What is meant by the term value buying? What are the typical signs of a value stock?
In the context of the stock market, value investing means buying a good quality stock at a cheap valuation. It is something like buying items (clothes, shoes) in a ‘sale’ or when they are available at a discount. Two factors are very important here. The stock should be of a ‘good quality’ company and it should be available ‘cheap’. Sometimes, value investing gets confused with buying whatever is available cheap. That is not value investing. On the contrary, it could end up being a value trap resulting in no returns over a period of time. As an analogy, it means buying brands like Zara, Puma, Zodiac, Van Heusen during a sale. A discount bargain at a roadside stall may not necessarily be value investing.
The technical definition of value investing is buying the stock of a good quality company at a price that is lower than its intrinsic value. Intrinsic value here refers to the present value of income generated by a company in future years. You calculate this by taking the income and then applying a discount rate. A discount rate is needed to find the present value of the cash flows. It denotes the expected return on an asset. A back of the envelope method is to take the long term government security yield, say 7 percent then add 5 percent to that to get 12 percent as the risk-adjusted return an equity investor would expect to make in the long run.
What is a defensive stock? What are the pros and cons of investing in them?
A defensive company is one whose earnings are stable amid the ups and downs of the economy. The main reason for the stability in earnings is that their products have steady demand irrespective of the business cycle.
A defensive stock is the stock of such a company. Stocks from FMCG and IT sectors are generally considered defensive. Earlier, pharma also used to be considered defensive, but that does not seem to be the case of late.
Defensive stocks move slowly, relative to the market. Relative here is with reference to the movement of the major indices like Sensex and Nifty. This means that if the market falls by 10 percent, this stock will fall lesser than 10 percent. It could be 4 percent or 6 percent. Mind you – this holds true in both directions. So, if the market moves up by 10 percent, a defensive stock will rise less than 10 percent. The advantage of investing in such stocks is that in a falling market, the decline in the value of your portfolio will be lesser. Obviously, the disadvantage is that in a rising market, your portfolio will appreciate less. An ideal portfolio will have a good mix of defensive and non defensive stocks. Defensive stocks are also known as low beta stocks.
What is a growth stock? What are the pros and cons of investing in a growth stock
Growth stock means the stock of a company with a high rate of revenue growth. ‘High’ will of course be a relative term, depending upon the overall growth rate of the economy, and the growth rate of other sectors. In case of an economy like India, which has a nominal GDP growth rate of around 10 percent, any company having a growth rate of 15 percent or higher will be considered a growth stock. Of course, the high revenue growth should convert into equally high or better growth in profits. Otherwise, the growth doesn’t have any meaning. Generally, growth stocks come from new/emerging sectors in an economy. IT was a high growth sector in the 90s. Till a few quarters ago, NBFCs were high growth companies. Before that, consumer durables firms were seeing high growth due to increasing penetration, rising affordability, improving living standards and increased power availability.
The advantage of investing in growth stocks is that investors get the benefits of two triggers. One, the stock price will anyway appreciate as long as the company’s earnings are growing. Two, if the growth rate exceeds market expectations, a growth stock will get re-rated. Meaning, investors will be willing to pay a premium. For instance, assume a growth stock is being valued at a price earning multiple of 15 based on the assumption of a certain growth in revenues. If the market sees potential for even higher growth, it will value the stock at a price earning multiple of 20. This will cause the stock price to appreciate quickly.
On the flip side, markets are quick to punish growth stocks harshly if the growth in earnings falls short of expectations. Just like stocks get re-rated when the going is good, they are de-rated when the business environment gets tough. So if a stock was valued at a price earning multiple of 20 assuming a certain revenue growth rate, it may be valued at a price earning multiple of 10 if the market fears that the growth rate could fall.
Growth stocks are also called high beta stocks. They will rise more than the market in an uptrend, but fall sharper than the market in a downtrend.
What is a dividend yield stock? What are the pros and cons of investing in them?
Dividend yield is the annual dividend divided by the current stock price, multiplied by 100. If a company has given a total dividend of Rs 10 during the year, and the stock price is Rs 150, then the dividend yield will work out to 6.67 percent (10/150 X 100).
Theoretically, any stock that pays dividend will have a yield. But dividend yield typically refers to those stocks where the yield is on the higher side. Higher side means a yield closer to the prevailing rate of interest. So, if the interest rate is 7 percent, a dividend yield stock will be one which gives a yield of at least 5 percent. The important thing to note here is that the stock should not keep losing its market price with time. If that happens then the yield is irrelevant as you will lose more in the price drop of the stock than what you have got by way of dividend. Generally, dividend yield stocks come from annuity businesses, rental businesses, high cash businesses, utilities etc. Also note that high performing companies (blue chips) will never be good dividend yield stocks even if they are paying very high dividends. This is because their stock prices are so high that even a high dividend results in very low yield. The advantage of these stocks is the regular income that an investor keeps getting and he does not necessarily have to sell his shares when he wants some money. Further, the dividend income is tax free up to a certain limit.
What is momentum trading? What are the pros and cons of momentum trading?
In momentum trading, traders buy and sell according to the strength of recent price trends. Here, price momentum is considered similar to momentum of physical objects subject to laws of physics.
In momentum trading, there is an underlying assumption that Newton’s first law of motion (applicable to physical objects) is also applicable to price trends. The law is as below -
Every object remains in the state of ‘uniform’ motion (or rest) unless acted upon by external forces which will change its state of motion (or rest).
Thus, momentum trading assumes that a particular price trend in the market will continue and can be taken advantage of. Obviously, its benefit is that if you get the trend right, you can make good money in a short time. Remember, momentum has nothing to do with the fundamentals of the company. If the stock price of a poor quality company has been rising, the trend could continue for a while even if the company’s fundamentals are unlikely to improve in the near future. Likewise, if the stock price of a fundamentally sound company is falling because of weak market conditions, you could profit from short selling that stock even if the fundamentals don’t justify the price.
The disadvantage is the huge loss that one can suffer when the trend changes, and almost always, without warning. If you are chasing momentum in a bull market, chances are that you may be left with dud stocks when the sentiment changes for the worse. Likewise, if you are short selling a quality stock in a bear market, you may be caught in a ‘short squeeze’ if the market suddenly acknowledges the true worth of the stock.
What is a value trap?
Value trap is buying a poor quality or average company simply because it appears to be available cheap. Often, a stock trading cheap tends to seem attractive, irrespective of its fundamentals. This usually happens when the stock has fallen sharply from its highs. Many people invest in stocks whose absolute prices are low in absolute terms say, below Rs 10 (also called penny stocks). Some people follow a strategy of investing in stocks that have fallen by certain level, say 50 percent. Some others invest in companies which are at a 52-week low. However, adopting such tactics without looking at the company’s fundamentals results in poor outcomes more often than not.
How can I avoid value traps?
Value traps are so called because they are hard to spot. Even experienced investors are occasionally known to fall for them. One way to avoid value traps is to analyse the company’s fundamentals rather than being tempted by a low price in absolute terms. Check out the financial performance, industry scenario, management quality and future growth expectations. A detailed SWOT (strength, weakness, opportunity, threat) analysis will always be helpful.
Accomplished investors and fund managers often talk about ‘the power of compounding’. What does it mean?
Power of compounding simply means money generating more money. In other words, if you keep reinvesting the returns generated from an investment instead of taking it out, your returns will obviously be far higher, than if you were to withdraw the returns. That is because both your original investment (called principal) and subsequent returns start to generate more return after being reinvested. If you keep withdrawing the returns periodically, only the principal will generate returns.
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