CEO, visionary, and, some would argue, aesthetic genius, is difficult if not impossible to replace. Investor confidence in the company has been wobbly since Jobs’s death. It remains to be seen whether CEO Tim Cook can strengthen that confidence through his leadership. This is another instance of an intangible having a direct impact on the stock price.
Assumptions of Value Investing
Value investing is based on two important assumptions:
- The intrinsic value of a company is not the same as the total value of its stock.
- Stock always, in the long run, will adjust to the intrinsic value of the company.
These come with two unknowns:
- You don’t know if your assessment of the company’s intrinsic value is right.
- You don’t know how long “the long run” is.
If you’re confident of your ability to rationally determine a number for the intrinsic value of a company (through fundamental analysis) and you’re willing to hold the stock until you see it adjust to the company’s value, you have the makings of a good value investor.
GROWTH INVESTING AND TECHNICAL INVESTING
Looking for Price Movements
Essentially, growth investors want to own a piece of the fastest-growing companies around, even if it means paying a hefty price for this privilege. Growth companies are organizations that have experienced rapid growth, such as Microsoft. They may have outstanding management teams, highly rated developments, or plans for aggressive expansion into foreign markets. Growth-company stocks rarely pay significant dividends, and growth investors don’t expect them to.
Instead, growth companies plow their earnings right back into the business to promote even more growth. Among other things, growth investors pay close attention to company earnings. If growth investing fits in with your overall investment strategy, look for companies that have demonstrated strong growth over the past several years. Technical investors, on the other hand, so-called because they rely on technical analysis for their stock picks, are concerned with immediate movements of stock prices rather than any long-term trends. In some respects, this makes them akin to day traders and short-term traders.
Growth investors look for younger companies, which are often possessed of cutting-edge technology and developing niche markets. In the past several decades, growth investors have looked carefully at high-tech companies. Since growing young companies tend to plough their profits back into themselves, investors rely on capital gains for their money rather than dividends. In their fundamental analysis, growth investors watch for indicators of future performance, especially how it compares to the past performance.
National Association of Investors Corporation
The NAIC is among the most important proponents of growth investing. Now generally called BetterInvesting, it was founded in 1951 as a national investment club. It aims to spread the gospel of growth investing while providing information and services for its members. Find out more at its website: www.betterinvesting.org. Because of its emphasis on the future, growth investment looks at different issues than value investing:
- What are the company’s projected earnings during the next five years? During the next ten?
- Is management controlling costs?
- Are there areas into which the company can expand to enhance revenue?
- Is the consumer audience for the company’s products growing? At what rate?
- What is the company’s market share compared to five years ago?
- Is the stock price trending upward? Can it double in five years?
Although growth investing seems simple, there is often no clear agreement on what constitutes a growth stock. Still, there is a lot of room for investors who are excited by seeing companies moving outward and upward.
Unlike value investors and growth investors, investors who rely on technical analysis for their picks are almost entirely unconcerned about the companies in which they’re buying stock. Instead, they make their decisions based on the movement of stock as a result of market activity. They are concerned with issues such as price highs and lows, the volume of trading, and short-term trends in the market. This is the basic thing to understand about this form of investing: The technical investor doesn’t care about what the stock represents. That is, a technical investor approaches stock in a high-tech company in exactly the same spirit as he approaches stock in a company that makes baby food. The intrinsic value of the company and the stock is irrelevant. What matters is what the stock is doing in the stock market.
Bonds and Analysis
We’ve been talking about stocks, but there’s no reason why bonds (or any other financial instrument) can’t be subject to the same kinds of analyses— fundamental and technical—as stocks. In fact, there are people who do nothing all day but analyze bonds, either based on their movement in the bond market or based on the institutions and organizations that are selling them.
One type of technical analysis that is very common is the use of candlestick charts. These are charts in which each entry (or “candlestick”) on the chart represents a day’s trading of a particular stock. The chart indicates what the stock opened and closed at and what its high and low prices were. Based on a study of these charts, technical analysts can determine whether a stock is trending up or down and make a decision as to whether to buy or sell.
DAY TRADING AND SHORT-TERM TRADING
Making Money in the Short Run
Although many people are fascinated by day trading, it is not an endeavor for the weak at heart. Toni Turner, author of A Beginner’s Guide to Day Trading Online, estimates that 80 percent of those who try day trading quit—usually having lost money. That said, it’s possible to make a lot of money day trading, and there are plenty of people who’ve done it.
Day Trading versus Short-Term Trading
Day trading is just what it sounds like—your purchase and sale of stock takes place within twenty-four hours. Sometimes it takes place within minutes. Short-term trading, on the other hand, is slightly slower-paced. The purchase and sale of stock take place over several days but generally occurs within a week. Day traders usually rely on very fast computers, since speed is a key asset in day trading. Day traders also need access to the trading desk; sources of news; and an understanding of technical analysis and the software necessary to perform it.
Stock Exchange and Forex
Day trading can occur anywhere, but it most frequently happens on the stock exchanges (particularly the NASDAQ) and the foreign exchange, also known as the forex.
This technical analysis software is key to effective day trading because one of the things such software does is to recognize patterns in the movement of stocks. These patterns signal to the experienced day trader a buy or sell decision.
If you buy and sell the same stock (or other financial instruments) at least four times in one day over a five-day period, you qualify to be considered a pattern trader by the SEC. In addition, you must have at least $25,000 in equity in your trading account. Such traders look for patterns in their technical analysis, relying heavily on candle-stick charts. These patterns can have names like:
- Evening Doji star
- Hanging man
Day traders and short-term traders, like technical investors, rely on trends rather than performing fundamental analyses on companies whose stock they trade (the deliberate nature of the fundamental analysis is incompatible with the immediate, highly charged world of day trading and short-term trading).
Day traders and short-term traders work within four basic time frames:
- Short-term: Trades take place over one to two weeks
- Swing: Trades occur within two to five days
- Day: Stocks are bought and sold within a day
- Scalping: Stocks are bought and sold within seconds or minutes
Day trading works best, for obvious reasons, in a bull market, but experienced traders can also profit from a bear market if they know when to sell and are ruthless about executing trades. What day traders often look for are small bumps in an otherwise down market when a stock begins rising, peaks, and then quickly falls. All such patterns offer opportunities for profit. If the day trader is working through a broker, there are various means of specifying orders:
- Market orders—the broker has the trader’s permission to set the buying and selling price.
- Limit orders—the trader sets upper and lower limits beyond which the stock cannot be bought or sold.
- Buy stops—the trader specifies a particular number of shares that can be bought when the stock reaches an agreed-upon price.
- Stop losses—the trader specifies a lower limit. If the stock reaches that limit, the stop loss becomes a market order and the position is lost.
All of these are in place to both maximize profits for the day trader and prevent losses. They’re also intended to keep up with the speed with which transactions on the exchanges occur. This is the aspect of day trading that—rightly—intimidates new traders: that everything in day trading happens fast. If you can’t deal with fast trading, day trading is probably not for you.