Most people shy away from individual stocks based on wrong assumptions and misinformation. We are in an age where technological advancements have changed the financial markets in a fundamental way. Ubiquitous market data, research, financial literacy, market access, reduced risk factors and plummeting trading costs are some of the factors that make it possible for just about anyone to be an investor. That’s right! Joe Mainstreet can and should become an investor in individual stocks. This, in my humble opinion, is how we can grow and sustain a viable middle class: by creating an investing class.
How can he make his investing decisions?
Below I look at 5 strategies that in total or different combinations can reward you handsomely if you are a long term investor.
This is a strategy that looks at the business fundamentals of the company. Here the stock performance and the business performance are tied to each other. This means the core business and market metrics, ratios, determine if you should invest in the stock or not. For instance P/E ratio looks at the price of the stock in relation to its earnings. It’s an “equalizer” that helps you compare between companies in the same sector or against the market. Lets say you want to invest in the financial sector (P/E 17) where company X has a P/E ratio of 19 while company Y has a ratio of 15. All other things being equal you would go with Y since it’s undervalued in relation to the sector and the peer.
This is a strategy based on the up and coming companies assuming that their growth trajectory will hold. Thinks back when Apple would deliver 60% growth in sales. When an investor picks the right company they can ride it for a while and the best stock performance comes early on. Ask your grandpa Walmart, Home Depot, Microsoft, were growth stocks. Check out a beauty retailer near you called Ulta Beauty: the chart is sexy, take that tech stocks (he’s looking at you FitBit!) Below is a 5 yr chart of Ulta compared to S&P 500
Grandpa can also tell you something profound about dividends. Dividends account for over 50% returns for long term investors. This comes in the forms of the dividends and dividend re-investments. Dividend paying companies generate enough funds from operations to give some back to its investors. It gets better when you can identify a company that grows its dividend year over year. Such companies tend to be less volatile and less prone to big blunders. Thinks of your water company, gas and electric company, do you know anyone who can go for months on end without paying that bill?
This is a strategy based on the price movement in a given time period. The stock price momentum may be divorced from the company fundamentals and as a long term investor you may have to suspend your business fundamentals rule. Such momentum may be stock specific, sector specific or whole market rising tide. This can be a great short to medium range strategy if well executed. The HP Enterprise has been in reorganization mode for more than a decade and will continue for a long while and its fundamentals don’t look good. Check out the one yr chart below comparing HPE to S&P 500 .
There are certain events, company specific catalysts that can influence a stock price. If you are aware of such events you can plan your trades and execute them against the event. For instance, in the Bio-pharmaceutical industry, the outcome of a clinical trial can see a stock rise or fall 30% or more in a day. A headline event like the Wells Fargo debacle that saw its CEO booted out erased over $2 Billion in market cap. Over-reaction? No. Typical investor reaction! Sell ask questions later. The stock fell to a $43 and it’s currently trading around $55. Being aware of such events and the possible outcomes can be a great strategy if employed alongside other long term investments strategies. Check out the 6 month chart comparing WFC to S&P 500.
Each investor should be aware of their risk tolerance, financial goals and seek advice from certified professionals while implementing and executing investing strategies.
These strategies are best utilized by savvy investors who can check their emotions at the door.
While this is not foolproof if well planned and executed a strategy that employs these 5 in stock selection can supplement your returns from passive funds.
I believe in low cost passive investing supplemented with a good well planned stock picking strategy.
The charts are borrowed from Yahoo (please don’t sue me i love and use your products)for illustration purpose and should not be interpreted as an endorsement or recommendation to trade in these stocks.
Keep learning and keep investing.