We have in Part 4 identified 86 potential companies for investing. How do we select 8 to 15 out of these to invest? The returns we make will ultimately to be determined by the companies we select. A poor selection could lead to huge loses while a good one could be the beginning of a journey towards financial freedom.
There are several strategies for selecting companies and we will examine three of these strategies in this post.
This involves buying shares in companies when their market price is below their calculated worth (intrinsic value). The gap between the intrinsic value and market price is called the margin of safety. The value investor believes that sooner or later the market price will increase to match the calculated price (intrinsic value) thereby enabling the investor to make a gain. The process of value investing thus involves:
• Estimating the intrinsic value of a share in the company
• Comparing the intrinsic value to the market price of a share
• Buying the share if the market price is below the intrinsic value. The gap, margin of safety, is determined by the investor’s risk tolerance and return expectations.
• Selling the share if the intrinsic value is much lower than the market price.
In general to succeed in value investing, you need to have a long-term horizon, ability to bear risk and high tolerance for bad news. You also need to be able to sit still as there are times when the best course of action is doing nothing.
Another popular strategy is growth investing. This involves buying companies whose growth potential is being under valued by the market. The growth investor is also concerned about value. The key difference between a value investor and a growth investor is where they look for value. Growth investors focus on companies that are in the growth phase of their life cycle (small companies, technology based companies etc.) while value investors tend to focus on mature, well established companies that are for some reason being under valued by the market.
To succeed in growth investing, you need to be able to estimate growth and price it well. A major pitfall to avoid in growth investing is paying a very high price for growth. This was what happened during the dot com mania when prices paid for growth were so ridiculously high that it was obvious to the discerning investor that such investments were bound to never provide adequate returns.
Technical Analysis (Charting)
Another popular strategy that is also much maligned is Technical Analysis (charting). Technical analysis involves studying how securities prices behave and then exploiting this information to make money. To the chartist, market value is determined by the interaction of demand and supply and charts send advance warning of shifts in this demand and supply via price and volume patterns. To the chartist, prices, volumes and trends rule.
The chartist also believes stock prices tend to follow a trend contrary to the efficient market hypothesis (which says prices follow a random walk) and changes in trend are caused by shift in demand and supply. The chartist is thus mainly a trend follower. Some chartist ride ongoing trends while others try to anticipate trends using momentum indicators.
Other strategies include arbitrage (too sophisticated for our market), trading on information (not insider dealing) and market timing. Most of our attention in this series will be focused on value investing, growth investing and to a lesser extent technical analysis.