There are essentially five main investment styles.
These are growth, value, income, fundamental and GARP investing.
Growth investors search for companies with high projected earnings and a strong history of earnings growth. These are typically small companies paying little or no dividends (profits distributed to shareholders); this is because the profits are ploughed back into the growing business.
Investors are willing to pay a higher price for these companies as they believe the earnings growth will sustain and lead to a much higher price.
Income investors generally search for mature companies paying high and rising dividends. They are sometimes referred to as ‘defensive’shares, this is because they provide provide essential goods and services, ones which customers purchase again and again. These would include food, medicine and utilities.
Companies paying decent dividends are typically large, predictable, global multinationals like Vodafone and GlaxoSmithKline.
These companies are typically characterised by having robust balance sheets and solid cash flow generation. This enables them to pay a secure, steady stream of income to investors.
Income investing is a low risk, low return strategy as the prospect for capital appreciation is limited.
This is a style which involves identifying companies with healthy balance sheets, quality management and a strong competitive advantage.
The cornerstone of fundamental investing involves diving into financial statements, sound exciting? This will help investors gain a better picture of the firm’s potential future performance.
Investors will typically want companies to have strong cash flows, low debt and a history of consistent earnings growth.
If you’d like to understand or further develop your knowledge of financial statements, I would strongly recommend reading ‘The Financial Times Guide To Investing’ by Glen Arnold’.
Value investors are contrarian by nature; they look for boring, unfashionable companies trading at a discount to their intrinsic values. The intrinsic value is what an investment is really worth independent of its current market price.
Value investors look for stocks trading at a low price to earnings ratio (a common valuation metric) relative to their projected earnings growth rate. This is then compared to the sector and industry earnings in order to gauge a company’s fair value.
In addition, professional investors will use a ‘discount cash flow model’ to more accurately measure the firm’s intrinsic value.
GARP stands for ‘growth at a reasonable price’; this is a hybrid system of stock selection – blending both value and growth investment styles.
GARP Investors search for companies with high growth prospects, usually between 10 -20%, coupled with a valuation at or below its intrinsic value.
The chief metric GARP investors use is PEG (price to earnings growth ratio). This is calculated by dividing the price to earnings ratio (which is how much an investor is willing to pay for a company’s’ earnings) by the forecast earnings growth. This is a favoured metric of mine – as its quick to calculate and much easier to understand than a discount cash flow model!
With this hybrid method, investors can reap the benefits of both worlds, and you can be comforted by the fact that ‘Peter Lynch’ (Fidelity’s star fund manager from 1977 -1990) is a fervent supporter of this strategy.
Investment style of Benjamin Graham and Warren Buffett
Benjamin Graham had a profound impact on one of his pupils – Warren Buffett who is now one of the most famous investors of all time.
His approach was to identify stocks which traded below their ‘intrinsic value’. The intrinsic value is the unbiased and rational value of a stock calculated using discount cash flow analysis and various financial ratios.
Value investors focus on long-term performance and aim to hold shares over a very long investment horizon. Benjamin Graham once said that markets are a weighing machine in the long term, because the share price will eventually come to reflect the fundamentals of the business.
This style of investing is contrarian by nature, because investors are going against the herd and selecting stocks overlooked by the market. Stock market volatility is an inevitable feature of the market, but this in turn opens up fantastic buying opportunities as share prices move more than the fundamentals of a business warrant.
I’ll end on a quote by sage investor Warren Buffett, a renowned value investor: “You should be fearful when others are greedy and greedy when others are fearful”.