If you are a new investor looking to find your feet in the stock market, you need to understand the different investment strategies and match these to your personality. I am a value investor, and I advocate for value investing, however value investing only works for certain types of investors. As someone just starting to invest in the stock market, read through the following description of various stock investment strategies and see what strategy appeals to you most.
Before we go deeper in this discussion, I want to make sure we all understand that there is no such thing as a perfect strategy in the stock market. There are many proven stock market strategies that work to get you a respectable returns if you follow the basic principles. Any of these strategies will get you outstanding returns if you go beyond basics and make a serious study and practice with diligence.
Let’s Start with the 2 Basic Investment Paradigms
The investment world generally splits in two separate camps.
One camp believes that the stocks derive their value from the strength of the underlying business. If a business grows its revenues, profits and market share, the company becomes more valuable and this will reflect in the stock price. As you see, the source of the stock value comes from the fundamentals of the business. Not surprisingly, this paradigm of investing is called Fundamental Investing. All analysis performed to measure and track various business metrics is called Fundamental Analysis.
The other camp believes that stock prices are mainly a result of the supply and demand of the stock in question. Investor behavior affects the stock prices more, at least in the short to medium term. Equally vocal, these investors make a living out of reading charts and patterns to understand the investor sentiment around the stock, and then take positions whenever the charts tell them that the stock is poised to rise. This type of investing is called Technical Investing, and the analysis performed to read the stock charts is called Technical Analysis.
Technical investors are commonly referred to as traders or speculators, since this type of investing focuses on short term results, and can involve rapid entry and exit into and from various stock positions. Fundamental investors are commonly referred to as investors due to the long term focus. Regardless of the term used, it is important to remember that there are highly skilled investors practicing either of these styles of investing with great success. Let’s look at both these paradigms in a little more detail.
There are many ways to consider the fundamentals as an investor. We will go over some of the common strategies.
1. Value investing
You are on a value investing website, so I am sure you are aware or atleast curious about this investment strategy pioneered by Benjamin Graham and David Dodd. Some very reputable investors, such as Warren Buffett, and Seth Klarman, owe their success to value investing.
Value investing aims to find companies that can be bought at a discount to its inherent, or intrinsic value. One way to think of this is to buy a stock on a sale. When you do this, it is very probable that investors will eventually discover that the stock is trading at a discount, and then they will buy it up and the price will go up. This price increase provides a profitable return for you as a value investor. Value investors typically look at the tangible value in the business that exists today.
Value investors come in different flavors, depending on where they are looking for value. Here are a few of these:
- Cigar butt investing – This is a metaphor for finding a lit cigar butt on the ground, that you proceed to pick up and take one last puff. The idea is that an almost dead company may still have something more to give to you as an investor. Perhaps one last management initiative creates a brief period of excitement among other investors, and you find a fleeting opportunity to sell the stock for a profit to those poor suckers. In his early days, Warren Buffett did a lot of cigar butt investing.
- Contrarian Investing – Once you realize that most of the investors do worse than the market, it makes sense to take positions that are contrary to the popular investment trends. Of course, a contrarian investor goes about his business with more intelligence than a blind rejection of the investment pop culture.
- Special Situations Investing – Investors are a lazy bunch. Most of them anyways. Sometimes a little bit of complexity in a business situation drives investors away. Maybe it is a lawsuit, or a spin off or an acquisition. After all, why bother to spend time (and gray cells) trying to understand stuff, when you can blindly buy whatever else others are buying. Within this complexity, lies opportunity, as many a billionaire special situations investor will tell you.
- Distressed Debt Investing – This is special situations raised to a higher level. Distressed debt investing attempts to make money out of a liquidation or a bankruptcy process. Some of this is understanding the math and the legal rights and seniority of various notes and debt instruments. A big part of this is sitting in a courtroom or across the table from other lenders and negotiating until you see green. This can be very lucrative but definitely not for the faint of heart.
Quantitative Value Vs Qualitative Value
Classic value investors that like to look at various business and stock fundamentals tend to vary in their reliance on the quantitative measures that indicate value. Quantitative value investors rely significantly on the financial ratios and other quantitative metrics. Qualitative approaches pay a lot of attention to business strategy, management pedigree, and other softer indicators of value. I do not think there is any value investor that is purely qualitative in approach – some level of quantitative analysis is essential – but the degree of quantitativeness varies.
2. Growth investing
A growth investor derives much pleasure (and sometimes profits) by finding companies that are expected to grow rapidly in the future. Ever heard someone say “buy Uber, it is the next Facebook”? You are talking to the so-called growth investor.
In all seriousness, casual investors who chase hot trends give growth investing a bad name. Serious growth investors do look at future business growth as a source of profitable appreciation in the stock price. However, their expectations of the future business growth is rooted in serious analysis and due diligence. Phillip Fisher was a growth investor, and a serious influence on Warren Buffett. You should read his classic book Common Stocks and Uncommon Profits (Amazon referral link).
One of the criticisms of growth investing is that it focuses on future more than the present. Therefore it is quite common for investors to chase growth in stocks with very little business earnings or profits to show today. At times it may become naked speculation if investors let their greed run free. There have been several attempts to reign in the more “growthy” aspects of growth investing.
- GARP Investing – Growth at a Reasonable Price is an attempt to buy growth without overpaying for it. This philosophy may let you buy Zoom because it is a profitable and growing company, but will stop you from buying Uber with its billion dollar losses. One of the main tenets of GARP is the use of PEG Ratio to find stocks that are reasonably valued for their rate of growth
- CANSLIM(c)– CANSLIM is a strategy formulated by William O’Neil, founder of Investor Business Daily, to find growth stocks based on fundamental and technical factors. I have never used it and have not much to say about it.
3. Income investing
Technically this encompasses bonds, but here we are primarily looking at investing for dividends, or other sources of yield (such as MLPs, REITs, etc). Income investors are interested in fundamental measures of the stock, not necessarily business, as long as it relates to preserving or growing the dividends. For example, dividend yield, dividend payout rate, dividend growth, etc are very important metrics in this style of investing. It is also very important to know that the company has a history of sustained dividend payments and even regular dividend growth.
However, while the investor is focused on how much income they are generating from dividends, they may lose sight of the fact that the company itself may be becoming fundamentally unsound. There is no use chasing a company that borrows from Peter to pay Paul (issues debt to be able to afford paying the dividend).
Dividends are also not very tax-sensible, here in the US. But they do indicate financial strength in most cases, so it is a good thing.
4. Buy and Hold
We have all heard stories of folks who bought AT&T stock (or something similar) 50 years ago and then forgot about it. Now the old dusty stock certificate is worth a fortune.
These kind of stories romanticize the buy and hold philosophy of investing – which asks you to buy stock in solid companies and then hold on to it for decades. While this is a great way to participate in the business fortunes of the company in question, perhaps reaping a solid dividend income along the way, it can also sub-optimize your welath growth. After all, you are betting that not only the company you buy will do well in the near future, but it will also be able to fight off all competition, current and future, will not stumble, etc. etc. By doing this, you are also not investing your dollars in other better opportunities that are bound to arise in the future.
You are committing to ignore valuations over the time you invest.
I don’t advocate it. I also suggest you do not confuse buy and hold investing with long term investing. They are two different things.
5. Quality Investing
Quality investing is pretty much value investing with a caveat. If you are a quality investor, you want to buy high quality companies (and you get to define what this means, for the most part) at a fair or cheap price. Warren Buffett today is a quality investor. Typical factors that go into building the quality attribute includes management credibility, balance sheet stability (no crazy ups and downs), long term orientedness of the business strategy, etc.
Tactics in Fundamental Investing
Fundamental investing gives us an opportunity to plan and invest for the long term, measured in decades. Over time, you will have many questions. Shall I invest all the capital at once, or shall I spread it out over time? What is the best way to spread out investment over time? How should my risk profile and capital allocation change as I get older.
I will briefly lay out some of these concepts. Your financial adviser who knows your situation and knows you well can help you finesse these tactics to suit you.
- Lump sum investing – If you have a significant amount of cash you want to invest, one of the ways to do this is to move the cash to your stock broker and instruct them to buy the stocks that you wish in your portfolio as soon as logistically possible. You are very much taking the market price that is available.
- Dollar Cost Averaging – Dollar Cost Averaging, or DCA, takes the same lump of cash and puts it to work slowly over a period of time. For example, you can split up the total investment in 6 equal chunks, and invest one chunk every month for 6 months. This way, if the stock price has declined, you end up buying more shares. If the stock price has risen, you end up buying less number of shares. On a long term basis, DCA has no perceptible advantage over a market index (DCAing in an index fund over a long period of time will just get you the index fund return)
- Value Cost Averaging – This is similar to DCA but slightly more complicated. You DCA but not in equal amounts. You adjust the new contribution down by the amount the investment has grown. For example, if a $1000 investment went up by $20, and your have decided to increase your investment amount by $100 each month, you will just add $80. On the flip side, if the investment fell by $20, you will end up investing $120 to make up the shortfall. This is a slightly more agressive form of cost averaging, and over long term tends to achieve better performance compared to DCA, but not by much. It also has the disadvantage of becoming unmanageable when the losses exceed your capacity to add enough new money to make up the shortfall.
- Age based asset allocation – This simply refers to becoming more conservative as you get closer to your withdrawal date (retirement for most). The assumption is that stocks are riskier than bonds, which are riskier than cash, and therefore the asset allocation shifts closer to bond heavy, and then cash heavy as you age.
Most technical analyst are not very concerned with fundamentals of the business or the stock. Primarily because the holding period tends to be smaller, shorter than a quarter, for the fundamentals to make much of a difference.
6. Momentum trading
Momentum investing relies on the inertia inherent in stock movements. The principle is that stocks that are rising, will continue to rise, until something changes. The goal is to find momentum stocks and keep riding them until the momentum fades and the stock turns back.
While this sounds cooky, momentum is one of the few factors that has proven to deliver a sustained out performance over the market (value investing being another such factor). Generally, momentum factor works in the periods when value factor is not working, and vice versa.
7. Trend Following
Very similar to momentum trading, but trends are longer term direction of movement. Different technical indicators are used to figure out the trends (such as moving averages).
8. Dual Momentum Investing
Originally laid out in the book by Gary Antonacci (Amazon referral link), dual momentum investing blends the short term momentum with longer term trend following. The strategy can be implemented with very few assets, mostly with ETFs.
9. Swing Trading
Most of the stocks are not in a trend at any given moment of time. These stocks move in trading ranges. Swing traders try to ride the stock long on the upswing and short on the downswing. The ranges can be small, and the positions can last for days to weeks.
10. Day Trading
Day traders have the same goals (make money) and techniques as the swing traders but they do not hold a position overnight. After market news is a big risk factor that they try to avoid at all cost. They may use significantly large amount of leverage, since the margin risk is not very high.
Tactics in Technical Analysis
Technical analysis and trading requires quick reflexes to react to quick movements in prices. It also requires very solid system to manage money and reduce risk of loss. Most technical traders figure out a system that works for them, otherwise the risk of a wipeout is very real.
- Kelly Criterion – Derived by John Kelly of Bell Labs, Kelly Criterion or Kelly Formula gives the optimal bet size for any bet, in order to maximize the long term wealth. The bet sizes depend on your win/loss ratio and expected winnings. Mathematically, this does maximize your wealth in the long term. In practical terms, it can cause a lot of volatiility in the portfolio that can be nerve-wrecking for you. Buffett and Bill Gross are rumored to use Kelly Criterion. William Poundstone wrote a very entertaining and educational account of this in his book Fortune’s Formula (Amazon referral link)
- Risk Parity allocation – While Kelly Criterion is meant to maximize wealth, the risk parity allocation method minimizes the risk of loss in your investing system. This takes into account the volatility of an asset. Many funds as well as us at Value Stock Guide Premium use the risk parity allocation (adapted for equity only portfolio)
- Optimal f – Created by Ralph Vince, it is similar to Kelly Criterion in the sense that your optimal fraction to allocate to any new investment is derived from your past performance history. It differs from the Kelly Criterion in the sense that the expected profit from this investment does not figure into the calculation.
At Value Stock Guide Premium, we have blended the Risk Parity Allocation capital allocation tactic with value investing to build low risk and high performance portfolio.
Most investors have no strategy and no portfolio management process. As a result, most investors lose money. Now that you have read this guide, you understand different stock investment strategies. Choose what fits your style, and then learn these strategies in greater detail. You will be further ahead than most of the stock investors who fly blind. Good luck.