There are many investment strategies which experts have used to maximize their gains in the stock market. They are growth investing, dividend income investing, value investing and contrarian investing.
Growth investing dictates one should invest in Businesses which show high growth characteristics. Growth investors may use historical growth rates of turnover and earnings to predict how the future numbers will look. They typically look for catalysts which can quickly boost revenue and earnings such as new technologies, large book orders or new drugs. However, some of these stocks can be highly speculative and rely solely on catalysts. Some growth stocks such as web companies can be trading at high forward price to earnings (P/E) ratios of over 50 times. When the P/E ratios and even forward P/E ratios are deemed too high to be sustainable, analysts use an innovative measure known as price earnings growth ratios (PEG). PEG ratios are derived by (price / earnings) / (annual EPS growth rate). Since EPS growth rate is an educated guess at best, forward P/Es of 50 times can have PEG ratios of only one. On the basis of PEG ratio, these stock prices do not appear to be that costly.
Dividend Income Investing
Dividend income investors concentrate on 2 main metrics, dividend yield and dividend growth. According to the dividend investment strategy, a stock is overvalued when the dividend yield is historically high and undervalued when the dividend yield is historically low. The track record of the dividend payments is also essential, making sure the companies pay consistently and gradually raise dividend payments. Some of the S&P Dividend Aristocrats have paid increasing dividends consistently for over 50 years. Other than looking at those 2 metrics, investors will also do well to analyze the sustainability of the future dividends by studying the payout ratio. The payout ratio indicates how much of the firm’s profits are paid out in dividends. Another useful metric is dividend cover ratio which is usually determined by how many times the free cash flow can cover the dividends paid out. This is my preferred style of investing.
Value investors typically focus on calculating book values of the assets such as cash, cash equivalents and fixed assets with the purpose of purchasing stocks which are priced below net asset valuations. The belief is that the market is irrational and has mispriced these stocks. The investors believe the stock price will ultimately move to more precisely reflect the value of these assets. When the economy is bad, property stocks, developer stocks and real estate investment trusts can often be acquired at huge discounts to the property valuations. Likewise, some small companies may even be trading below cash per share value without any debt. Other than asset values, another common valuation technique is to rely on P/E ratios, both trailing P/E and forward P/E. One would compare P/E ratios against historical trends of the stock itself and also within the industry to determine if the stock is undervalued. However, it is important to note that it may take a very long time for the stock to move to its net asset value. If the stock does not pay dividends, one would have to assess the capital appreciation against the opportunity loss from the holding period.
Contrarian investing is quite simple and goes directly against momentum investing. Basically, you buy when the stock market is in bad shape. In fact, it’s one of Warren Buffet’s most famous strategies, “be fearful when others are greedy and be greedy when others are fearful’. On the other hand, if the market is extremely bullish, one should be cautious about buying overpriced stocks. Contrarian investing is not foolproof though as some companies may become bankrupt like the recent Bear Stearns and Lehman Brothers. Contrarian investing cannot be deployed without first studying the companies and ensuring that they are fundamentally strong and undervalued to begin with.
My Ideal Investment Strategy
My ideal investment strategy is a combination of contrarian and value investing. I focus only on high dividend yield stocks when I invest. Dividends are true cash returns which cannot be window dressed, unlike the financial reports. Value investing provides a framework for me to pick undervalued stocks among the dividend payers, giving me a good safety margin. I place the least emphasis on growth as the growth story is usually overblown, creating high volatility in the stock price.