Basic investing strategies in the stock market…

The very term basic investing strategies in the stock market can be quite diffused. There is a plethora of ways to approach the markets. When we are talking about strategies, we are talking about approaches to investing. If we were to take all the different approaches and classify them into a few broad baskets, then we can have 5 broad investing strategies that investors can adopt. Of course, no investor looks at these 5 strategies as discrete choices and there is some part of each of these strategies that investors use at different points of time.

Strategy 1: A value based approach to stock markets…

This approach is also popularly referred to as value investing. The core of this strategy is to identify stocks that are beaten down and are therefore available at very low P/E ratios or low P/BV ratios. Normally, P/E ratios are used as a benchmark for manufacturing companies while P/BV ratios are used as the benchmark for financial services companies. Normally, the value companies are those that are beaten due to a mix of internal and external factors but considering the future potential, they may be good stocks available at attractive levels. The waiting period for value stocks can be long but if it works out then one can look forward to super-normal returns on the stock.

Strategy 2: A growth based approach to stock markets…

The growth based approach to investing is slightly in contrast to the value based approach. The growth approach does not obsess itself too much with low P/E ratios and high P/E ratios. Under the growth based approach, P/E ratios are largely irrelevant if the company is able to sustain growth in sales, growth in profits as well as high levels of ROE. The private banks are classic examples of growth stocks where valuations may be quite rich but the high growth and ROE are used as justifications for these valuations. Normally, growth stocks have momentum in their favour and institutional investors also are known to prefer this growth-based approach to stocks. Returns can be quicker in case of growth stocks but such stocks are also quite vulnerable to sector and macro level shocks.

Strategy 3: Income earning approach to stock markets…

This is a slightly more conservative approach to investing. Normally, investors tend to invest in bonds in search of stable returns. An alternate could be to invest in high-dividend yield stocks. Classic examples are stocks like Coal India and NMDC which have dividend yields in excess of 6-7%. The reason dividend yield approach works is that dividends are tax-free in the hands of the recipient up to a limit of Rs.1 million per annum. A 7% dividend yield, therefore, becomes equivalent to 10% return on bonds. This is what makes the dividend yield approach to stocks quite useful for conservative investors. There are some investors who also use the earnings yield approach (inverse of P/E ratio) as a proxy for income earning capacity; but that is not very popular.

Strategy 4: Trend based approach to investing in stock markets…

This approach is very popular among traders and short term investors. This trend-based approach largely relies on technicals and charts that captures past price experiences through sophisticated tools like divergence, oscillators, supports/resistances, MACD etc. This approach is based on the premise that past trends in price and volume will tend to repeat in the future and therefore entry and exit into stocks can be timed by studying and extrapolating past experiences. However, this approach is not too conducive to long term wealth creation as the short-term approach tends to overlook larger fundamental trends and fundamental shifts that are happening in the sector. Also this approach works only in case of companies that have a price and trading history; not otherwise.

Strategy 5: News or Event-based approach to investing in stocks…

This approach is popular not only among smart traders and proprietary desks but many large funds also run such event-based funds. This approach tries to bet on specific events like credit policy, union budget, quarterly results, Fed policy etc and then takes a view and assigns probabilities to outcomes. This approach manages to capture the momentum in the best possible manner. To be frank, this is not a very scientific approach to investing but it is a very useful and pragmatic way to capture the momentum surrounding specific events. However, it needs to be remembered that this approach is quite a risky approach and hence proper risk management as well as checks and balances are a must to adopt this strategy.

There are different ways to create a strategy for investing in this market. More often than not, companies may qualify under more than one of these approaches. Normally what investors do is to rely on either the value approach or the growth approach to identify stocks for investing. Subsequently, the trend based approach is used to decide the timing and phasing of the entry and exit. After all, when it comes to investing, it is an eclectic approach that always works best!

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