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4 Types of Stock Market Investment Strategies (Part 1)

· Financial Services

Trading is a relatively recent phenomenon made possible by the technology of communication networks and the development of the paper stock ticker. Details of stock transactions – stock symbols, the number of shares, and prices – were collected and transmitted on paper strips to machines located in brokerage offices across the country. Specialized employees using their memory, paper and pencil notes, and analytical skills would “read” the tapes and place orders to buy or sell stocks on behalf of their employer firms.

As a young trainee on Wall Street in the early 1960s, I remember the gray-haired, bespectacled old men bent over and concentrating on the inch-wide tapes spooling directly into their hands from the ticker. As technology improved to offer direct electronic access to price quotes and immediate analysis, trading – buying and selling large share positions to capture short-term profits – became possible for individual investors.

While the term “investing” is used today to describe to anyone and everyone whoever buys or sells a security, economists such as John Maynard Keynes applied the term in a more restrictive manner. In his book, “The General Theory of Employment, Interest, and Money,” Keynes distinguished between investment and speculation. He considered the former to be a forecast of an enterprise’s profits, while the latter attempted to understand investor psychology and its effect on stock prices.

Benjamin Graham – whom some consider to be the father of security analysis – agreed, writing that the disappearance of the distinction between the two was “a cause for concern” in his 1949 book The Intelligent Investor. While Graham recognized the role of speculators, he felt that “there were many ways in which speculation could be unintelligent.”

While there are observable differences in the goals and methods of the different philosophies, their successful practitioners share common character traits:

  • Intelligence. Successful investors, speculators, and traders must have the ability to collect and analyze diverse, even conflicting, data to make profitable decisions.
  • Confidence. Success in the securities market often requires taking a position in opposition to the majority view. Like Warren Buffett advised in a New York Times editorial, “Be fearful when others are greedy, and be greedy when others are fearful.” In a letter to Berkshire Hathaway shareholders, he noted the Noah Rule: “Predicting rain doesn’t count. Building arks does.”
  • Humility. Despite one’s best preparation, intention, and effort, errors occur and losses inevitably happen. Knowing when to retreat is as important as knowing when to dare. As Sir John Templeton, founder of the mutual fund family with his name, said, “Only one thing is more important than learning from experience, and that is not learning from experience.”
  • Effort. Christopher Browne, a partner in the New York brokerage firm Tweedy, Browne Company LLC and author of “The Little Book of Value Investing,” claims, “Value investing requires more effort than brains, and a lot of patience. It is more grunt work than rocket science.” The same applies to intelligent speculation or active trading. Recognizing and translating price patterns and market trends requires constant diligence; success in the stock market requires hours of research and learning the skills to be successful.

1. Investing

Investors intend to be long-term owners of the companies in which they purchase shares. Having selected a company with desirable products or services, efficient production and delivery systems, and an astute management team, they expect to profit as the company grows revenues and profits in the future. In other words, their goal is to buy the greatest future earnings stream for the lowest possible price.

On May 26, 2010, speaking before the Financial Crisis Inquiry Commission, Warren Buffett explained his motive in buying a security: “You look to the asset itself to determine your decision to lay out some money now to get some more money back later on…and you don’t really care whether there’s a quote under it [at] all.” When Buffett invests, he doesn’t care whether they close the market for a couple of years since an investor looks to a company for what it will produce, not what someone else may be willing to pay for the stock.

Investors use a valuation technique known as “fundamental or value analysis.” Benjamin Graham is credited with the development of fundamental analysis, the techniques of which have remained relatively unchanged for almost a century. Graham was primarily concerned with the metrics of companies.

According to Professor Aswath Damodaran at the Stern School of Business at New York University, Graham developed a series of filters or screens to help him identify under-valued securities:

  1. PE of the stock less than the inverse of the yield on Aaa Corporate Bonds
  2. PE of the stock less than 40% of its average PE over the last five years
  3. Dividend yield greater than two-thirds of the Aaa Corporate Bond Yield
  4. Price less than two-thirds of book value
  5. Price less than two-thirds of net current assets
  6. Debt-equity ratio (book value) has to be less than one
  7. Current assets greater than twice current liabilities
  8. Debt less than twice net current assets
  9. Historical growth in EPS (over last 10 years) greater than 7%
  10. No more than two years of negative earnings over the previous decade

Warren Buffett, a disciple and employee of Graham’s firm between 1954 and 1956, refined Graham’s methods. In a 1982 letter to shareholders of Berkshire Hathaway, he cautioned managers and investors alike to understand “accounting numbers are the beginning, not the end, of business valuation.”

Buffett looks for companies with a strong competitive advantage so the company can make profits year after year, regardless of the political or economic environment. His perspective when he decides to invest is always long-term. As he explained in another shareholder letter, “Our favorite holding period is forever.”

Morningstar considered Philip Fisher as “one of the great investors of all time” – as such it is not surprising that he concurred with Buffett and Graham, preferring a long holding period. In a September 1996 American Association of Individual Investors (AAII) Journal article, Fisher is credited with the recommendation that “investors use a three-year rule for judging results if a stock is under-performing the market but nothing else has happened to change the investor’s original view.” After three years if it is still under-performing, he recommends that investors sell the stock.

Investors seek to reduce their risks by identifying and purchasing only those companies whose stock price is lower than its “intrinsic” value, a theoretical value determined through fundamental analysis and comparison with competitors and the market as a whole. Investors also reduce risk by diversifying their holdings into different companies, industries, and geographical markets.

Once taking a position, investors are content to hold performing stocks for years. Fisher held Motorola (MOT) from his purchase in 1955 until his death in 2004; Buffett purchased shares of Coca-Cola (KO) in 1987 and has publicly said that he will never sell a share.

Some market participants might consider an investing philosophy based on conservative stocks with long holding periods to be out-of-date and boring. They would do well to remember the words of Paul Samuelson, Nobel winner in Economic Sciences, who advised, “Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”

2. Speculation

According to Philip Carret, author of “The Art of Speculation” in 1930 and founder of one of the first mutual funds in the United States, speculation is the “purchase or sale of securities or commodities in expectation of profiting by fluctuation in their prices.” Garret combined the fundamental analysis popularized by Benjamin Graham with the concepts used by early tape readers such as Jesse Lauriston Livermore to identify general market price trends.

Milton Friedman, writing in In Defense of Destabilizing Speculation in 1960, noted much of the public equates speculation with gambling, with no value as an investment philosophy. However, Friedman contends that speculators often have an information advantage over others, enabling them to make profits when others less knowledgeable lose. In other words, speculation could be defined as the buying and selling of securities based upon a perceived advantage in information.

Paul Mladjenovic, a certified financial planner (CFP) and the author of four editions of “Stock Investing for Dummies,” explained the point of speculation best: “You’re putting your money where you think the rest of the market will be putting their money – before it happens.”

Jesse Lauriston Livermore, named the “most fabulous living U.S. stock trader” in a 1940 TIME article, developed his skill buying and selling stocks in bucket shops – unregulated businesses that were the equivalent of today’s off-track betting parlors, where customers placed wagers on the price movement of stocks, according to Bloomberg. No securities changed hands, and the transactions did not affect share prices on stock exchanges. Livermore’s ability to detect and interpret patterns in the movement of stock prices quickly made him persona non grata in the shops, much like card counters are banned from the casinos of Las Vegas and Atlantic City.

But Livermore’s focus on stock prices and the patterns of their price changes enabled him to identify “pivot points” – now known as levels of support and resistance – that guided his buys and sells. He purchased stocks as they rebounded from a support level, and sold them when they approached a resistance level. Livermore understood that stocks move in trends, but could quickly change direction depending upon the mood of stock market participants. Accordingly, in his book “Reminiscences of a Stock Operator,” he advocated a strategy of quickly cutting losses and letting profits run.

Other Livermore stock trading rules include the following:

  • Buy rising stocks and sell falling stocks.
  • Trade only when the market is clearly bullish or bearish; then trade in its general direction.
  • Never average losses by buying more of a stock that has fallen.
  • Never meet a margin call – get out of the trade.
  • Go long when stocks reach a new high; sell short when they reach a new low.

Livermore also noted that the markets are never wrong, though opinions often are. As a consequence, he warned that no trading strategy could deliver a profit 100% of the time. Livermore and others following a similar philosophy are willing to be on the sidelines – out of the market – until an opportunity for profit is readily apparent.

The techniques used by Livermore evolved into what is now known as technical analysis by extending Livermore’s pivot points to more esoteric price and volume patterns of price changes such as head and shoulders patterns, moving averages, flags, pennants, and relative strength indicators. Technicians led by John Magee and Roberts Edwards – authors of what many claim to be the bible of price speculation, “Technical Analysis of Stock Trends” – claim that the bulk of information which “fundamentalists [investors] study are past history, already out of date and sterile, because the market is not interested in the past or even in the present! In brief, the going price, as established by the market itself, comprehends all the fundamental information which the statistical analyst can hope to learn (plus somewhat is perhaps secret from him, known only to a few insiders) and much else besides of equal or even greater importance.”

The underlying assumption of speculation or technical analysis is that patterns repeat themselves, so a review of past and current prices, properly interpreted, can project future prices. The assumption was challenged in 1970 by Eugene Fama, professor of finance at the University of Chicago and a Nobel prize winner, with the publication of his article “Efficient Capital Markets: A Review of Theory and Empirical Work” in the Journal of Finance. Fama proposed that securities markets are extremely efficient, and that all information is already discounted in the price of security. As a consequence, he suggested that neither fundamental nor technical analysis would help an investor achieve greater returns than a randomly selected portfolio of individual stocks.

His ideas became popularly encapsulated as the Efficient Market Hypothesis (EFH). While acknowledging critics of EFH, Dr. Burton Malkiel – economist, dean of the Yale School of Management, and author of “A Random Walk Down Wall Street” – defends the hypothesis. He claims that stock markets are “far more efficient and far less predictable than some academic papers would have us believe…[the behavior] of stock prices does not create a portfolio trading opportunity that enables investors to earn extraordinary risk-adjusted returns.”

While the academic battle over EFH continues, adherents of technical analysis – speculators – continue to embrace the philosophy as the best method to pick optimum moments of buying and selling.

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