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Winning Strategies for Beginner Investors (Part 1)

Many people will never experience how it is to invest in stocks. They are, sadly, missing the great benefits as well as the possibilities that they and their money are capable of doing. If you are one of those people, take a few minutes to consider how you can begin the experience and find out what it has really in store for you.

Mutual funds provide the appropriate ice-breaker for beginners. For just a few hundred bucks, mutual funds can offer you easy access to thousands of various stocks, giving every investor enough protection from the variety of broad-based mutual funds. The potential of losing a significant amount of money may happen when the whole market melts down; however, losing in one or two companies will not hurt as much as long as your overall portfolio remains buoyant.

On the other hand, investing in individual stocks can bring higher returns. This is because choosing the right individual stocks can offer potentially greater benefits compared to a diversified mutual fund.

How do the winners choose?

As with everything else in life, those who succeed are the ones who have perfected the method of diminishing, if not totally eliminating, careless mistakes or choices. A chef always has to depend on a recipe to make a perfect dish. A chess player will have to decide the best opening or defense to defeat one’s opponent and use either to gain the best positions. A teacher will need to prepare an outline of every lesson before facing a class. Investors also need a viable strategy.

There are specialized approaches to investing; but first, you have to get acquainted with the various methods for analyzing stocks. Chess playing can be more nerve-wracking or head-splitting than investing; nevertheless, you have to spend enough time seriously planning how to invest your hard-earned money.

Analyzing Fundamentals -- Buying a Business (Value, Growth, Income, GARP, Quality)

Buying a share of stock represents your owning part of a business or company. Hence, in order to determine the right value of a stock, you should figure out how much the company’s worth is. In general, this is done by evaluating the financials of a business, breaking it down in terms of the value of each share to arrive at the proportional worth of the share of the business. We often refer to this as "fundamental" analysis; and for many people, no other alternative way of evaluating stocks is as good.

In spite of the fact that evaluating a business may seem like an easy task, the challenge arises from the availability of various methods of fundamental analysis. Investors usually raise contrary views and apply subcategories in their desire to fully comprehend their chosen investing approach. Ultimately, most of them apply a method that incorporates the best strategies of various approaches. Whatever unique characteristics that differentiate these approaches are generally invented academic techniques and not real practical distinctions. And so, economists who evaluate the stock market categorize value and growth while practitioners consider these labels to be very useful. It will serve some good for the beginning investor to understand the following descriptions; hence, we will clarify what most investors mean in using these terms, although you must take care to verify the exact meaning of any person using them.

Value

A wise guy once said that a cynic is anyone “who knows the price of everything and the value of nothing.” That may apply to many people; but your goal as an investor is to know the price and the value of a firm’s stock, that is, to buy companies at a considerable discount to their intrinsic value or the worth of the business if sold the following day. In short, every investor is essentially a "value" investor, buying a stock whose value is greater than the price paid for it. Ordinarily, value investors intentionally look for the liquidation value of a company, meaning to say, the value of the assets if sold tomorrow. Nevertheless, the concept of intrinsic value is not explicitly attached to the liquidation value, making value quite an elusive matter to pin down. This only goes to show that while so many value investors have their own specific views, not everyone using the term "value" agree on one meaning.

Benjamin Graham is considered as the pioneer who established the foundation for modern value investing, in his 1934 book, Security Analysis (with co-writer David Dodd), which is currently used by many investors. There are other personalities known as dedicated practitioners of the value method, such as Michael Price and Sir John Templeton. Most of them apply extremely stringent guidelines for buying a company's stock. Their rules are often usually founded on the connections of the present market price of the business to specific business fundamentals. The following are examples:

  • Price-to-earnings ratios (P/E) beneath a specific absolute limit
  • Dividend returns beyond a specific absolute limit
  • Total sales at a specific level in relation to the firm's market value
  • Book value of each share at a specific level in relation to the share price

Growth

Growth investing refers to the concept of buying company stock with potentially high growth rates in earnings and sales. In this case, growth investors often focus the company's worth as a current business venture. Most of them choose to maintain their hold on these stocks for long durations. Eventually, growth ceases to be a real determinant of a company’s value, especially when investors refrain from buying into companies which are not growing. Two individuals are responsible for popularizing the idea of growth investing in the 1940s and the 1950s, namely: T. Rowe Price, founder of the mutual fund firm having the same name, and Phil Fisher, writer of one of the most influential investment books published, Common Stocks and Uncommon Profits.

Growth investors analyze the essential quality of the business and the growth rate before buy into it. Often, these investors get enthused with the arrival of new industries, new companies and new markets and buy company stocks they consider to have potentials of enhancing sales, earnings, and other vital business metrics at a certain minimum level yearly. Usually, growth is seen as a contrasting measuring stick in relation to value by many investors; however; the distinctions can blur at times.

Income

Even though many people buy common stocks, expecting the shares to grow in value, many others still buy stocks principally for the regular dividends they provide. These people are called income investors, who commonly neglect businesses offering shares with high prospects of capital growth to buy high-income, dividend-generating businesses in slow-growth industries. They prefer businesses that offer attractive dividends, such as real estate investment trusts (REITs) and utilities, in spite of the possibility of investing in firms going through dire problems and whose share prices have dipped substantially low that the dividends are subsequently so high.

GARP

GARP stands for “growth at a reasonable price” – and we know how much easier it is to use acronyms. To GARP investors, the best approach is to unify the value and growth approaches and incorporate a numerical twist. GARP practitioners prefer companies with sound growth potentials and high resent share prices which do not represent the fundamental value of the company, earning a "double play" as earnings grow and the price-to-earnings (P/E) ratios of those earnings also grow. GARPs most popular practitioner is Peter Lynch, the former Fidelity fund manager.

GARP involves one of the most common methods of buying stocks when the P/E ratio goes below the rate at which share earning can grow later on. As a business’ share earnings grow, the P/E of the company will decrease if the share price stagnates. Since rapid-growth firms can ordinarily maintain high P/Es, the GARP investor buys shares which will be low-priced tomorrow if the growth happens as predicted. But, if growth fails to arrive, the GARP investor's expected gain can go up in smoke.

Since GARP offers so many chances to only consider numbers rather than the business per se, many GARP methods, such as the almost pervasive PEG ratio and Jim O'Shaughnessy's ideas in What Works on Wall Street, are actually mixtures of fundamental analysis and quantitative analysis.

Quality

Nowadays, majority of investors apply a combined approach using growth, value and GARP strategies. They seek excellent companies offering "reasonable" prices. While they possess no compact guidelines for the type of mathematical connection between share price and business fundamentals, they do have a common philosophy of evaluating company valuations and their intrinsic worth. Generally, they utilize quantitative analysis, such as return on equity (ROE) and qualitative measurement of the management’s capability. Most of these investors call themselves value investors, even though they focus more on the worth of the company being a dynamic organism instead of a static asset that has value.

Warren Buffett of Berkshire Hathaway is considered the most well-known defender and practitioner of this method. Having learned from Benjamin Graham of Columbia Business School, he subsequently partnered with, Charlie Munger, who helped shift Buffet’s focus on Phil Fisher's mantra of growth-and-quality.

Misgivings about fundamental analysis

Critics of the fundamental analysis point to two primary points against it. First, they think that the approach uses precisely the kind of information that all primary players in the stock trade know and use beforehand. This, they say, does not add any genuine edge. Why bother with the fundamentals if all you do is remain as knowledgeable or as unaware as the next guy beside you? Second, a bulk of the fundamental stats is “muddy” or “blurred”, any person can make one’s own interpretation. A few talented investors may have succeeded with this method; however, detractors believe the ordinary investor can save a lot of trouble by leaving fundamentals alone.

Quantitative Analysis -- Using Numbers to Buy

The method of analyzing only the numbers with practically no regard for the business involved is called pure quantitative analysis. So, if you talk, walk and eat numbers more often than not, you must be a quantitative analyst. Whereas fundamental analysis considers numerical analysis at times, the main thrust is the concerned business, looking closely at management's capability, the nature of the competition, potential markets for innovative products, and others. Such things, for quantitative analysts, belong in the realm of personal opinions and not in the field of solid, raw facts that generate objective analysis.

Benjamin Graham, a major proponent of fundamental analysis, also helped popularized this method. At Graham-Newman partnership, he urged analysts to avoid talking to management in evaluating a business and told them to wholly focus on the numbers, thus eliminating biased management views.

With the proliferation of computers, many "quants" (as proponents are called) have cranked up the numbers more efficiently and, thereby, buying and selling businesses purely on quantitative evaluation while totally disregarding the present valuation or tangible business involved. Quite a revolutionary step away from fundamental analysis, we must admit. Moreover, "quants" will commonly inject concepts, such as a stock's comparative strength, which is the level at which the stock has stood in relation to the market, in general. These investors are fully convinced that discovering the appropriate figures can assure positive results. The company, D.E. Shaw, utilizes complex mathematical algorithms to determine tiny price differentials in the markets.

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