After writing my article about The Top 10 Investors of All Time, I thought it would be interesting to look at some of the most popular investment strategies. I’m not talking about buy-and-hold or diversification, but really what people look for in stock selection. While not scientific, I compiled this list based on what the professionals are doing, what types of funds are out there, and what people are searching for on the internet. It is also interesting to note that almost all of the Top 10 Investors used mostly fundamental trading strategies focus on value.
This list just looks at the two main types of stock selection strategies: fundamental and technical. Fundamental strategies are ones that look at the financial health of a company, as well as micro and macro economic issues and trends that face a particular market and is more focused on long term trades. Technical analysis looks at price movements in a stock, as well as market trends, and is more focused on short-term trades. It is important to note that many investors do combine the two: if a stock meets their fundamental criteria, they may look for a technical trend as to when to buy in the short term.
For The College Investor portfolio, I use mostly fundamental analysis to look for value companies to invest in. Here are the most popular investment strategies!
Fundamental analysis looks at the financial health of the underlying security. They are different than price performance of a stock. The biggest fundamental is earnings, which can also be viewed through sales, profit margin, cash flow, etc. There are also fundamentals that look at debt and equity of a company, as well as how earnings are generated: operational efficiencies, sales growth, debt repayment, etc.
When looking at true fundamentals such as growth or value, you must always compare it to the market or sector, so a financial analysis of all is required.
Market/Sector: When looking at a market or sector as a whole, the same analysis applies, but it focuses on the macro-economic issues that could drive entire sector performance. A big example currently is the crisis in Japan. Many electronic items are manufactured in Japan, and as a result, the entire electronics sector may struggle in the short-term. Another area is energy: higher oil prices usually mean higher profits across the sector, while declining prices could mean declining profits. Other things to consider are governmental reforms: one sector this applies to is health care and potential changes to Medicare or Medicade.
Growth: A growth stock is a stock this is expected to grow at an above-average rate compared to its industry or sector. Some typical identifiers of growth stocks include little or no dividends, as these companies typically reinvest their earnings to further growth. Technology companies typically fit this profile. Growth companies also usually have high valuations, such as Earnings-per-share, since it is the expectation of growth that is driving share price.
Value: Value investors actively seek stocks that trade below their intrinsic value. They believe that the market overreacts to good and bad news, which makes the stock price not accurately reflect the company’s long-term financial situation. There is no definite intrinsic value to a stock, which makes this strategy difficult. Some investors look at present assets versus debt and earnings, and don’t look towards the future. Others base their estimates on future cash flows. Some even look at non-financial value such as brand or management.
Warren Buffett did say it best thought: “Growth and value investing are joined at the hip”.
Range Trading: This is a technical trading strategy that identifies major support and resistance levels in price, and buys the stock at the lower level of support and sells at the major resistance level. This is also called channel trading. This process is usually repeated many times until a stock breaks out of the channel. If you look at most stocks, they trade in a tight range, and these traders try to take advantage of that range. The upper resistance level is usually calculated by trending the stock’s highs, and the lower support is usually calculated by trending the stock’s lows.
Moving Average Trading: Moving averages are a very popular tool used by traders to measure momentum. A moving average trading strategy involves charting the moving averages of a stock, and then looking for crossovers: when the price of the stock moves through a moving average. This type of signal is regarded as an early indication of a change in price direction. For example, if a stock crosses below the 30-day moving average, a price pullback may be coming.
Contrarian Trading: This is an investment style that goes against the market trends of the day. They usually buy assets that are performing poorly, and selling when they perform well. This also usually goes with the belief that short term news results in overcorrections in the stock price. For example, in the financial crisis, a contrarian trading strategy would have been to buy financial stocks as the market crashed. This may not have worked well in the short term, but would have paid off handsomely over time.
Scalping: Scalping is a trading strategy that attempts to make many profits on small price changes. Many large banks use this strategy to take advantage of small price changes that occur with a wide bid/ask spread. The main goal is to buy a number of shares at the bid price, and then sell very quickly to make a few cents. This doesn’t work very well for the individual trader, as commissions quickly erode profits.
News Playing: This strategy is very similar to the contrarian strategy, except that it doesn’t need to be the opposite of the market. The idea here is to play news events, such as earnings calls or other headlines. Many traders place trades on a stock the day ahead of earnings announcements, with bets that the price will break out in their favor based on the company results. This strategy can be risky because large price moves happen very quickly, and if you bet the wrong direction, you can sustain large losses.
There are also many other different types of trades, such as the Barbell Investment Strategy or options trading strategies, which I will go more in depth on in the future.
Are you a technical or fundamental trader? Are there any strategies that you use beyond the ones mentioned here? Any of these strategies prove successful for you?