Stock Picking Strategies

While it is important to have a sound asset allocation plan, having a basic understanding of the different stock picking strategies available to investors (and knowing which 'style' suits you) is also equally important in attaining your investment objectives. In this section, we examine three different stock picking strategies.

1. Growth Investing

Investors who follow the growth investing approach typically invest in growth stocks whose earnings are expected to grow at significantly faster rates as compared to the overall market or the industry. These stocks tend to be in the earlier stages of development, or operate in rapidly expanding industries, such as those related to new technology. Some of these stocks may not even be profitable, and even if they are, they are likely to reinvest every cent of their earnings to spur growth. As such, growth investors are less concerned about a stock's ability to pay dividends. They are primarily focused on a stock's future prospects, and believe that its above-average growth in earnings will likely translate into an increase in its stock price in the future. Growth investing tend to carry substantial risks, given that growth stocks usually carry high valuations and stock prices can be quite volatile, and thus may not be suitable for everyone.

There is certainly no one size fits all method of evaluating growth stocks, but there are some common areas that growth investors usually look at. Investors will usually first assess if a particular stock has strong historical earnings growth. While past performance is not necessarily indicative of future returns, a stock with a strong historical earnings growth is likely a reflection of a well-run company. Profitability ratios such as return on equity (ROE) and return on invested capital (ROIC) also give investors clues on how efficient a company is at generating profits using shareholders' equity or invested capital. However, if a growth stock is approaching its market limits and is unlikely to scale its business up any further, its fast growth can come to an abrupt end. As such, it is also important to consider a stock's expected future earnings growth.

2. Income Investing

Income investing, as its name suggests, is an investment strategy that focuses on generating a regular stream of income from an investor's stock holdings. The idea behind this strategy is to purchase a diversified portfolio of dividend-paying stocks and reinvest the dividends to accelerate the growth of our portfolios, such that the passive income from our stock holdings will be able to fund our spending needs in our retirement days. At first glance, an income investing strategy may sound straightforward: invest in companies with high dividend yields. However, investors who pick stocks based solely on its dividend yield may experience losses if dividends are slashed, and stock prices fall further. As such, while dividend yield is certainly a criteria that investors should look at when assessing a stock, it is also important for investors to perform their due diligence to ensure that such dividend payments are sustainable in the future.

No matter how profitable a company is, it must have cash on hand in order to pay dividends to its shareholders. A profitable company that runs into cash flow problems will eventually have trouble paying out stable dividends at the end of the day. For this reason, investors should invest in companies that can generate a sustainable stream of positive free cash flow, which is a measure of how much cash a company can generate from its operations after accounting for capital expenditures. Besides free cash flow, another indicator that is useful for assessing dividend sustainability is the pay-out ratio, calculated by dividing the company's dividend per share by its earnings per share. A dividend pay-out ratio of more than 100% should raise a red flag that warrants further scrutiny by the investor, as it implies that the company is dipping into its cash reserves to fund its dividends, a trend that could result in dividend cuts in the near future if continued. Consistency is also a must if investors desire a constant stream of passive income from dividend pay-outs. As such, investors should also consider a company's track record of growing and paying its dividends over the past few years.

3. Value Investing

Value investing is an investment strategy in which investors seek to purchase stocks that are trading at prices significantly below their intrinsic values. It is analogous to shopping for goods when they go on sale at prices much lower than what they are actually worth. Investors who use this strategy generally believe that stock prices do not always incorporate and reflect all relevant information. In other words, stocks can sometimes be overvalued or undervalued, as investors over-react to market news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The focus of value investors is mainly on a stock's fundamentals and intrinsic value. They think about stock investments for what is actually is – to be an owner a good and well-run company (at a reasonable price). As such, value investors make profits by purchasing undervalued stocks, and selling them after they go up in price when market participants recognise their true value.

Value investors should always assess stocks by evaluating their financial health, making forecasts of their future earnings, and arrive at a reasonable estimate of their intrinsic values using a suitable valuation method, such as the discounted cash flow model, dividend growth model and valuation multiples. If the current market price of the stock is significantly below its intrinsic value and offers a comfortable margin of safety, an investment in this stock may be justified. Conversely, if the stock is currently trading at near or over its intrinsic value, then it may be advisable for the investor to sit on the side-lines until the price falls within an acceptable range determined by the investor. Value investing can be extremely rewarding if applied in a prudent manner. It is, however, something that is psychologically challenging for many as it sometimes involves going against the crowd. If not properly thought through and executed, value investing could also lead to added amounts of risks, as well as potential losses if investors fall into value traps.