Investing in Stocks

Value Investing

The idea of value investing and looking for a bargain is one of the oldest ways to pick stocks. Benjamin Graham and David Dodd, finance professors at Columbia University, laid out the framework for value investing way back in the 1930s. The concept is similar to shopping; you look for the product that is reasonably priced without sacrificing quality. This strategy tends to come into favor when there is uncertainty on the horizon.

Background
A value company is one that is relatively cheap compared to its earnings and book value. In most cases value stocks tend to outperform other stocks during bear markets and because of this quality they are often considered a defensive investment. In contrast, a growth company is relatively expensive compared to its current earnings or assets. Value stocks tend to have a P/E ratio and book value (or tangible assets) much closer to the stock price. Furthermore, value investing is founded on the concept of investing in companies that have a solid history of earnings and sales. There should be little uncertainty about a value company's operations or future performance.

Value investors pay very close attention to the price-to-earnings ratio (P/E ratio) which is indicative of an "inexpensive" company. They also conduct fundamental analysis using various other ratios to decide on stocks they like, then wait for those stocks to trade at bargain prices before placing and order to buy.

The PEG Ratio is another common method used by value investors to identify oversold stocks. The PEG Ratio is calculated by taking a stock's P/E ratio and dividing it by the stock's projected year-over-year earnings growth rate. In other words, the ratio measures how undervalued the stock while taking into account its earnings growth. If the company's PEG ratio is less than one then it is considered by many to be undervalued.

The results of value investing have been proven by one of the greatest investors of all time, Warren Buffett. His value investing strategy has taken the stock of his company Berkshire Hathaway from $12 a share in 1967 to $60,900 in 2001, that's right, over $60,000 per share.

When to Buy
Value investors are always looking to capitalize on bad news and stocks that are shunned by other investors. By examining the fundamentals of a company value investors decide if the tumble in stock price was "over done". If the company meets their criteria, the value investor will strike.

Value, Not Cheap!
The prospects of value investing may sound intriguing, but simply buying a stock that is cheap is not the right approach. There is a significant difference between an undervalued company and a cheap company. Cheap companies have seen a tumble in their stock price because there something is fundamentally wrong. Furthermore, all the analysis in the World might not detect the fundamental problem with the company. This is a risk that all value investors take when investing in beaten down companies.

A perfect example of this risk is the recent tumble in Lucent's stock price. Back in January, 2000 Lucent warned of earnings shortfall and the stock plummeted from $70 to $50. Had you bought then, you wouldn't have seen much upside. The stock subsequently had several more earnings warnings throughout the year and is trading at the time of writing at a pitiful $7 per share. Many value investors lost a lot of money on Lucent because they purchased the stock each time the price plummeted.

Things To Remember about Value Investing
  1. Value is Relative, manias exist from time to time, whether Tulips, Gold, or Internet stocks. You usually only get a bargain when something is out of favor.

  2. Enormously undervalued stocks are usually cheap for a reason. Be wary!

  3. Avoid investing in a stock that has significant uncertainty, it could go from a value stock to a Chapter 11 (bankruptcy) stock faster than you think.

  4. Value stocks may take some time to prove their worth, sometimes 10, to 15 years or longer! You must be patient when value investing.

Growth Investing

Chances are that you've heard about this strategy before. Like many of the core strategies in use today growth investing was pioneered a long time ago. With growth investing, investors enjoyed previously unheard of returns in the late 1990's. But, before you jump on the bandwagon realize this strategy isn't for everyone as there are additional risks.

Background
Growth investing is based on the concept of buying stock in companies that tend to grow substantially faster than others. In most cases this involves buying young companies with high potential. The idea is that growth in earnings and/or revenues will directly correlate into growth of the stock price. In the 90's most technology companies took on the title of growth stocks. Because this strategy has proven viable over a long period of time, growth investing has many followers.

What factors are involved?
What factors are involved? For the most part growth investing involves looking at a company's earnings. Earnings per share (EPS) tells investors how much profit is being made for each share in the company. There are many examples of companies with astounding growth in sales but a widening loss in earnings. For investors who follow growth investing, a stock that has a revenue growth of 40% annually is very good as long as the earnings have increase from year to year. If the company's EPS has declined, then the basic principles of growth investing have been broken.

Earnings Per Share
As mentioned above, the EPS of a firm is the main determinant of a company's growth. But EPS growth can sometimes be tricky to determine, and figuring out whether the growth is average or above average can also be difficult.

Profit growth of 40% is great, but if the outstanding shares of the company doubles because of secondary issues then EPS growth is only 20%.

What do we compare the growth number against? 20% may seem like a pretty decent rate, especially since the firms in the S&P 500 Index have an average EPS growth of around 13%. Looking at the main averages can be misleading though. It is important that investors look at the industry that the company is in. The 20% growth rate is a negative if the industry is growing at 30%. Another example is the oil and gas industry whose growth is heavily dependent on the price of oil. In the year 2000 the price of oil has nearly tripled and as a result energy companies are expected to show earnings growth of 250% this year. (Many traditional industries have a steady growth of 10-12%). Therefore, the stock with EPS growth of 20% in a traditional industry is great, but terrible in the oil and gas industry.

It is important to remember that inevitably some of today's leading growth companies will be tomorrow's laggards. Some of these laggards will renew themselves and return to the fast growth, but others will fade and become average performers. On the other hand, there are a few companies that have been remarkably successful in maintaining their earnings momentum year in and year out.

Things To Remember about Growth Investing
  1. Growth stocks are risky, and fluctuations in the stock price will probably be more volatile than the market as a whole. Which means the stock will have a higher beta than the market.

  2. Most growth stocks have higher than average P/E ratios because the investors as a whole have higher expectations for the stock.

  3. Fast-growing companies need their capital to finance their expansion. Most reinvest a high portion or all of their earnings in their own businesses, therefore don't expect any dividends.

  4. Growth stocks have often performed best relative to the overall market when the economy is slowing or downright sluggish. At such times, consistent earnings growth shines more brightly.

Momentum Investing

Momentum investing is a relatively new strategy that has taken the markets by storm. Momentum investors are known for moving fast and having little patience for under-performing stocks.

Background
Momentum investors buy stocks with accelerating numbers such as a surging share price, rising earnings or bulging revenues. At the first sign of a dip they usually sell. The objective of a momentum investor is to buy a stock after its rise has just begun and sell it as soon as it begins to falter. Most are indifferent to positions and will go long or short on a stock as long as they see significant momentum.

Cockroach Theory
The basis of the momentum strategy centers around the cockroach theory, which states "bad (and good) news tends to be released in bunches". Just as cockroaches tend to travel in large groups momentum investors buy hot stocks on the way up and bail out on the first hint of bad news, believing that one item of bad corporate news is rarely an isolated event. A perfect example is Lucent (LU), which gave earnings warnings back in January 2000 and has subsequently warned several times since then. This has resulted in a decline from $70 down to $7 per share at the time of writing.

Earnings Growth
Similar to growth investing, a momentum investor wants to find companies that are improving at a faster rate than the market. Momentum investors also seek out average companies that are becoming good or good companies that are becoming great. It is in this transition that the momentum investor makes his or her money. This "improvement" can be anything from an earnings surprise to a drastic change in business strategy or scope.

There are four major factors that can be used to detect a company with momentum:

  1. Earnings Growth - when a company's earnings are accelerating fast than they have previously grown.
  2. Upside Earnings Surprises - when a company delivers better earnings performance than analysts had predicted.
  3. Analyst Upgrades - when an analyst or brokerage revises the earnings forecasts for a company to be higher.
  4. Overall Strength - when a company's stock price is increasing faster than the overall stock market.

Risks
Like all strategies that try to make big money in a small time frame, there are additional risks. The danger of momentum investing is that you believe in and are betting on "The Greater Fool Theory", which basically means you are going along for the ride with these fools hoping that someone will be a greater fool than you allowing you to get out before them with a profit. The momentum strategy sows the seeds of its own collapse. You buy in because of attractive prospects for the company and move the price higher until finally the stock price becomes so horribly overpriced that it collapses. Sounds quite similar to the "Dot-com crash" of 2000.

Things To Remember about Momentum Investing
  1. This strategy is short-term and can be very risky. It is best suited for investors with ample experience and strong risk control discipline.

  2. A momentum investor's "sell discipline" should be as strong if not stronger than his or her "buy discipline" because a missed trade is less painful than entering the wrong trade and not getting out in time.

  3. Successful momentum investors trade without getting emotionally attached to a stock or company. They are indifferent to the stock and don't fall in love with it.

  4. Risk control is top priority. Momentum investing can include buying stocks that are being driven up on speculative hype. A momentum investor must know exactly how capital is at risk and take appropriate action to control losses.

CANSLIM Investing

CANSLIM is a philosophy of screening, purchasing, and selling common stock as described and developed by William O'Neil (The co-founder of Investors Business Daily) in his book "How To Make Money In Stocks".

The name may sound like some boring government agency, but this 7 letter acronym is one of the most successful investment strategies around. What makes it different is its consideration for tangibles like earnings, as well as intangibles like overall strength and ideas in the company. The best part about this strategy is that it is proven, there are countless examples over the past couple decades of companies that have shown CANSLIM potential and gone on to increase enormously.

Background
In a nutshell, here is a summary of seven characteristics for CANSLIM:

  1. C = Current quarterly earnings per share. Earnings must be up at least 18-20%.
  2. A = Annual earnings per share. They should show meaningful growth for the last five years.
  3. N = New Things. Buy companies with new products, new management, or significant new changes in industry conditions. Most important, buy stocks as they initially make new highs in price. Forget cheap stocks, they are that way for a good reason.
  4. S = Shares outstanding. This should be small and reasonable number. You are not looking for an older company with a large capitalization.
  5. L = Leaders. Buy market leaders, avoid laggards.
  6. I = Institutional sponsorship. Buy stocks with at least a few institutional sponsors with better than average recent performance records.
  7. M = The general market. The market will determine whether you win or lose, so learn to interpret the daily general market indices (price and volume changes) and action of the individual market leaders to determine the overall market's current direction.

Each of these characteristics are basic fundamentals of successful stocks. History has shown that a large majority of winning companies have these characteristics. Remember, it is important that all of these fundamentals are met before investing.

CANSLIM does not support investments in high risk companies. Best of all it takes virtually all major investment strategies into consideration. Think of it as a conglomeration of value, growth, fundamental, and even a little technical analysis.

Things To Remember about CANSLIM Investing
  1. This strategy is a mishmash of many different types of investing.

  2. All criteria for CANSLIM must be met for it to warrant your investment.

  3. The astounding success of CANSLIM has been proven back as far as 50 years.

  4. Like every stock picking strategy, CANSLIM is not perfect, so always have an exit strategy on hand for each position.

Income Investing

Income investing is perhaps one of the most straight forward stock picking strategies. The goal is to pick investments which can provide a steady stream of income every month, quarter or year. This typically involves buying bond, preferred shares, or common shares that pay regular (and substantial) dividends. As a result, we end up looking at older, more established firms which have a very predictable earnings stream.

Dividend Yield
Simply investing in companies with the highest dividends is not the premise of this strategy. More important is the dividend yield, which is calculated by dividing the annual dividends of common stock by the current market value of common stock per share. For example, if the company share price is $100 and a dividend of $6 per share is paid, the result is a 6% dividend yield. The average dividend yield for companies in the S&P 500 Index is 2-3%.

Income investors demand a much higher yield than 2-3%. At minimum most are looking for a 5-6% yield. On a $1 million investment this would produce $50,000-$60,000 in income (before taxes). And forget those tech stocks, virtually none of them pay dividends.

Dividends are Not Everything
Never invest solely on the basis of dividends. Keep in mind that high dividends don't necessarily mean a good company. Dividends are paid out of a company's net income, the higher the dividends, the lower retained earnings are for the company. Problems arise when a company is paying out large amounts of their income to shareholders when that income would have been better spent investing within the company.

Other Options
Investing in dividend paying stocks is not the only way to become an income investor. For example, many "A rated" corporate bonds are currently averaging 6-8% coupon yields. Furthermore, many municipal bonds offer 3-5% tax free returns.

Risks
Like every stock picking strategy we have discussed, income investing has risks too. When you buy common stock, there's a chance that the value of your original investment could drop.

Dividend distribution and the levels of those payouts are not guaranteed with stocks as they are with bonds. Should the firm run into financial hardship, or if there is a great investment opportunity, which requires significant cash outlay, you could end up without a dividend.

One last thing, income from dividends is taxed at the same rate as ordinary income for the year, not as capital gains.

Things To Remember about Income Investing
  1. Income investors can use a combination of common and preferred stocks as well as bonds.

  2. It is important to look at the company's fundamentals, don't just look at dividend yields.

  3. "Income" from dividends and bonds are taxed as ordinary income, not capital gains from price appreciation.

  4. Like every stock picking strategy, income investing is not perfect, so always have an exit strategy on hand for each position.

GARP Investing

GARP investing combines the two successful strategies of value and growth investing. The name really says it all; GARP (Growth At Reasonable Prices) investors look for a stock with growth potential, but only if it is reasonably priced. More recently the GARP name has been associated with another great acronym, SWAN (Sleep Well at Night).

Background
As we've mentioned in previous parts to this series, value investors search high and low for relatively cheap stocks compared to their earnings and book value. Growth investors are on the opposite side of the spectrum, buying stock in companies that tend to growth substantially faster than others or firms with high potential in hopes that earnings will come in the future.

GARP investors are somewhere in between these two, they aren't looking for the companies in trouble or drastically undervalued, but they also avoid the high flying growth stocks.

How to use GARP
How to Use GARP Practitioners of GARP are somewhat traditional. They use various fundamental analysis ratios to search for companies with solid growth prospects and share prices that are somewhat lower than the intrinsic value of the business. GARP investors stop short of looking at the companies business in great detail, they are more concerned with historical growth and the stock price and not the qualitative factors. Traditionally, GARP investors have sought growth in two ways, from the firm itself, or earnings growth. An undervalued stock price is usually detected from the low price-earnings ratio relative to its industry. More recently, GARP investors have discovered the PEG ratio, which has become a pillar in the strategy by only investing in stocks with a PEG ratio less then one.

One common pitfall for GARPers is mistakenly investing in high growth companies with high P/E's. In most cases their P/E indicates a higher growth rate than earnings are currently showing. This means that it is inevitable the stock price will eventually come down or remain the same to wait for the P/E ratio to "catch up". On the other hand, investing in a drastically undervalued stock means if the earnings growth or turnaround does not come to be, the GARP investor's perceived bargain will disappear.

Who uses GARP?
One of the biggest supporters of GARP is Peter Lynch, someone who many of you may be familiar with. He has written several books on sensible investing and more recently has starred in Fidelity Investment commercials. His success in the stock market has associated him with high profile investors like Warren Buffet. By many he is considered the "The World's Best Money Manager".

Risks
This might sound like the perfect strategy, but being the "jack" of both growth and value investing isn't as easy as it sounds. If you don't master both of the two strategies you could potentially find yourself buying mediocre stocks rather than good GARPs. Furthermore, GARP investing can depend a lot on the current market conditions. For example, in the late 1990's people were so captivated with high tech and Internet stocks that value and even some traditional stocks had a tough time increasing their stock price even though fundamentally there was nothing wrong with their company.

Things To Remember about GARP Investing
  1. This strategy is a combination of growth and value investing principles.

  2. Avoid buying stocks at either end of the spectrum, that is avoid high flying stocks and those deeply undervalued.

  3. The PEG ratio is one of the major tools used by GARP investors, it should be less than one.