Finding a company to invest in can feel like you’re on the game show Perfect Match.
It was a TV show where one lucky individual gets to choose between three hidden candidates for a date based on a short Q and A. The trick is to ask the right questions. And to not get the theme song stuck in your head.
It’s the same when you’re investing. What questions should you ask the companies you’re thinking about investing in? How do you figure out which is the best fit for you? And how do you shut out the ‘noise’…the distractions that can cause you to make the wrong decision?
Today’s Money Morning is about three types of investor: the speculative investor, the value investor and the technical analysis trader. Each of them uses a carefully thought out strategy to make their buying and selling decisions.
So that you can see all three of them in action, we’ve thrown in a mystery stock for them to analyse…
Which Investor Are You?
Here’s the scenario: the company is recovering from prices not seen since the global financial crisis. It narrowly escaped the mining tax, but the main commodity it mines has taken a breather after a ten-year bull market.
This year’s ordinary dividend is 17% higher than last year’s, and the company has just issued significant debt to fund operations.
The Speculative Investor
What would the speculative investor say about such a stock? Well, speculators like triple-digit returns in short spaces of time. Those are much more common with smaller companies.
Unfortunately, the mystery stock isn’t exactly likely to double in value any time soon. It’s just too big and predictable already. Nothing much unexpected could happen here.
But speculative investors do like resource companies. That’s because the chances of big moves are very high, especially with explorers.
Most speculators buy into a stock before the company pays a dividend. Speculators are after big gains, so that means buying the stock before the company has made a profit.
Buying a stock at the early stage of exploration can mean big returns if the company strikes a resource…or it could mean a loss if the company doesn’t find a resource.
In other words, will the company uncover a vast supply of profits, or a bottomless pit of costs?
But some speculators look at bigger companies too, especially if the speculator can leverage their position using a margin loan, CFDs or options. So if the company is profitable, but it’s just hit a rough patch, it could be a stock worth looking at.
The Value Investor
How about a value investor? They are more like bargain hunters than gamblers.
They try and establish a value for a company based on its business. The question is, is the mystery stock a bargain or not? Here’s what this type of investor might look for:
- Earnings history
- Book value relative to market prices
- Earnings forecast, and if it is reasonable
- Long term business prospects
- Debt
- Does the company have responsible management?
Having established a ‘fair value’ share price, a value investor would then look at the share price. If the shares are trading below the ‘fair value’, the stock may be a buy.
Value investors also look at dividends as an important indicator. For our mystery stock, the company has a good record of raising dividends. It has also paid a special dividend, which tells you management aren’t afraid of returning cash to shareholders.
You can look at a cash return in one of two ways: it’s bad because it indicates they can’t use the cash to expand the business, or it’s good because it enhances returns.
There are endless books written on the intricacies of value investing. Warren Buffet is perhaps the world’s most famous value investor. But, unless you’re dedicated to valuing companies, going through the process can be time consuming.
That’s why value investors use a few short-cuts to make the analysis a bit easier. They use something called ratios. For example, the quick ratio compares current assets to current liabilities. It tells you if the company is safe in the short term.
The Stock Market Trader
Finally, what would a stock market trader make of this stock?
Stock traders who use technical analysis reckon they can make predictions about a company’s share price, just by looking at a company’s price history. They look for patterns and other hints that have signalled price trends in the past.
The other integral part of successful trading is a risk management strategy to make sure that wins add up over time.
For a technical trader, it’s not as important to know about the balance sheet or profit and loss (although it does play a part for some traders). The trader is more interested in the price action.
In the case of our mystery stock, if it had fallen another five dollars from its lows last month, it would have hit its 2009 low. When a share price hits an important price level (such as a previous high or low) it gives the trader a clue on where the share price is headed next.
One Stock, Three Different Approaches
So, what is our mystery stock? And who should speculate, invest or trade it?
The stock is Newcrest Ltd [ASX: NCM]:
The truth is, it probably has a bit of something for every type of investor.
The speculator could make a few quick bucks if the price rallies higher with a rising gold price…
The value investor could see a bargain buying a profitable resources company where the share price has fallen 32% in a year…
And the trader could profit along with the speculator if the share price reverts to its longer term trend…or short sell if he or she thinks the price could continue the short term down trend.
It’s interesting to see how many different ways you can look at a single stock.
It’s very rare to find companies that suit all the types of analysis. But one of the good things about the stock market is that you can usually find a company that fits whatever it is you’re looking for.
The question is, what are you looking for? Do you want a short-term trade? Do you want the thrills and spills of a volatile small-cap? Or are you looking to invest part of your retirement fund?
It’s easy to go astray if you don’t start with a clear goal and method in mind. That’s what separates the good investors from the broke ones. Establishing a strategy and sticking to it.
Nick Hubble
Editor, Money Morning
PS. Sound Money. Sound Investments editor, Greg Canavan, is a value investor. But he doesn’t just look at individual companies, he also looks at the big picture too. And right now there’s one economic story he just can’t ignore. In fact, he has prepared an extensive report on the biggest threat the Australian economy faces, and what you can do about it…whatever type of investor you are. You can find it here.
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