CommonLounge Archive

Stock Market Investing Strategies

February 09, 2018

Broad Investment Strategies: Active vs Passive Investing

There are plenty of investing strategies and factors to consider before buying (or selling) an asset. However, when it comes to the time horizon of your investing strategy, your strategy can fall somewhere between two extremes.

Active Investing Strategy

This strategy is characterized by a short term frame of investments, and more frequent investments. This strategy requires more effort from the investor since the number of investment decisions to make will be significantly higher. Investors who use this strategy are looking to take advantage of short term opportunities.

Passive Investment Strategy — Buy and Hold

Investors who implement this strategy are more passive in their investments. They typically hold their investments for years. This strategy works with specific kinds of assets. However, with some assets, it can be risky since some assets do return to the exact price they were years ago, which renders the investment as futile. The most suitable assets for this type of strategy are the ones with long term growth horizon.

Investing in Growth Stocks

Companies working in stable industries that are growing steadily generally have better growth prospects. Those companies may not yield high regular income to their shareholders, but they are profitable in the long term in that their value grows steadily with time. Often companies that have growth stocks tend to retain the profits and reinvest them in projects that would warrant further growth. Therefore, growth stocks do not usually pay dividends and are more suitable for investors with long term horizon, or a buy and hold strategy.

Prominent examples of growth stocks are technology companies such as Google and Apple. Moreover, larger companies with economies of scale are also good examples since they are more efficient.

Investing in Dividend Income Stocks

Investors who focus more on the short term may consider stocks that pay higher dividends. To discover those stocks, investors may look at PE ratio, EPS, and other measures since they give insight into the company’s earning potential. Another factor may be the company’s tendency to retain its earnings. Companies who distribute little of their earnings to shareholders are not good candidates for dividend stock investments.

Examples of dividend income stocks:

  1. Pfizer, Inc. (PFE)

Dividend Yield: 3.7%  Forward P/E Ratio:13.3  (as of 1/8/18)

  1. Brookfield Infrastructure Partners LP (BIP)

Dividend Yield:4.0%  Forward P/E Ratio:11.7  (as of 1/8/18)

Investing in Value Stocks

Another option for investors can be to invest in companies who current share price does not reflect its true value. In other words, the company may be undervalued (its market value is lower than its fair price) and therefore investors may choose to buy those shares to take advantage of the increase in price to reflect a fair value. There are many ways to see if the market price of a stock is undervalued. One way is to look at its price to book ratio. Another way is to look at the company’s performance in terms of profitability such as return on assets or return on equity.

Growth at a Reasonable Price (GARP)

This investment strategy builds on the advantages of growth stocks and value stocks at the same time. The focus in this strategy is on stocks whose earnings are above the market’s benchmark while excluding stocks that are overvalued (i.e. those with high P/E multiples). In other words, this strategy focuses on buying growth stocks that are not expensive. A suitable ratio that can be used to assess stocks in this strategy is the PEG ratio (the price/earnings growth ratio). For stocks to be chosen for this strategy, the PEG of the stock should be 1 or less. This would imply that the P/E ratios are commensurate with expected earnings growth.

Examples of GARP stocks:

  1. Perrigo Company plc, the long term expected grwoth of this stock is 9.6%
  2. PBF Energy Inc. the expected growth rate of this stock is aove 70% for the next year.

Dogs of the Dow

Micheal B. Higgins popularized this strategy in his book “beating the Dow”. According to this strategy, investors simply buy the 10 highest dividend paying stocks from the companies listed in the Dow Jones Industrial Average, which includes 30 high quality industrial stocks. The investors would hold those 10 stocks for one year, and at the beginning of the next year would review stock in the Dow to see if other stocks appear to be paying a higher dividend than the stocks he holds. If so, he would adjust his portfolio accordingly to maintain the highest dividend paying stocks in each year. This strategy has been shown to offer 3% better return than the Dow’s return, but this is not the case for every year. One disadvantage of this strategy is that it does not take into account other important performance metrics of the stocks such as payout ratio and volatility, among others. Another disadvantage is that it works better in lower interest rate environment which stimulates growth, whereas in a high interest rate environment the highest yielding stocks are dropped and affected negatively.

Dividend Aristocrats

This strategy is suitable for investors who are seeking a steady stream of income. Dividend aristocrat stocks are stocks in the S&P 500 index which have a track record of increasing dividends. This strategy becomes a good option in an environment where interest rates are low. To invest by using this strategy, investors can either research the stocks that have high dividends historically or invest in an ETF which tracks the aristocrat’s index. The S&P aristocrats index makes it easier to track the performance of this strategy. It generally produces a performance that is higher than that of the broader S&P 500 index.

Monkeys, Darts, and the Stock Market

There is a considerable amount of randomness when it comes to financial markets. In 1973, Princeton university professor Burton Malkiel proclaimed:

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

Ironically enough, Research Affiliates did a study where they randomly selected 100 portfolios, each of which had 30 stocks, from a set of 1000 stocks. This was to represent a 100 monkeys randomly throwing darts at the stock pages in a newspaper. Research Affiliates simulated this process annually over the course of many years. Astonishingly, 98/100 monkeys did better than the 1,000 stock capitalization weighted stocks each year.

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