But what is the best information to pay attention to and what do you ignore? Does the economic cycle, for example, have more influence on a company’s share price than the quality of the management running that company?
Unfortunately there is no right or wrong answer. Professional investors consistently argue for and against the effectiveness of using different types of information. In the end the best information to pay attention to depends on whether it works for you.
The different types of information individual investors pay attention to are categorised and called investment strategies. Among the most common of these are: top down, bottom up, value or growth, large or small cap, ethical investment and technical analysis.
Top Down and Bottom Up
Value v growth
Large v small cap
Thematic investing
Technical analysis
Are global economics a more important influence on how well your investments do than the health of individual companies themselves? Whichever you decide is more important will determine whether you can be categorised as a ‘top down’ or ‘bottom up’ investor.
If you think that correctly analysing the economic environment and basing your investment decisions on your assessment is the best way to pick shares, you can classify yourself as a ‘top down’ investor. Followers of this investment strategy believe that picking individual stocks comes second because if the economic conditions are not right for the industry a company operates in, it will find it difficult to make profits, regardless of how efficient the company is.
But, if you think that identifying individual companies that can grow rapidly and have attractive valuations is more important, you are a ‘bottom up’ investor or a ‘stock picker’. Bottom up investors look at a variety of factors to work out which companies have the best opportunities, including strong management and growing market share and then look at whether these positive aspects are reflected in the share price. If they don’t believe they are, the shares are worth buying.
In reality professional investors tend to employ an element of both strategies when making investment decisions.
Another way investors categorise themselves is by whether they are growth or value investors.
Growth investors invest in companies they think will produce the fastest growth and are usually prepared to pay premium prices to buy them. Growth investors are usually happy to pay more for these companies, which tend to have high price earnings ratios, because they think that over time, share prices reflect the earnings a company is capable of producing. Growth investors also tend to follow the ‘bottom up’ style of investing.
Investors who spend most of their time trying to find companies that look cheap in relation to their real worth or potential future value are called ‘value’ investors. Companies that fall into the value camp usually have low price/earnings ratios (P/Es) compared to other businesses in their sector.
There is no simple answer to whether growth or value investing is best, as each goes through cycles and many investors tend to employ an element of both strategies. Growth investors will, for example, usually pay attention to the price they are paying for shares. They prefer to call themselves ‘growth at a reasonable price’ or ‘GARP’ investors. This means that they are only happy to pay what they regard as a fair price for a company’s shares.
Similarly, value investors do not simply go out and buy all the companies with low P/E ratios. Instead they look for reasons why the company is lowly rated to weed out the good companies from the bad. It may, for example, have poor management and therefore deserve its rating. But if the company later puts better management in place you might decide that the company’s prospects have improved and that the shares are too lowly rated.
Stock market investors often characterise themselves by the size of companies they invest in. Size in stock market terms is not measured by looking at the value of a company’s assets but by the total value of its shares in the market, known as the market capitalisation or ‘cap’.
Big companies will often be referred to as ‘large caps’ or, in the UK, as blue chips while smaller firms are known as ‘mid caps’ or ‘small caps’. Shares in these three different size categories often perform in a similar way. The largest companies, for example, are usually more attractive to overseas investors because their shares are traded more frequently which makes them easy to buy and sell. Big companies are also more attractive to investors during a recession because they dominate their markets and so are less likely to go bankrupt than smaller firms.
But large companies are very well researched by professional investors and this can make it harder to find ones that are undervalued. They also tend to produce lower growth rates than smaller companies. For this reason some investors prefer focusing their portfolios on this part of the market. Investing in smaller companies can, however, be more risky as these firms are more likely to suffer financial problems than larger companies.
Other investors, however, think that it makes more sense to move between large, medium and smaller companies as market conditions dictate. These investors are often said to have a ‘multi-cap’ approach to investing.
With the world becoming an increasingly global marketplace an increasing number of investors have started to look at the major themes that drive share prices around the world rather than just focusing on how share prices move in local markets. This strategy is called thematic investing.
One of the major themes that drives share prices, for example, is population change. Many countries, including the UK, Europe and US have ageing populations. Older people spend more on healthcare and financial services and, so the theory goes, companies in these sectors will do well regardless of the country where they are listed. Another theme is technological change, which could be positive for technology companies long term.
Global themes are not, however, the main influence on all sectors of the market. Retail stocks, for example, are driven more by wages and employment in local markets than what is going on at a global level.
A different type of thematic investing is ethical investment. Investors who follow this strategy seek out companies that adhere to certain ethical criteria, perhaps avoiding those that damage the environment. Shares in sectors such as tobacco and defence are typically avoided.
The rise of home computing and the Internet has brought a whole new world to the fingertips of investors. Technical analysis of shares is no longer the preserve of the professional investor but something any private investor can do.
Technical analysis, also known as Chartism, is simply the study of past share price movements and stock market index trends, which are then used to forecast how shares and stock markets will behave in future.
Some investors view technical analysis as a kind of crystal ball gazing but few ignore it completely and many professional investors employ people to analyse what history may teach us about the future.
Technical analysts try to identify, for example, trends in a variety of stock market charts. They argue that if the charts show an upward trend, investors should continue buying. If, however, the charts show a downward trend, you should sell. They also look at moving averages, showing changes in the average share price over specific periods, say a month., and employ a range of other studies to predict future share price movements.