Introduction to Investing Strategies #1

Afrika Kesho Blog Post on Introduction to Investing Strategies

 

There are many plans and back up plans you need to have in place as an investor – such as how you are going to allocate the capital you are investing, or how you are going to deal with life’s emergencies without selling your investments – one of the most fundamental plans to put in place is an investment strategy. After all, at some point or another, we’ve all heard the saying that it is often better to have a bad plan than no plan at all.

An investment strategy includes the behaviours, procedures, and rules that guide what stocks and other financial instruments you should buy. The type of person you are has some bearing on the appropriate investment strategy for you. If you tend to avoid risks in your daily life, it is a recommendation that you pick a safer strategy than one that may expose you to a lot of investment risk.

Although there are a lot of investing strategies you could use in your investing, the ones I am going to discuss in this article the two most traditional and philosophically different strategies: value investing and growth investing.

The Value Investing Strategy

What it is

The value investing strategy focuses on the concept of intrinsic value and perceived value of a stock or financial instrument. At times, a company’s stock may be perceived to have more value or less value on the JSE than it is worth in reality.

There are a number of reasons for this distortion in value, these include:

  • a growing or declining interest in the company by the public
  • good or bad news being broadcast or published about the company
  • bubbles in the stock market – when most stocks are extremely overvalued by the public
  • stock markets crashes – when most stocks are extremely undervalued by the public

What this information about value distortions says to the value investor is: buy stocks whose price on the JSE is less than the true value of the company, called undervaluing the stock; and sell stocks whose price on the JSE is more than the true value of the company, called overvaluing the stock.

value

The personality of a value investor

As a value investor you are constantly on the lookout for stocks that are undervalued on the JSE. You believe that these overreactions by other investors on the market that cause the perceived value of a company to decrease, is a good opportunity to purchase the stocks. When a company is undervalue it is practically on sale – you are buying at a discounted price. Most of us are familiar with the concept of an item being on sale: however much the price of an item was before the item went on sale does not matter, all we know is that we can get the same item for cheaper now.

Other qualities possessed by the value investor is the ability to avoid herd mentality and maintain a long-term view about the true value of a company. As a value investor, when the herd causes the price of a stock to decline, you may choose to buy the stock instead. This is because you determine the company’s true value by analysing the company’s financial information, you believe that in the long-term the herd will begin to realise the true value of the company and join you in your buying. By the time the herd buys, you will earn yourself a handsome return because a company’s share price increases with more demand for the stock, and since you bought at a bargain you stand to gain more when the price of the company stock increases.

The process used in value investing

Just as is the case with all investing strategies, value investing requires doing the work to find which stocks are on sale in the stock market. The process which may be employed to achieve this is Fundamental Analysis; a topic I will write about in future. For now, you can use this intrinsic value calculator by buffettsbooks.com.

The risks involved

Value investing does have risks, and these may stem from the investor being wrong about the true value of the stock and therefore being on the wrong side of the investment. These risks include incorrectly applying the fundamental analysis process and overlooking some important information about the company.

The Growth Investing Strategy

What it is

The growth investing strategy focuses on, as the name says, growth. You get growth by looking for companies that you think are growing a lot, well, their share price is growing a lot. In technical terms, you are increasing your capital through the purchasing of stocks whose earnings performance is expected to be above benchmarks within the industry the company operates in or the entire stock market. But, I’m trying not to be too technical. The nature of these companies is usually young and small companies, the name often used to describe them them is “growth stocks”. This is because small companies have the potential to become big companies, and in that process, they grow. Big companies usually have very little room for growth.

When a company gets access to some technology that helps them do their business more efficiently, they gain a competitive advantage. Such a company may have a share price increase on the JSE because of the new growth potential in the company brought about by the new technology. Believing in this growth of the company and its increased earnings in future, the growth investor will purchase shares in that company. The capital appreciation (increase) sought by the growth investor does not always have to be long term, the appreciation can also be short-term in nature.

growth

Personality of the growth investor

A growth investor must be forward looking. The investor will typically consider the industry that the company operates in. If the industry does not have a great outlook for whatever reason, then the stock may not be considered one worth buying. A growth stock should be doing as the name suggests, it should grow.

Another personality trait that the growth investor needs is the ability of self-sacrifice. This is because growth stocks don’t usually pay dividends to their investors, especially since the company is usually small or newly listed on the JSE. Growth companies usually reinvest their profits into the business, and that would be where the growth typically comes from. It is important to note that if the company does remain consistent in beating growth expectations, the capital appreciation will make up for the lack of dividends.

The process used in Growth Investing

Growth investing does also require application of fundamental analysis, including the monitoring of management of the company you are looking at. “Management” is the grouping of all the top officials in a company, including the CEO, CFO and the rest of them, and is an important consideration since incompetent management can be the downfall of a company, leading to loss of money for the investor because of the declining company value (as opposed to growth).

The risks involved

Because small companies have fewer resources, they are more affected by negative publicity, bubbles and market crashes. This means that small companies have share prices that are more volatile – they move up and down a lot. This high volatility may cause losses if you find yourself in the wrong side of a price spike. The company not paying dividends to its investors may also be considered a risk.

There is also the concept of premium prices: If you pay more for a stock than you believe it is worth, then you’re buying at a premium. You are buying an overvalued stock. When you buy a stock at a premium, the risk is that the price falls back to the company’s true value, which would also result in a loss for you.

In a nutshell…

That completes the introduction to both value investing and growth investing. In my next article, “An introduction to Investing Strategies #2,” I will be discussing Momentum Investing and Dividend Investing.

Image sources:

  • http://www.valuewalk.com/2017/02/buffett-series-value-investing/
  • https://www.vicarea.com/growth/

 

This article was written by Karabo Manasoe.

You can contact Karabo Manasoe by clicking on the social media buttons below, or by emailing him on: karabom@afrikakesho.co.za.

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