A beginner's guide to investment styles
Investment styles go in and out of fashion. The key is to pick a style that suits you and stick with it. So what are the main investing styles?
Investment styles go in and out of fashion, but the key is to choose a stock-picking style that suits you, and stick with it. Here is our guide to the main investment styles.
Growth investors look for companies with great projected earnings growth supported by a solid history of earnings improvement. They are prepared to pay high p/e ratios because they believe higher earnings growth will lead to a much higher price as other investors come to believe that the growth rate is sustainable. The downside here is that, when confidence turns negative, the share price can fall dramatically.
Signs of high-growth companies are: high earnings growth forecasts for the next one to five years; strong historical earnings growth; high quarter-over-quarter earnings growth rates; regularity of positive earnings surprises; recent analyst up-grade of earnings estimates; and directors and management buying their own company's shares. Although the p/e ratio is usually high relative to the market (minimum 15-20 times), it should be reasonable compared to earnings growth. Other indicators are increasing revenues and profit margins; high return on capital as evidence that growth is adding value; strong cash flow to finance expansion; and organic growth, rather than growth through acquisitions.
Value investors take the contrarian approach, scouring the screens, analyst reports and company accounts for shares that are cheaper than fair value'. They often trade on low p/e ratios relative to the projected earnings growth rate, to historical earnings and to industry and sector earnings and also usually have low price-to-book (price-to-assets) ratios. Probably because of recent earnings disappointment, these stocks are often perceived as boring, with prices below their long-term price trends and moving average. But like growth investors, value investors believe earnings will outstrip the shares' current p/e ratio.
Momentum investors are followers, always looking for the next party. They buy the fastest-moving shares (in the fastest-moving sector) in the belief that they will continue to soar and use technical measures, such as the relative strength indicator (RSI), to identify the swingers from the stay-at-homes. Common features of momentum stocks include: high relative percentage price changes over one day, week and month; the share price breaking out of an extended narrow trading range; high short-term earnings growth quarter-over-quarter; upward change in analysts' earnings estimates; and high money flows into shares, which indicates institutional investor buying. The momentum should ideally be underpinned by solid foundations positive earnings revisions, or, at worst, by widespread belief in a new fashion or trend. The risk here, of course, is failing to get out of the share before its momentum dies and gravity takes over.
Income investors look for shares paying high, secure dividends. They will sacrifice capital appreciation, but not the capital itself. This is a long-term, low-risk style; a variation the growth and income strategy demands a moderate earnings growth rate, translated into growing dividends.
Growth at a reasonable price (GARP)
This approach combines features of growth and value investing: the key ratio is the p/e to earnings per share growth ratio (called the PEG ratio). It's best if this is less than one, but in a falling interest-rate environment, slightly higher is acceptable.
Companies with strong balance sheets and undervalued assets: especially low price-to-book ratios (less than one), strong cash flow and low debt. Investors should focus on the long-term economic characteristics of the company's business and the quality of its management and culture.
The size of a company as measured by market capitalisation large, mid, small, micro goes in and out of favour with investors, depending on market conditions. Pick large-caps for stability, diversified revenues, predictable earnings, and for matching the broad indices; small-caps can offer rapid growth potential and are often niche earners in weak economic environments, but have little research coverage.
A systematic approach to stock picking has been advocated by professionals and academics for decades. There are plenty of books suggesting stock-picking methodologies and an internet search will list scores of software packages for data management and stock-screening.