Stock Investment Strategies

Stock Investment Strategies

There are more than a few ways to approach long-term investing when it comes to investing. Investors use different strategies depending upon various factors such as risk appetite, investment time horizon, investment goals, etc. 

Stock Investment Strategies

The approach usually depends on the investors' comfort level and, most importantly, their circle of competence. 

Each of the strategies has different risk levels associated with it, and with varying levels of risk also come different returns.

As discussed, different investment strategies have their unique variables. However, most of these strategies usually focus on wealth creation for the investor.

This article will limit our discussion to investment and not short or medium-term trading strategies.

The most widely accepted and practiced investment strategies are value, growth, quality, index, and smart-beta investing

There are umpteen investing strategies in addition to the above. However, we will only talk about certain important strategies which usually are easy to implement and practice.

Let us now shift our focus and delve into each of these strategies.

Value Investing

Benjamin Graham, the father of value investing, coined the term "value investing" with David Dodd while teaching investment philosophy at the Columbia Business School and first used it in their book Security Analysis.

Value Investing

Graham defined value investing as buying securities trading at a discount in relation to their intrinsic value

Graham picked stocks that were trading at heavy discounts to their book value or had low price-to-earnings multiples and relatively low debt levels.

The concept of buying securities that are trading at a discount to their intrinsic value is called "Margin of Safety", which is the difference between the market value and the stock's intrinsic value.

Graham also derived something called the Graham Number. 
 

Formula

According to Ben Graham, a fair P/E multiple for a stock is 15x, and a fair book value per share (BVPS) multiple is 1.5x. So 15 x 1.5 = 22.5.

Example: Waste Management (WM)

EPS = 4.29 

BVPS = 9.18

Graham Number = $29. 

Waste Management is trading at $164.Therefore, according to Graham's theory, this stock is overvalued. However, it must be noted that this theory also had its flaws like other financial theories.

Investors must not rely on anyone ratio or indicator to filter stocks. Instead, they must use a variety of tools to pick quality stocks.

Another one of Graham's valuation metrics was the Net Current Asset Value Per Share (NCAVPS). It is derived by subtracting the total liabilities and preferred stock from the current asset and dividing the result by the total no. of outstanding shares.

NCAVPS Formula

The NCAVPS is essentially like the liquidation value of the company.

Discounted Cash Flow valuation is probably the most widely accepted metric for calculating the intrinsic value of a firm. It was used as early as the 1800s, but it was explained by the American economist John Burr Williams in his book The Theory of Investment Value in 1938.

Ben Graham's methods were helpful at that time when the market was not as liquid as it is in the modern era of investing. 

Graham consistently found companies trading below their liquidation value or even below the total cash balance because market discovery and institutional research were not very advanced.
 

Value Investing

It is challenging to find graham-style old-school value buys in today's age where every news is almost immediately discounted along with a flurry of institutional funds.

Warren Buffet is probably one of the most famous investors. Buffet is responsible for turning around Graham's traditional value investing, which focused on buying stocks at extreme discounts, to "buying wonderful companies at a fair price".

Graham recommended booking profits once the stock had shown extraordinary run-ups. On the other hand, Buffet believed in holding the stocks for extended periods.

Buffet understood that the market had evolved to a point where it discounted available information much quicker. As a result, Buffet also changed the traditional approach of not focusing on the quality of business brought. 

Philip A Fisher influenced Buffet's theory of buying quality stocks.

The definition of the term "value investing" has gone through a lot of evolution. Investors these days have great difficulty finding stocks trading below their intrinsic value. This is due to the advancement of stock research mechanisms.

Therefore, the modern value approach focuses on another important metric: free cash flows.

The free cash flows are probably the most critical metric when calculating the intrinsic value of a business. 

This shift from simple valuation ratios to a more fundamental and qualitative ratio is because investors and institutions have recently realized that valuation is not the only metric to filter companies. Instead, several other factors determine the quality of a firm.

Value investing has been through a lot of evolution throughout the history of stock investing. However, it is still based on a single principle, i.e., buying securities available at a discount compared to their relative or absolute intrinsic values.

The value investing philosophy is very similar to the mean reversion investment concept. The mean reversion concept suggests that the asset price volatility and historical returns will always revert to the mean.

Similarly, the stock's market value will eventually revert to the stock's intrinsic value.

Growth Investing

As the name suggests, growth investing focuses on buying companies with a higher than average growth rate due to several micro and macro factors.

Growth Investing

The companies that qualify as "growth stocks" are usually smaller firms with very high future potential or companies with very large tailwinds and competitive advantages so that their prospects look lucrative.

Growth stocks are usually classified by their improving profitability and efficiency metrics. This is because they increase their margins while working towards making the business more efficient.

Growth stocks have Capex above the industry average as most of the earnings are reinvested back into the business. As a result, these businesses need a lot of CAPEX to fund their expansion.

Growth stocks are not limited to a certain market capitalization, but one common factor among them is that the top lines are growing faster than their bottom lines.

As their reinvestment needs are higher than the industry average, they can have considerable debt on their books, but that depends on many factors like industry, sector, management vision, etc. 

Growth stocks usually command premium valuations as the investors believe in the growth story of such a firm and are ready to pay a premium over and above the actual intrinsic value.

However, the thing to be cautious about is that growth stocks often do not have a proven track record of performing under depressed economic conditions (unlike some value stocks). Therefore, investors must allocate only a certain portion of their portfolio to high-beta stocks.

Growth stocks are the opposite of value stocks, with lower P/Es and higher free cash flow. However, growth companies have lower free cash flow levels when compared with the industry average due to their higher reinvestment requirements. 

Even though the FCF is lower, it still is growing at a significantly higher rate, reflecting the improving business efficiencies.

Growth Investing: charts

Capital expenditure and working capital are always deducted from the post-tax operating earnings to get free cash flow. However, as these companies usually have higher Capex requirements, not much free cash flow is left.

CAPEX

A healthy free cash flow of a growing firm that operates in asset-heavy industries is usually not considered an excellent sign. This means that the company is not actively engaged in capital expenditures to improve its production capacities.

Once the free cash flow starts going up, you can conclude that the business is going towards the maturity phase.

Evaluating a company's potential for growth is usually a mix of quantitative and qualitative factors like management vision, capital allocation, earnings potential, and margin expansion.

Growth businesses are riskier investments than value stocks as they have weaker balance sheets due to high debt levels and CAPEX, but the reward is also higher in percentage returns.

Quality Investing

The term quality investing is pretty self-explanatory. This investing style only focuses on deploying funds to companies considered market leaders and with a proven track record.

There is an overlap in the concepts of quality and growth investing. 

Quality businesses are classified by high operating margins, efficient operations, high returns on capital, and stability in free cash flows. 

These companies are usually at the end of the growth phase and entering the market consolidation phase. Here the bottom line grows faster than the top line.

Philip A. Fisher was one of the first investors to focus on buying quality businesses. Fisher began as a securities analyst in 1928 and later founded his investment firm, Fisher & Co. At that time majority of the stock, pickers were focused on predicting cycles of buying value.

Fisher's approach to stock picking was simple: Purchase and hold for the long-term a concentrated portfolio of outstanding companies with compelling growth prospects that you understand very well.

Quality Investing

The economic moat theory also applies to quality investing. An economic moat is a competitive advantage built around the business. These competitive advantages allow the companies to earn higher returns on their invested capital.

A high and consistent return on invested capital (ROIC) reflects a high-quality business.

The valuations of these quality companies are usually on the higher side. As the market understands what the company's moat is, the firm's price-to-earnings (P/E) multiple expands.

The high multiple of the business will usually sustain until the company has strong barriers to entry. Then, once the moat starts to show some cracks, the company is re-rated, and the P/E starts shrinking as a result of the entry of more competitors.

The Coffee Can style of investing is an active-passive style of quality-focused investing first discussed by Robert G. Kirby in his paper titled "The Coffee Can Portfolio".

The Coffee Can Portfolio

The term coffee can comes from the old west, where people would keep their valuable possessions in a coffee can and put it under the mattress.

This investing style focuses on picking quality stocks and assigning equal weight to them, and keeping the investment untouched for a considerable time.

Kirby believed that the majority of active managers could not beat the index over the long term due to their high turnover rate, which increased the fees and sold securities very early. 

This way, fund managers may miss out on companies with bright long-term prospects but are currently sailing through rough waters. Therefore, it is suggested that quality businesses should not be sold unless there is some fundamental change in the company's model.

The coffee can portfolio has zero turnover rate as it does no rebalancing. The absence of rebalancing also means no limit to the return a stock can give in that portfolio. There is no specific weight assigned (after the initial capital has been invested).

Index Investing

All the investment styles mentioned above are active ones that focus on superior stock selection through different investment philosophies to create a portfolio that can beat its benchmark and generate alpha.

Picking stocks can be compared to finding needles in a haystack, you have to put a lot of effort, and still, there is a chance of failure. Index investing is compared to buying the haystack, where the effort is lower.

Index Investing

A lot of data suggests that passive funds have consistently beaten the majority of the actively managed funds, considering that they charge a high fee from investors. 

The outperformance of passive investing is that the markets are very efficient in pricing. Of course, there are still irregularities, but markets have efficient pricing in the larger picture.
The second reason is related to the portfolio turnover of such funds. High turnover often results in higher transaction costs which are passed on to investors through the means of higher fees.

Due to these reasons, index investing is considered better for most of the investee population. Index funds mimic the composition and weightage of the index it is based on. This drastically reduces costs as there are no additional brokerage charges and no management fees.

An exchange-traded fund (ETF) is nothing but an index fund trading on the public market. The advantage here is you don't need to buy ETFs from mutual funds. Instead, you can directly buy these on the exchange through your stockbroker.

Stocks

ETFs have the lowest fees compared to other investment funds, VOOIVV, and SCHX are US-based broad market tracking ETFs with the lowest expense ratios in the industry at 0.03%.

ETFs and Index funds are the best tools for retail and large institutions to diversify their portfolio at a very low expense.

The best strategy for retail investors to invest in an ETF or a basket of diversified ETFs is through dollar-cost averaging (DCA). Dollar-cost averaging is investing a specified amount at specified intervals.

What DCA does is help create wealth in the long term through compounding your investments. Although periodical investing eliminates the risk of market volatility, it is considered one of the best ways to accumulate wealth in the long term.

Smart-Beta Investing

Smart-beta investing is the latest trend in investment strategies.  

Smart-beta investing is an active-passive style of rule-based investing that focuses on beating the market while still keeping the cost relatively low. This is very similar to the coffee can style of investing.

Smart-Beta Investing

Rule-based filters pick out stocks from the broader market or the benchmark. The rules can be based on value, growth, quality, dividends, etc. 

For instance, a smart-beta ETF can select companies with high margins, ROC, and dividend histories, weigh the stocks by market cap and create a portfolio.

Smart-beta ETFs are usually AI-driven, which also eliminates fund management costs. In addition, they aim to keep the turnovers to a minimum, saving on brokerage costs and short-term capital gains taxes.

The VUG is a growth-focused smart beta ETF. It has an expense ratio of 0.06%, which is 0.03% higher than the VOO but has beaten the S&P 500 and its benchmark by a considerable margin while still having a lower expense ratio than actively managed funds.

Key Takeaways

☞ Stock investment strategies can be broadly categorized into 5 approaches.

☞ Value investing focuses on buying the security that is trading below its absolute or relative intrinsic value. It is based on the principle of 'Mean Reversion.'

☞ Growth investing focuses on business growth rather than value. Growth stocks usually trade at higher valuations due to higher growth prospects.The high beta of the stock makes them a risky bet. However, the high risk usually translates to high rewards in the case of such stocks.

☞ Quality investing emphasizes the quality of the stocks. The concept has some overlap with growth investing. Businesses categorized as quality stocks usually have competitive advantages, trading at a premium valuation.

In addition, high-quality companies usually possess healthy financials and can survive through depressed or unfavorable economic conditions due to their high margins.

☞ Index investing, also called beta investing, tracks the entire market or a specific sectoral index. This passive style of investing still beats the majority of the active funds by reducing the transaction-related costs of frequent buying and selling.

☞ Smart-Beta investing is an active-passive style of rule-based investing. Usually, the stocks are picked by AI and driven by parameters set by fund managers. These parameters differ for each fund.

For example, some funds focus on quantitative parameters such as - ROE, ROIC, EPS, etc., while some focus on riding the momentum by studying the technicals of a stock.

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Researched and authored by Aditya Salunke I LinkedIn

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