The two most popular investing strategies for picking stocks are value investing and momentum investing. You’ve probably seem mutual funds with these terms in their names, but not known what they meant and why they are important to you. Both techniques can be profitable. While this blog tends to lean more towards the value investing side, since the strategy tries to minimize trading, there is certainly nothing wrong with momentum investing. In both forms of investing it is surprisingly simple to pick stocks – it is a wonder that more individuals don’t take advantage of the techniques in their stock screening.
Now before going further, if you’re a mutual fund investor and don’t plan to invest in individual stocks, all you need to know is that you want to have both value stocks and momentum (or “growth”) stocks in your account. If you invest in a broad index fund, such as an S&P500 fund or a Small Cap index fund, you’ll have both of these types of stocks already because they just “buy everything.” You can also find value funds and growth funds and split your money between them. Over long periods of time, value funds have outperformed growth funds by a couple of percentage points, but there have been stretches of time, like the last 20 years or so, where growth has been king. You want to be in both areas so that you always own shares in what is doing well.
For those interesting in owning individual stocks, let’s dive deeper….
The first technique, value investing, is based on the Firm Foundation Theory. In this technique, popularized by Benjamin Graham (Warren Buffett’s mentor), a value is assigned to a stock based on current and expected future earnings. Stocks are then screened where the current price of the stock is compared to this “fair value.” If the stock is a certain percentage below the fair value, the stock is bought; if it is significantly above this value, it is sold. One simple way to calculate fair value is to look at the Price Earnings ratio (PE), which is the ratio of total earnings to total market capitalization (price x Number of shares). This number can be found from a variety of sources for most stocks. For stocks that are not always profitable, Price/Sales can also be used (see an excellent discussion using this factor by the CEO of Cypress, Semiconductor in “Thinking about Cypress Stock”: http://www.cypress.com/?rID=35390 ).
If future earnings can be predicted, which is done by a number of analysts, one can also use this ratio to predict the future price of the stock. If the PE is historically around 15, and earnings are expected to be around $4 per share next year, one could calculate the fair value of the stock as $4 x 15 = $60 per share. If the current price is $30, one could expect a return of 100% on the stock over the year.
Now before you rush out and put all of your money into a stock because you calculate it to be cheap and sit back, waiting for your 100% returns, note that everyone else can also do the same calculation. If earnings could be predicted reliably, and a gain of 100% can be expected over the next year while the broad market is only expected to make 15%, investors would quickly bid up the price of the shares until it falls more inline with the market. If the gain seems extremely large compared to the broad market, it either means that earnings aren’t very predictable and investors don’t put much credence in the predictions or there is something going on with the company. Per usual, if it seems too good to be true….
So, if it isn’t a magical path to wealth, what can you do with value investing?
I keep a list of stocks I’m interested in, called my “watch list.” I calculate fair values for a group of stocks, then determine the expected return of each stock based on the predicted future price (usually 3-5 years out). I then use this to decide which of the stocks I will buy shares when I have some money to invest, choosing the one that is least expensive, relatively at the time. Note that I do not use relative price alone in choosing stock since some stocks are cheap for a reason – I’ve already decided on the stocks I want to own, but need to select which one to buy at a given moment. Because the market does not always correctly price stocks for future earnings, there are often times when a stock will be under priced for periods of time, even if it is a good stock to own. So if I expect the earnings for a company to continue to grow, and the stocks drops in the near-term because the company is having some issues that should pass or the economy in general is in the doldrums, I will scoop up the shares. If the price drops further, I’ll check the facts and reevaluate the stock, and then add to the position if everything still looks good until I’ve acquired as large a position as I wish to have in the stock. Then I wait for things to turn.
In a future post I’ll go into momentum investing and explain how that is done.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.