Academics and researchers have spent considerable time searching for the secret to making it rich on the sharemarket.
The trouble for investors is that – when every supposed ‘expert’ yells from the rooftops proclaiming the secret to successful stock investing – it’s almost impossible to separate the researched theory from the pure sales pitch.
For this reason, we decided to overview the major theories of stock analysis recognised worldwide – everything from GARP, growth and income investing to technical analysis. The theories presented here have attracted plenty of supporters over the years – some amassing fortunes by carefully applying these ideas to find, buy and ultimately sell top-performing stocks. So which theory is the best?
The best theory is the one that you can use to the best effect – according to your individual needs. If you hate taking on risk, work full-time and dislike spending long-stretches at your computer then trading using technical analysis is not your game. Similarly, if you enjoy the process of analysing balance sheets, calculating financial ratios and generally keeping on top of major company events, then fundamental analysis is probably more your style.
There’s no point even attempting to follow the rules of a theory if it doesn’t suit your temperament, risk appetite, mindset and way of living. So with that in mind, we’ll launch into outlining the major theories below.
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This is the school of investing best represented by billionaire stock guru, Warren Buffett, who amassed over $52 billion from applying this theory to purchase stocks largely in the US. Buffett is widely regarded as the most successful investor in history, which certainly gives this school of investing some credence. Cynics argue that Buffett’s advantage is his fame: in short, whichever stock Buffett buys has a pretty good chance of going up as investors jump on for the ride. Notwithstanding, few would argue that the sage of Oklahoma doesn’t know a thing or two about the stockmarket and how to be a successful stock picker.
Fundamental analysis regards buying a stock like buying a part ownership in a business, and similar factors are taken into consideration. How much the business is worth, or its value – derived by analysing such factors as revenue, profit, debt levels and other factors of the business such as competition, economic cycle and competitors – is always compared to the current share price. This gives the fundamental analyst a per-share figure; typical examples are the price/earnings ratio (P/E) and earnings per share (EPS). It’s only by using a per-share figure that the fundamental analyst can compare a company against its peers and the market.
Below we outline the major categories or schools of fundamental analysis. While there are always purists who religiously stick to just one category, there are other investors who successfully pick stocks by mixing and matching elements of different categories.
Value – The bargain hunter
A common mistake of investors is to look at the share price of a stock in isolation and decide whether a stock is expensive or cheap. For example, regarding a $3 share as cheaper than a $500 share. Just one word of warning: don’t say this at a party full of fundamental analysts. They’ll eat you for dinner.
Price on it’s own is irrelevant and useless for a fundamental analyst. The price of a stock must always be compared to the value of the company.
The tricky bit, of course, is working out the value of the company, called its intrinsic value, and not all fundamental analysts agree on how this should be calculated. Some will look to how much the company would be sold if liquidated (if all of its assets were sold tomorrow). Other approaches are to use the highly popular price/earnings (P/E) ratio, sales relative to the market capitalisation of the stock or even dividend yields.
Once a value investor has decided on a company’s intrinsic value, this value is compared to the current share price to discover whether the company is currently cheap or expensive.
When you think about it, it is not really different to any investing decision. When buying property, for instance, investors always try to get a bargain by aiming to buy the property less than it’s really worth. Value investing is no different.
Personality traits of the value investor
Value investors are comfortable buying shares in out-of-favour stocks. For this reason the value investor must think independently, and execute their buying and selling decisions with courage and conviction. If you have a penchant for following the pack – buying and selling stock because everyone else is – then value investing is not your style. Read on.
Growth – The action hunter
The growth style of fundamental analysis involves buying shares in a company you believe has the potential to significantly boost earnings and profits over the coming years. Spotting a bargain, which is the key concern of the value investor, comes second to finding a company that has the potential for explosive growth.
Therefore growth investors look to factors such as the growth rate of the company and industry it operates in. New markets such as biotech, technology, or up-and-coming mining stocks in a growth industry such as uranium, for instance, can make the average growth investor hot and bothered.
Since growth investors are more interested in the future value of the company, the current share price isn’t a major concern. In fact, in complete contrast to the value school of investing, the growth investor is actually content to pay more than the intrinsic value of the company to jump on board a dynamic company, whose explosive growth in revenue and earnings should fuel the share price over time.
Personality traits of the growth investor
Growth investors are always on the lookout for the next Microsoft or Google and are happy to pay what may appear to some as a rip-off at the time to get on board. The growth investor must be patient as it can take some companies a long time to realise their full potential.
Growth investors are dreamers or idealists. They like new technology, new markets, and are comfortable with backing a smaller company provided it seems blessed with a bright future. If you’re someone who feels more at ease with the status quo – you prefer big bank stocks for example – then growth investing mightn’t be your style.