There are three basic approaches to investing in the stock market: growth, income, and value.
The Growth strategy looks for companies that are poised to grow. The basic idea is to find companies that are going to grow more quickly than anyone expects them to (since their current anticipated growth rate is "priced into" their current stock price). Usually these are small to medium sized companies with plenty of room for growth. Often these are regional companies going national, or national companies going international. The primary risk is that the company will not grow as quickly as anticipated, sending the share price into a tumble. But when a good growth stock takes off, watch out! These can be some of the most profitable stocks to own. Think Wal-Mart or Microsoft before they were household names. These are the kinds of stocks Peter Lynch likes (although he also likes some kinds of value plays).
The Income strategy focuses on dividends. Income investors typically buy stock in large, mature companies that are not growing but which have very good cash flow. Since the companies are not growing any longer (usually because they are already as big as they can get), they typically pay their profits out to shareholders in the form of dividends. Utilities are usually income stocks but so are a lot of other stocks. If you buy a company's stock for $20 a share, and they pay you $1 a year in dividends, then after twenty years, you essentially have not paid anything for the stock. Well, there's inflation -- the dollar in dividends you'll get in 20 years is not worth the same as the dollars you bought the stock with -- but we'll ignore that for now. In any case, after receiving $20 in dividends, you'll still own the stock, and you can either cash it out and take your profit or continue to hold it and receive more dividends. The primary risk is that a company will fall upon hard times and need to decrease or even eliminate its dividend. However, a solid income stock is a good stock to own during retirement. You'll earn much more than a savings account with only modest risk, particularly if you're diversified.
The Value strategy looks at a company's fundamentals in search of companies that are undervalued by the market for one reason or another. For example, the price-to-earnings ratio (P/E ratio, the ratio of the share price to the earnings per share) of the overall market is 20. If you find a company that is selling at a P/E of 10, it might be a fantastic discount if the company's fundamentals are otherwise sound. If you find a good company at a discount, the theory is that eventually the market will take notice of them and their share price rise until it falls more in line with the rest of the market. (Actually, different types of businesses often have different "normal" P/E ratios, so you can't always assume a company with a P/E around 20 is fairly valued by the market, but this is a detail.) There are other measurements of value that one can use to determine what a company's stock price "should" be, and most value investors use several. The primary difficulty with a value strategy is that, because the market is mostly efficient, most companies that are trading at below the market average P/E are below-average companies! The company's poor prospects have been "priced into" their stock's price and they are fairly valued for what they are. For obvious reasons, relatively young companies are more likely to be overlooked by the market than established ones, but these same companies might not have enough of a track record to allow you to accurately calculate what they "should" be worth in the future. You might really have a growth stock on your hands, in other words. Warren Buffett is almost exclusively a value player, although he buys companies rather than stocks.
There are a few angles on value investing. For example, in an "asset play" you calculate how much the company's assets are worth and compare that to the share price. For example, if if a retail company owns real estate worth $15 a share and the stock is trading at $20 a share, the market is valuing the retail portion of the business at a mere $5 a share. In many cases this is ludicrously low. In any case, it's insurance of a sort -- if the company goes out of business, you have a claim on $15 of the company's real estate for each share you own, which means your shares are unlikely to fall below that floor. Particularly exciting is when a company is carrying assets on its books at what it paid for them twenty or thirty years ago, during which time they have appreciated tremendously. In rare cases, the appreciated value of the assets can actually exceed that of the stock, meaning that when you buy the stock, you get the rest of the business for free -- or are even paid to take it!
Another kind of value play is the turnaround. When a company stumbles, the market often overreacts and cuts the share price dramatically. Such stocks can be great bargains, especially if the company's board of directors (the representatives of the shareholders) bring in new management. The stock price will soar if the new management proves itself.
The best investments combine more than one strategy or angle. If you find a company that pays a great dividend and is still growing, that can be excellent! Not only will you get a yearly dividend, you'll also probably see your shares increase substantially in value if the company's growth exceeds expectations or if they increase their dividend. If a growth company stumbles, or is in a boring business (like death care or insurance), it can become undervalued even while it's growing, making it a turnaround or plain old value play in addition to a growth play. Small companies that switch management teams when growth stalls, as Flamel Technologies (FLML) recently did, can be very attractive.
Right now I'm not really an income investor. All my stocks are growth and value plays or combinations thereof. Blackboard (BBBB), New York & Co. (NWY), and Paxar (PXR) are almost pure growth stocks: their increase in value is expected to come from growing a relatively small business into a much bigger one. No surprise there, as that's the kind of stocks that the Motley Fool's Hidden Gems newsletter focuses on. There are plenty of universities in the United States to which BBBB hasn't yet sold its software, not to mention institutions in the rest of the world. NWY is nowhere near saturating the market with its stores, and year-over-year the company is selling more and more in each existing store. PXR is the dominant player in tagging and branding for clothing and is trying to expand into the RFID space which, after all, is just another form of tagging. If I were to buy Cheesecake Factory (CAKE), it'd be a growth play.
Sears (SHLD) is a value play, a combination of asset (excess commercial real estate currently tied up in unneeded K-mart stores) and turnaround (under new CEO Eddie Lampert). Toll Brothers is basically a sector value play -- homebuilders as a group are considered undervalued. Some analysts believe that homebuilding has ceased being a cyclical business and is now secular -- that is to say, it is no longer subject to business cycles (like interest rates) and can continue to grow long-term. I don't buy that, but I'll happily make money holding TOL while the sector's hot.
My sole exchange-traded fund, the iShares Emerging Markets fund (EEM), is a pure growth play. Emerging markets are countries in which the entire economy is really just getting started. There's a lot of risk, but that can be ameliorated through diversification, which is exactly what you get with a fund. EEM invests in dozens of different Asian, Eastern European, and Latin American companies.
I've talked about investing, where you buy stocks and hold them for substantial periods of time, but you can also do a value-style short-term trade based on the knowledge that the market overreacts to bad news. For example, if you buy Pixar (PIXR) right now, after they took a 10% or better dive on news that the DVD of The Incredibles might not meet their expectations, you'll almost certainly see the stock go back above 50 within a few weeks or months. The market is afraid PIXR is like Dreamworks Animation (DWA), which makes mediocre films and recently has had not only a shortfall in Shrek 2 DVD sales but also something of a box office disappointment in Madagascar. PIXR is not DWA, though; it has Steve Jobs and John Lasseter and Brad Bird, while DWA has, um, well, Jeffrey Katzenberg and, okay, a deal with Aardman, which is a plus, but they put out three of their own CGI films for every Aardman flick. I have no doubt PIXR will rebound soon and then some. I'm considering putting my seventh chunk into it for a couple months, in fact.
Do you know the forces driving the price of each of your stocks? Is it growth, value, income? If not, sit down and figure it out. What you find may surprise you.
Posted by kindall at July 15, 2005 12:01 AM