In our initial article, we discussed why investing in stocks can make sense and how you can approach it (e.g. invest every month or invest all at once). Now we’ll talk about some common strategies you can use to actually pick specific investments.
Why Should I Care? (Reading time 0:16mins)
While some investors stick to just investing passively in the overall stock market, perhaps via a low-cost ETF that tracks the value of a stock market index like the S&P 500, others buy individual stocks or invest in funds that follow specific strategies. Below we outline some of the main strategies for actively investing in stocks.
What Can I Do? (Reading time 5:13mins)
The grandfather of this classic strategy is Benjamin Graham, and it’s the approach that Warren Buffett broadly takes. The idea is to buy companies that are currently valued at a low level relative to the profits they’re generating (compared to other companies in the same sector or in the stock market as a whole). Typically these companies pay out a high dividend (relative to their stock price), which means value investors get paid a steady stream of cash (no bad thing…).
Often such companies are big players in established industries (think: Verizon or BP) which allows them to produce a steady stream of profits. However, their large size and entrenched position can make it difficult to grow those profits any faster than overall economic growth, which dissuades investors from buying their stock.
Value investors hope that, over time, other investors will notice that their investments are undervalued and will also buy the stock – pushing up their price. Some event might alert those new investors to the opportunity – perhaps a big increase in a company’s dividend, or the company selling off a struggling part of its business. And that’s when the value investors cash in.
✅ Who is this good for?
Value stocks are typically less risky – they move less dramatically in price – than other stocks, which makes them more suitable to investors with a relatively low risk appetite. Note, however, that they’re still stocks, and that their prices can still swing drastically.
📋 How to invest in value stocks
Investors looking for value stocks tend to screen the broader market for stocks that fit their criteria (sometimes a data service, like Factset, makes the data collection and analysis easier). The criteria for value stocks typically include:
- Price-to-earnings ratio that is lower than the market average
- Price-to-“book value” (which is the value of the firm’s assets) that is lower than the market average
Value stocks sometimes have a fair amount of debt, since they tend to be large, stable companies. Beware, however, of a company that has too much debt, especially if its profits are declining. The riskiness of buying shares in such a company may mean the company is cheap for a reason.
Try to solve the new Formula Cube! It works exactly like a Rubik's Cube but it is only $2, from China. Learn to solve it with the tutorial on rubiksplace.com or use the solver to calculate the solution in a few steps. (Please subscribe for a membership to stop adding promotional messages to the documents)
Growth stocks are usually typified by their high price relative to their underlying profits. Why would anyone want to pay such a high price for a stock? If they expect the company’s profits to grow quickly in the coming years. For example, Facebook has historically been valued at a high multiple of its profits – investors have bet that Facebook’s “high” valuation is actually attractive because it will be making so much more profit in, say, two years time (so far, such investors have been proven correct!).
Growth stocks are generally perceived to be riskier than value stocks because investors’ expectations are high (as evidenced by their high price). If companies don’t follow through with the requisite growth, the fall in their stock prices can be very large (see GoPro, Fitbit and many others).
✅ Who is this good for?
Certain “growth” stocks are also prone to failure, meaning investors must be able to absorb permanent loss of their capital (this risk can be mitigated by diversifying one’s investment among various growth stocks). Even when successful, growth stocks tend to be more volatile than other stocks (like Google and Amazon over their lifetimes), which makes them more appropriate for investors willing to stomach some pain. The more long-term one’s investment horizon, the more likely such risky investments are appropriate.
📋 How to invest in growth stocks
Again, screening for companies with the relevant characteristics can provide a set of possible stocks to buy. The criteria for growth stocks typically include:
- Revenue and/or profit growth significantly higher than the market average
- Certain industries are more likely to contain growth companies, particularly tech; so sorting a universe of stocks by sector can help identify ideas
- Usually, low levels of debt. If a company is growing quickly, it’s likely because its product is only just being widely adopted – and therefore a high debt level is a potential red flag, as the company’s ability to pay back that debt is less firmly established.
Like value funds, there are dedicated “growth” funds that target only fast-growing companies – so you don’t have to buy individual stocks.
There may be “special situations” that create specific investment opportunities. For example, an acquiring company may have agreed to take over a competitor, but risks that the deal doesn’t get completed may have caused the stock price of the target company to trade below the acquisition price. Investors betting that the takeover will get completed would buy the target’s stock and profit once the deal is completed. Other opportunities may involve companies undergoing major restructurings where certain businesses are being sold off or new management has been hired to cut costs aggressively. These “turnaround” strategies can be lucrative for investors, but they’re often high-risk, as a successful turnaround is far from guaranteed.
✅ Who is this good for?
Special situations investing is typically only performed by professional investors, or those with enough time and skill to properly monitor and profit from each situation.
📋 How to invest in special situations
It’s more difficult to screen for these sorts of opportunities, although you could use a service like Dealogic to keep track of ongoing M&A deals. Otherwise it’s simply case of paying attention to corporate newsflow.
Investors may invest in certain stocks depending on their view of macroeconomic conditions. For example, an investor that thinks interest rates will go up may buy bank stocks, as higher interest rates typically mean banks can charge more interest, thus boosting their profits. Or perhaps an investor thinks that tax cuts will spur more spending by consumers, so they buy “consumer discretionary” stocks (think: Nike or BMW).
✅ Who is this good for?
Generally, sophisticated investors that have an excellent understanding of macroeconomics and how changing macroeconomic factors affect certain sectors and individual companies.
📋 How to invest in “macro-driven” stocks
A thorough analysis of the current macroeconomic environment and an outlook for the future are necessary. There are a wide variety of sources, including routine releases of economic data and macroeconomic research (usually for a fee). Of course, reading Finimize every day doesn’t hurt! The investor then must apply their macroeconomic view to particular sectors or stocks in order to determine an expected outcome.
Investing in stocks is one of the most tried-and-true methods of increasing the value of your savings over time. It comes with risks, for sure – but the benefits of a consistent, long-term strategy are clear. By shedding some light on “why” and “how” to invest in stocks, we hope we have made the decision to invest clearer.
Keep in mind investing is difficult and risky; your capital is at risk.