Investment strategy is defined as a set of rules or procedures guiding an investor to choose his investment portfolio. The components of most investment strategies include asset allocation, buy and sell guidelines, and risk guidelines.
A stock picking strategy must answer what investment style is to be followed, what company size, what markets are to be considered, will the portfolio be concentrated or well diversified and when to buy and sell.
Investment style sets out how the investor will set asset allocation and choose individual securities for investment. Will the investor buy cheap and then sell high or look for good growth opportunities?
Will the investor choose small companies or buy large companies? Financial theory is divided whether small companies give a small cap premium for the higher risk in investing in them. The original study has had its statistics questioned and recent studies seem to show that there may be periods when a small cap portfolio out performs but over the long run there is no overall gain. However, individual small companies can certainly grow much faster than large companies and this can be rewarded by the market but small companies are more volatile downwards as well and are more likely to go bankrupt.
US investors have a strong home bias to invest in their home market but what if markets in foreign countries are doing much better? There are certainly greater risks with investing abroad including foreign currency fluctuations, greater corruption and political risks. ETFs and funds have opened up these foreign markets even if investing in individual shares is too expensive for the individual investor.
How diversified is the portfolio going to be? It may have been a problem for individual investors to be diversified in the past but ETFs and index funds mean that the individual investor can be almost perfectly diversified. However, to make the greatest gains in the market the portfolio needs to be focused but this will increase risk. Some investment styles require the portfolio to be focused due to the lack of shares that meet its criteria.
When is the investor going to buy and sell individual shares? Technical analysis may be used to time the purchase of individual shares. Market timing systems such as Martin Zweig’s give a guide line as to how hostile or benign the market currently is.
Other investment strategies are based on the idea of following the smart money. The investor can copy the purchases and sales of a successful Guru investor such as Warren Buffett. This is possible due to published information from bodies such as the US Securities and Exchange Commission (SEC). However, not all investors and styles are successful at any given time and even the best investors make mistakes. Another similar but more involved strategy is to follow the purchases of directors who are insiders in a company, again using SEC information but this is normally combined with an investing style. Deep value investors may look for evidence of insider buying in companies with a low price book to value as evidence that they are starting to recover.
An Introduction to Investment Styles
There are a number of investment styles that have been followed by various professional investment stars or gurus. It is known that these styles tend to work better in some economic climates than others. These gurus can have periods when they do far worse than the benchmark index but other periods when these styles come into their own and they outperform the index.
Value investors bargain hunt stocks using various ratios such as price-to-earnings (P/E) and price-to-sales (P/S) to identify when a stock is selling at a price much lower than its peers. The original value investment strategy was theorized by Benjamin Graham and David Dodd, finance professors at Columbia University in the 1930s. They wanted deep value with Companies that have current market values substantially below true or liquidating value. Value investors believe a stock’s price will eventually rise to at least meet its intrinsic value. Value investment is not just simply buying any stock that declines in price and therefore seems cheap. Some stocks that appear to be good value are likely to continue having a low stock price and these are described as value traps. The main part of this investment style is doing fundamental analysis to find what the stock is really worth or its intrinsic value and Graham and Dodd originated the fundamental analysis of companies.
Growth investors buy stocks that have higher-than-average growth in sales and earnings, with the expectation that this will continue and push the price higher. Growth investors may target young or small companies that have a higher potential for growth. Growth investors can vary greatly in the amount of growth and expected price increase they search for.
Growth at a Reasonable Price (GARP) is a mix of value and growth investing that looks for companies that are selling for less than their intrinsic value and also have good growth potential. Investors such as John Neff are considered GARP Investors. They are less interested in high rates of growth and avoid high valuations. Like growth investors, GARP investors are concerned with the growth prospects of a company and they like to see positive earnings numbers for the past few years, coupled with positive earnings projections for upcoming years. GARP investors are skeptical of extremely high growth estimations, as they see these companies as carrying too much risk and unpredictability.
Long-term Growth investing is a label that could be used to describe the investment style practiced by Warren Buffett, the most successful investor of all time. It has been popularized by the Buffettology series of books by Mary Buffett and David Clark, and also Robert G. Hagstrom together with Phil Town’s Rule #1. Warren Buffett's investment style has changed over time and he has moved away from the pure value investing style of his mentor Benjamin Graham partly due to a lack of available investment opportunities for the increasingly vast amount of money he manages. Long-term growth investors tend to focus on a small number of shares and hold them for a very long period of time.
According to the Buffettology series of books, Buffett searches for shares of companies whose growth he can predict over the long-term and then values them in a similar way to a bond. (However, doing this for company shares because of their more unpredictable nature is not theoretically thought to be possible.) Such a company in the Buffettology books is described as having a durable competitive advantage. Buffett has in the past bought stocks in companies that are valued by the market below their worth but Buffett has picked these shares not just because he believes that they will recover but will prove to have a high return on investment over the long-term. Buffett is combining value investing with his own system of picking long-term growth shares and will now often buy such shares that traditional value investors do not believe are being sold by the market at a 'discount'.
Momentum investing is following an existing trend in the market in the hope it will continue. Technical analysis uses market statistics such as past prices and volume to identify patterns that can suggest future activity believing that any fundamental factors concerning a security's intrinsic value are already discounted by the market. A stock chartist uses graphs of a security's historical prices or levels to forecast its future trends. A chartist looks for well-known patterns that represent support and resistance levels. Chartists believe that price movements in a security are not random, but can be predicted through a study of past trends. These techniques do not fit in with economic theory on share price movement and are often looked down upon by fundamentalists and economists. However, many momentum investors use a combination of fundamental and momentum factors such as value or high growth together with statistics of share volume or charts of price movements. Momentum investors tend to hold their stock picks for a much shorter period of time. It has to be said that all shares will require some level of market momentum to rise.
Quality investing originated in the bond and real estate markets where both the quality and price of potential investments are determined by ratings and expert attestations and this methodology was then applied to equity investing. The quality style is most useful for income investment which can include fixed-income securities such as bonds but also stocks that can provide a steady income by paying a solid dividend. Investors do not just search for high yield stocks which can be a sign of distress but quality companies that have the financial strength to maintain this dividend. The quality style gives a methodology to identify companies with quality characteristics based on certain fundamental criteria such as balance sheet strength over time and possibly more qualitative aspects such as management quality. Quality style characteristics are often combined with value or growth methodologies to find cheap companies that are unlikely to go bankrupt or growth companies likely to maintain this growth.
Almost all methodologies for how to go about picking winning shares will use elements from more than one style. Past advice has been to pick an investment style that suits your interest or physiological make-up.