What Camp Are You In?
June 5, 2024
What Camp Are You In?
The internet is a mixed blessing for investors. We have access to all the information we could ever need. But with that comes information overload. With such a crushing amount of data available, it’s often difficult to find the stock and market news that’s relevant to the way you invest.
Our parents and grandparents were told to read The Wall Street Journal cover to cover every morning with the hope that eventually they’d get the hang of how markets tick. Learning how markets work is much more complicated in the era of Big Data. Now the big question is “What don’t we need to know?”
BetterInvesting principles and the Stock Selection Guide make investing much simpler by providing a comprehensive yet straightforward framework for thoughtful analyses. But as clear as the SSG might be, we still need to make forecasts and estimates to fill in those blanks. That brings us right back to drinking from the fire hose of market data and opinion.
Some of that is unavoidable. If you aren’t going down a few blind alleys, you probably aren’t doing enough research. Even so, we still need some way to tune out what’s irrelevant. Here’s the good news: Market views and data divide into three investing philosophies. Though there’s major overlap between them, once you can identify what a news item or accounting ratio is mostly concerned with, you’ll have an easier time filtering out what’s irrelevant to how you pick stocks.
Those three philosophies are value investing, technical analysis and growth investing. Our method leans towards growth, but also includes a few value measures. Technical analysisdoesn’t play a huge part in what we do, but is popular in financial news.
Most investors draw a few tools from two or even all three camps, but it’s still easy to identify where their hearts are. Usually an investor’s initial screen tells us what measure he or she thinks is most important. If you’re looking at a publication or website, look for what the articles lead off with or emphasize most. And once you find a source that consistently provides you relevant information, bookmark it on your browser so you can return to it.
Value Investing
Value-focused investors want to buy undervalued companies and hope the market will eventually figure out the stock is mispriced and drive the stock up to a target price. That doesn’t meansimply buying low-priced stocks.
Some low-priced stocks are at those levels for very good reasons. They can be overpriced even at multi-year lows.
Value investors try to buy assets and cash flow on the cheap. Some examples of potential targets might be a stock trading at less than liquidation value or a stock trading at an undeservedly low price to earnings multiple compared to similar companies (remember, “undeservedly” is key).
Naturally, value investors prefer growing companies to nearly dead companies if they’re trading at the same price multiples, because growing companies have higher potential cash flows. That makes them bigger bargains. But any growth questions won’t be relevant to a value investor unless the stock is already in the bargain bin.
The tools value investors rely on first almost always include the stock’s price. Price-to-earnings, price-to-book, dividend yield, price-to-free cash flow and discount to the estimated intrinsic value are common ratios. Value investors will compare one stock’s ratios to other stocks in similar businesses or against its own history (as we do in the SSG) to provide some historical and current context to ratios.
The perfect value opportunity would be a stock with dramatically low price multiples compared to its history and its closest peers and when the company is on the brink of a turnaround or being acquired or liquidated at a profit.
Occasionally, activist investors will take huge stakes in an underpriced company and push management to take steps to unlock the company’s value, perhaps through a spinoff or a dividend.
If all it takes to be a successful investor is buying low multiple stocks, then everyone would be rich. But, as said before, some stocks are cheap for a reason. Your default assumption should be that a stock’s current price is the best estimate of its true value until you have compelling evidence otherwise. Even then, stocks can stay undervalued for years, so you may also want to look for undervalued stocks that are on the cusp of change; for example, they might hire fresh management or are about to roll out a compelling product.
Any list of famous value investors needs to begin with Warren Buffett and the lateCharlie Munger of Berkshire Hathaway. Joel Greenblatt is another famed bargain hunter and Carl Icahn is an example of an activist investor.
The Art of the Charts
Technical analysts (also called “chartists”) pay the most attention to the price action and volume of markets and securities. Instead of trying to outsmart the markets about a company’s
“true” value, technicians hope to identify price points when supply and demand for a security or a market might change. They are interested most in investment behavior, specifically the behaviors that can be predicted from price and volume action alone.
Some clubs and members might identify stocks that fit their criteria but then wait to buy or sell until the price chart suggests it’s the best time. That’s the best use of technical analysis.
One reason for the popularity of charting is its ability to analyze stocks and markets at a glance. Once you know the rules, you can form a quick opinion on a stock in seconds. The two primary rules are: first, once a trend is observed, it’s assumed to continue until there’s compelling evidence otherwise. The second is that investors aren’t completely rational. We tend to follow predictable mental shortcuts that can lead to investment bubbles and oversold stocks.
Some common technical terms you won’t hear from value and growth investors include support, resistance, candlesticks, Fibonacci levels, retracements, flags, pennants, wedges, head-and-shoulders, price momentum, breakouts, pivots, swing trades and many others that have nothing to do with who’s running a company or how profitable that company is.
Financial sites love the technicals because stories can be written using artificial intelligence instead of expensive journalists who desire pesky things like compensation and benefits. Algo-
rithms identify which stocks are hitting new highs or underperforming the market and generate a story.
You’ll find examples of these computer-generated stories in the iPhone Stocks app, especially under news on individual stocks. The dead giveaway you’re reading a technical-driven article is when the main point of the story is that a price changed instead of why it changed.
The two major challenges facing technical analysis is, first, the discipline isn’t yet very scientific. Rules frequently fail to generate the trading profits they promise. The second comes from that ease of analysis. Computers can identify, trade on and discard those rules far quicker than individual investors.
But that doesn’t mean the discipline has to be thrown on the slag heap. Investors often use the most basic rules to time buys and sells, under the sensible assumption that it’s better to invest with a trend rather than against it, since we assume the market is mainly right.
Famous technicians include Ralph Acampora, the market strategist who called the 1987 crash, Merrill Lynch veteran Bob Ferrell and a long list of quantitative hedge fund founders.
Grow for the Gold
Growth investors want their companies to, yes, you guessed it, grow. We want profit margins to grow and dividends to grow but, most of all, we want sales to grow. If a company’s sales aren’t growing, then earnings and dividends won’t continue to grow.
Ultimately, shareholders are most interested in cash flow, not sales. Companies can sell mammoth amounts of goods and still not be profitable. But profitability is usually a much easier fix than falling sales. Companies can cut costs through economies of scale or leaning down, or they can raise prices if demand is strong enough.
Declining sales can be temporarily fixed through lowering prices and forcing a competitor out of the market, but the nice thing about growing sales is that there isn’t any ceiling. Growth companies can continue to grow for decades.
Growth investors are concerned with rate of change and the consistency of that change. The SSG plots revenue and profits. Our ideal plot has revenue and profits moving upward in nice, straight, parallel lines. That confirms the company isn’t paying up for sales by reducing prices or spending proportionately more money on advertising or some other costly boost. We’re looking for organic growth of the company’s core business, because that’s what will drive the stock price long term and, because we’re busy people who can’t study stocks all day every day, that’s what we prefer. We want stocks we don’t need to obsess about.
But we do want to know when the company’s growth story is weakening or worse. Growth investors want to know when earnings, sales or cash flows miss expectations or fall below trend. Though it’s common for stocks to occasionally miss for a quarter or two, we’ll want to understand why. Even stellar growth companies can be adversely affected by a recession. If the company’s revenues fell less than the gross domestic product, then the growth thesis might still be intact. If it fell more than the GDP, then the company might be more driven by the economic cycle than its innovative products.
Are growth investors interested in the stock’s price? Sure. We’re most concerned when we’re considering buying it or adding to a current position. We don’t want to overpay. And there may come a time when even growth investors believe a stock has become too rich or there are better stocks to hold. But once we buy in, we generally trust the market will reward successful companies. William O’Neill, the founder of Investor’s Business Daily and Fidelity veteran Peter Lynch are famous growth investors.
Now Go Forth and Skim Those Headlines
Now that you know the different buckets investing info falls into, you won’t need to read everything about a company you’re interested in, nor must you consider what every loud- talking pundit might say about the markets. It might be interesting and could lead us to new ideas later, but it’s not efficient, nor is it usually even productive.
Value investors have very different reasons to buy and sell stocks than technicians and growth investors. As you read though the news, note what type of investor it’s targeted toward. Most articles will make it clear who they are speaking to in the first paragraph, if not the headline. If it’s not relevant to you, give it a miss.
Our goal is to build wealth by investing into solid companies and staying with them, not trading them. Once we do enough research to compel us to buy a stock, we simply need to monitor the company’s progress.
Happily, monitoring requires much less time than scouring multiple news sources every day.
Sam Levine, CFA, CMT, is long-time writer for BetterInvesting magazine.
