Value investors look for companies that are trading at a discount. Value seekers look for companies that are currently out of favour due to various reasons including an earnings miss, trouble with management, or lack of analyst coverage. Determining if a stock is trading at a value can be done by evaluating metrics such as the Dividend Discount Model, Price to Book ratio, or Price to Earnings ratio. Value stocks will have consistent earnings and solid dividend yields.
Growth investing involves looking at companies that are relatively new to the market. These businesses are seen as disruptors in their industry and typically have high earnings potential, strong profit margins, and minimal if any dividends. Growth investors believe the future of the particular stock will be much brighter than current standings. Because investors are expecting the company’s earnings to grow exponentially in the future these stocks will trade with high Price to Earnings ratios.
Large capitalization stocks are businesses with a valuation of $10 billion or more. These companies are much more established than Mid or Small cap companies. It is possible for Large cap stocks to be new to the industry compared to its peers. This may result of the company going public early and have high prospects with investors. The more reputable Large cap stocks are considered staples of mutual funds and ETFs which means they are more liquid than Mid or Small caps. Large caps will often have more diversified business operations and cover a wider geography than Small caps.
Small market capitalization focuses on companies with a market cap of $300 million to $2 billion although they may slightly fluctuate depending on the institution making the assessment. Small cap stocks are characteristically volatile, have limited information compared to Large caps, and have high growth potential. The difference between Small cap and Growth stocks is that Growth stocks can still have big market valuations. Small caps are also very sensitive to the economic cycle.
Passive management looks to replicate the returns of a given index or specific market. Passive investors believe in market efficiency and that long term, Active managers cannot outperform the indices. Passive funds charge lower fees than Active funds due to the fact there is less research and switching costs that occur with the Passive approach. Passive funds are typically more tax efficient although that only matters if you hold them in a non-registered account. Both styles achieve diversification with the major advantage to Passive investors being the lower costs.
Active management involves much more diligence in the belief that markets are not efficient and above average returns can be achieved. Although both methods are diversified, Passive funds are typically focused on one region or sector, making them prone to risk if those areas have a downturn. The major advantage for Active investors is drawdown protection. In times when the market is performing poorly, Active managers have the ability to make changes to their funds that can mitigate risks. Active managers often have specific experience in an industry or will work in a team with members of complementary knowledge to potentially achieve superior market returns.
There are a bunch of different approaches to analyze a particular stock. The two major ones are bottom-Up and top-Down. Bottom-Up analysis begins with microeconomic factors with a specific company, usually starting with the finer details such as product, debt level, and profit margin, eventually moving to bigger outlook factors such as management and company expansion. One tenet of the bottom-up approach is businesses that have strong fundamentals can perform relatively well even in a poor economy. Another trait of the bottom-up investor is they typically hold their stocks for the longer term. This is because they have a solid understanding of the underlying business and given their belief in the potential of the company the stock owner will hold through ups and downs. For the most part bottom-up investors will buy stocks they are familiar with such as Rogers, Netflix, or the Royal Bank of Canada. This is because these businesses are easy to comprehend and are apart of our everyday lives. Critics of the bottom-up approach say at times this method is overly optimistic at market peaks. At the same, its overly pessimistic at market bottoms.
On the contrary top-down analysis begins with the macroeconomic picture. Things like inflation, interest rates, currencies, and geopolitical risks will create a framework of which industry or region, not a specific stock at first, is favourable to invest in. For example, industrials might be more promising than healthcare or Europe might be more favourable than Canada given the macroeconomic climate. Comparing industries and regions can be done simultaneously or separately. Like in bottom-up investing that starts with microeconomic factors and moves up to macro, the opposite is true for top-down investing. Next one could choose on how they would like to get exposure to a given industry or region through a wide range of assets such as commodities, bonds, foreign stocks, ETFs, or American Depository Receipts (ADRs). A benefit to top-down analysis is it gives you a panoramic picture of the global economy. Economies can be contagious for better or worse so understanding one sector can give insight on how other sectors will perform. One disadvantage is the immense research needed to conduct the analysis. There are eleven different investment sectors and nearly two hundred countries so the task can be overwhelming. Having said that the two methods can be used in conjunction and often compliment each other. Using one does not have to mean ignoring the other. It comes down to preference, time, and research skill.