Investing Styles
Large Cap vs. Small Cap
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.
Value vs. Growth
The basic principle of value investing is a stock’s price does not always reflect its’ intrinsic value. This is because investors often overact to negative news such as an earnings miss, trouble with management, or unsuccessful products. By “value”, we mean what the stock is truly worth based on factors such as cash flow, assets, or shareholder equity. Determining if a stock’s price is undervalued can be done by evaluating metrics such as the Dividend Discount Model, Price to Book ratio, or Price to Earnings ratio.
Typically value stocks are well established with long track records, consistent earnings, and solid dividend yields. Value investing is a buy and hold strategy meant for long term investors. Qualities to look for in a value company include growing profit, an economic moat, low debt, and low P/E, or P/B ratios. Management teams will have long tenure within the industry and business, regular public communication such as conference calls and financial updates, and compensation such as stock options and bonuses should be tied to long term goals.
What are some of the risks value investors face? We did say value stocks are a long term play. Well, the time period for a stock to realize its’ intrinsic value may not align with the investors’ or the true value may never be realized at all. Values are subjective therefore the value a stock picker puts on the company may be wrong. For this reason investors will often build in a margin of safety, meaning they might only invest if the stock is undervalued by a certain percentage, say 20%. Some metrics could set up a value trap such as low P/E, strong dividends but other less tangible business factors like poor management or employee turnover might prove the company is weak.
Growth investing is another long term strategy that involves looking at smaller companies that are relatively new to the market. These businesses are seen as disruptors in their industry and typically have high earnings potential, little profits at first but rapidly growing margins, and minimal if any dividends. These firm’s offer unique products that have widespread appeal.
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, and Return on Equity ratios. Growth stocks are famously volatile for a few reasons. They do not have a lengthy track record for analysts to review performance, they have little earnings so there is not much room for error, and their products are often untested. Other risks are competition: due to high earning potential and attractive margins others may attempt to outperform a growth company, execution risk: because the company is essentially offering a new product or service its uncertain if it will work or be well received.
It’s also possible for a growth stock to fall after improving financials if they did not improve as much as the analyst consensus. In fact a growth stock’s price can swing more on the forecasted earnings than the actual earnings because current prices are mostly based on future revenue. One thing that is important to note with growth companies is that not all relevant information is captured in the balance sheet, cash flow statement or income statement. For example product developments, management changes, and expansion plans are all particularly relevant to growth stocks.
“Price is what you pay, value is what you get” – Warren Buffett
Passive vs. Active
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.
Bottom-Up vs. Top-Down
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. Â 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.
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Technical Analysis vs. Fundamental Analysis
Technical analysis is used to analyze securities based on historical trends. Advocates for this approach will comb over certain numerical details of a stock such as price, volume, public float, and different stochastic indicators. A favourite for day trades and quantitative analysts, technical analysis builds off behavioural finance and assumes three principles:
- prices move in trends and counter trends
- markets discount everything
- price action is repetitive
Let’s unpack each of these a little bit. Security prices trade primarily on probability as opposed to random market events. Price movements will follow a certain pattern until a new pattern emerges. Generally technical traders will take action in the direction of the trend. This frame of investing assumes that markets are efficient with factors that materially affect a stock’s price. Any random event that occurs is thought to already be factored in to the price and even random events can form an identifiable pattern. Examples include geopolitical tensions, natural disasters, or demographic shifts. The most basic idea of technical analysis is that history repeats itself. Proponents of this type of analysis attempt to predict future movements in price based on how they performed during similar markets in the past. If you are interested in learning technical analysis, we suggest you get very familiar with charts and different type of averages to start.
Fundamental analysis gauges a security’s intrinsic value by assessing microeconomic and macroeconomic factors. The idea of this type of analysis is to look at economic and financial data and put a number on the intrinsic value so it can be determined if it’s undervalued or overvalued and perhaps be compared to alternative opportunities.
The process to determine intrinsic value involves discounting the future cash flow of a business back to its current value. If the market value is deemed to be higher than market price then the stock is considered to be undervalued and vice versa. Fundamental analysts will review company financials such as balance sheet, income statement, and cash flow statement. The method can be divided into three categories of study:
- economic analysis
- industry analysis
- company analysis
These areas are all pretty intuitive. As mentioned, fundamental analysis will look at both macroeconomic factors such as inflation or GDP and microeconomic factors such as compensation. Industry analysis will examine the security in question’s sector specific tailwinds or challenges verses other industries. Company analysis aims to figure out if the company’s core business ratios such as P/E or Debt-Equity are inline with competitors. Analysts of this mindset will take a longer term approach to a stock than a technical analysts because the data is produced at a much slower rate. Consider that financial statements are generated quarterly whereas price and volume movements happen daily.