You’ve taken the time to develop a trading plan and now you want to figure out your investing style. Where do you begin? Determining your investing style will largely dictate how you view opportunities, read performance measures, and interpret the technical charts of a particular investment. Different trading styles will see prices differently, and look for different entry points for an equity.
Developing an investing style begins with understanding yourself – mainly your preferences, strengths, and risk tolerances. While investing is largely about numbers, it is not hard science, and individual personality, psychology, and temperament play a large role in investing. Certain styles benefit certain types of people, and investors will find one strategy is easier to stick to (and causes less stress) than another. For this reason, finding an investment style that fits you is very important. An investment style should be well thought out and one that can be replicated several times to achieve investment success. A trading style shouldn’t be based on one extraordinary outcome of a particular opportunity, since that can often be more of a sign of luck than skill.
A personal investing style should often mirror characteristics that are evident in your personality in other areas. Are you cavalier and a risk taker? Then an investment style that seeks more risk to generate outsized returns is likely one that will suit you. Are you very cautious and risk adverse? Then an investment style that focuses on achieving consistent returns with minimal volatility will likely be best for you.
Here we’ll explore two common styles: value and growth investing (see separate piece in Learning Center). While both of these styles will appeal to many personalities, most people will gravitate more towards one or the other.
Value Investing
If you have ever heard of Warren Buffet, then you are familiar with one of the greatest value investors of our time. He tends to target his investments on companies whose business model and revenue streams he can fully understand, and which he sees as undervalued, or trading at a discount. He also looks for companies that have a strong position in the market, a great brand name, and can be expected to maintain these strengths and appreciate as a result of those strengths for the foreseeable future. For instance, Warren Buffet bought a large share in Coca-Cola (KO) many years ago when the majority of Wall Street was bearish on the stock. As a result, Buffet’s firm Berkshire Hathaway capitalized on the firm’s robust growth and has outperformed the market thanks to that and similarly valuable but underappreciated stocks.
Buffet’s criteria for buying an equity is similar to the approach shared by all value investors, although some may focus on certain metrics over others. In short, value investors seek to purchase stocks trading below their intrinsic value. In plain English, value investors seek to buy something for less than it is worth, tantamount to shopping on sale.
Value investors focus on the fundamentals of the company and look for hidden value uncovered by this analysis. Much attention is paid to the price of a particular stock relative to current and future earnings; under this premise, value investors tend to identify companies with low P/E ratios relative to the individual company’s industry and the broader market.
Price-to-book-value is seen as the most important ratio to a value investor, and it is seen as the most effective measure of valuation. Book value measures what a company’s net assets are worth. A profitable, well-managed company should not trade for a price equivalent to or less than its liquidation value. When a stock trades at or below its P/BV, it is often an indicator to “buy”. (A price-to-book-value of 1.0 means a company is worth the same as its net assets) Generally speaking, a company trading at a book value of 2.25 or lower is generally a good investment to make, including all other value metrics being present. However, there is a downside to book value. Very poorly managed companies or companies with outdated business models may very often trade at or below book value as they “die slow deaths”. These “value traps” should be watched out for since they can have deceiving signs of value. To ensure you don’t fall for such a trap, make sure to look out for other value metrics such as industry position, management quality, and stable earnings. It should be noted that many value investors also look at price-tangible-book-value as a more stringent method of valuation, whereas others will try to incorporate more qualitative ideas into their valuation.
Another area that value investors tend to focus on is shareholder repayment or the ability for a company to reward its shareholders and have them share in the financial success of the company. Dividends and a history of increasing dividend payments is a way to capture the heart of a value investor. However, value can be returned to investors in other ways such as stock buyback programs, which makes shares more valuable (this is done by lowering the amount of shares outstanding, which increases the EPS of the remainder). A good metric for a value investor is a strong history of dividend payments, since this is a sign to investors that they will see some return on their investment regardless of stock price fluctuations.
Debt, especially high levels of total debt outstanding, is viewed as a negative to a value investor. (Revenue generated must be paid out in the form of interest versus being used in other ways to grow the company or repay shareholders). A good indicator for value investors is the debt/equity ratio. Value investors use this ratio as a good metric to determine how severe a company’s debt load may possibly be. In general, the higher debt/equity ratio is often seen as a sign of concern, although it can also signify that a company is aggressively growing in an expanding market or requires massive capital to establish its presence in a sector, industry, or market.
Value investors very often look at the consumer staples sector of the market. Consumer staples companies tend to have business models that allow them to perform consistently throughout an entire economic cycle (from peak to trough) due to their stable consumer engagement. As you can imagine, stable earnings and consistent performance are very important to a value investor. These companies tend not to grow more slowly and, as a result, they tend to have lower P/E ratios in comparison to the broader market. This is one reason why value investors are rarely aggressive.
Value investors also tend to focus on a longer time horizon for their investments. This means they tend to ignore short-term fluctuations in assessing the performance of their portfolios, but they will look at short-term fluctuations as buy opportunities. A good example would be the subprime mortgage crisis in 2008, when market panic caused the prices of most stocks to fall, including dividend-yielding large-cap stocks that had a history of solid performance and great value. The crash was, from a value investor’s perspective, the buying opportunity of a year, when many reliable stocks could be bought at a heavy discount, producing excellent dividend yields on cost in the short term and great capital appreciation potential in the long term. At the same time, value investors may have seen their holdings fall throughout the crash as prices tumbled further. This is one reason why value investing tends to be less successful when applied to short-term horizons for quick gains. Value investing requires a healthy dose of patience.
The “Bible” of value investing is considered to be The Intelligent Investor by Benjamin Graham. All professional value investors have read this book in addition to Graham’s other major book on investing, Security Analysis.