04 Jul 11 Most Common Investing Strategies
Investor strategies are as varied and colorful as the people who employ them. The following require little introduction, but it is sufficient to note that rarely do investors stick to a single strategy, especially those one might consider the most savvy. Without further adieu.
Long & Short Positions
Long and short positions are two diametrically opposed ways of investing. The most sophisticated investors, including hedge funds, employ both long and short positions simultaneously to protect their exposure to risk. Conventional stock investing includes long positions in a security. That is, an investor buys a security with the hope, desire and expectation that the security will appreciate in value over time and eventually be sold for a nice profit. Long investors actually maintain ownership in the underlying business. That is, they actually own the shares in which they invest. In some instances an investor may take a long position in a derivative instrument. In this case, the owner will profit when the value of the derivative itself rises, even if the value of the underlying assets has decreased. This is referred to as a put.
On the other hand, short investors are looking for a profit when the value of the security declines. In contrast to the long investor, short investors do not actually take ownership of the underlying shares or equity in the business itself. No, they simply borrow the security at a cost and then sell the security in the open market, hoping to profit on the spread when the price falls. Stock “shorting” is an interesting phenomenon that allows investors to profit by selling shares of stock in which they do no actually own. But, at some future point, the investor must buy the securities to cover his or her short position that was previously sold. Profit from a short strategy comes from selling short, profiting in the amount of the decline less any borrowing costs of the underlying security. Unfortunately, this strategy can cut deeper and is much more risky than many long positions. For instance, if the price of the stock rises, the investor can realize significant losses.
Many sophisticated investors will also combine a short strategy with the long game in order to protect gains in the same security.
A distressed investing strategy acts almost like it sounds. Companies in financial distress are often targets for this type of investor. These types of companies could include those in or emerging from bankruptcy. Equity investors may take a position in companies restructuring through bankruptcy, but the debt holders are typically in the best position as they have priority in liquidation in the unfortunate event that such should occur.
Distressed investing does not come without its risks. However, operating in this world can prove quite lucrative. Just ask Warren Buffett who doubled-down on Wells Fargo during the financial crisis or the debt (not equity) holders in Enron or Worldcom. In many cases, distressed debt can pay double digits above that of the typical Treasury yield. Investing in distressed businesses requires a great deal of confidence that the underlying business can perform a successful turn-around and right the ship. I suppose Buffett wholeheartedly believed that Wells Fargo’s brand was strong enough to withstand the potentiality that it would fail. Distressed investing does not track similarly with the overall market and performance in various distressed assets can have some large volatility and variability as well as higher risk. Hedge funds, private equity and even some mutual funds pursue this strategy. In fact, most investing in the distressed arena occurs on the larger institutional funds, not by individuals. However, there are some institutional investors, like pension plans, that are precluded by their own internal rules from taking on these high-risk opportunities.
Income investing is one of the most conservative strategies available on the market. As such, most of those that are found using an income-based strategy for investing are typically concerned with preservation of capital for an extended period. Retirees and others on fixed-incomes often rely heavily on investment income for regular and recurring expenses. Hence, an income strategy is more common among this demographic.
Value & Deep Value
Much like the distressed investors previously mentioned, value investors are on the constant hunt for stocks that are undervalued. In typical fashion, value investors are those that will buy and hold stocks until the market finally recognizes the stocks’ true worth and the price rises. This is where value investors make their profit. The investor’s objective is to find and purchase stocks that are under-priced, but whose underlying business is still performing well. Fundamental analysis techniques for comparing P/E ratios and the like are often implemented in order to understand which stocks are being offered at a value. Value investing is not a quick strategy. It requires a decently long time horizon to realize the true value of the underlying securities.
Similarly, “deep” value investors are on the hunt for stocks that are significantly undervalued relative to the underlying performance. Deep value investors are not looking for a deal, they are looking for a killer deal. If the issuer does not go out of business, these investors are looking to profit from the upside potential in the deep value investment. Deep value investors are typically on the hunt for companies that may have been tarnished in some way and the market is currently “punishing” them. Thus, their current market price may be significantly below a true value. This often occurs in companies that may have been part of a scandal or some other form of bad publicity.
The typical momentum investor is seeking a stock with positive “momentum” in an upward direction and on high trading volume. Stocks that are trading above or at their 52-week highs would qualify for a typical momentum investment. The theory is that such a stock will move higher still as momentum continues and the investor can sell at a profit. Momentum investors can also do the same thing with downward momentum by selling short. The long momentum investor will typically sell the stock once there are signs of weakness that the stock rise may slide. Momentum investors are not long-term investors. They seek a quick profit on the rapid rise of a single or small group of stocks. Unfortunately, this type of investing strategy typically ignores security fundamentals like P/E and PEG ratios. They are typically concerned with ensuring they are following and timing a rapid surge in volume in the sale or purchase of the company’s securities.
Index investing involves duplicating the returns of a specific market index. Indexes such as the S&P 500 or any of the various Russell indexes are good examples. In most cases, index investors purchase shares various index funds, rather than buying individual stocks across the index. Index investing is very much a buy and hold strategy. Investing in indexed funds requires little to no research, experience or analysis. Fees on indexed funds are typically much lower than actively-managed funds. The age-old debate over indexed vs. actively managed funds is likely to never die. Index investing is one of the more common practices, particularly among most retail equity investors.
Take your pick in energy, technology, healthcare, financial services, manufacturing or biotech. Each of these fields represents a very specific niche that investors may target. An investor that focuses on a specified sector is likely to become more an of expert in that field and thus (in his/her own mind) have a pulse on arbitrage or exploitation opportunities that others might not see. In addition, a sector-specific investor may pool a basket of stocks in a particular sector. Or, in contrast, a sector-specific investor is likely to pursue a broader strategy of purchasing stocks across a varied mix of companies within a given sector. While individuals can and do pursue a sector-specific investing strategy, most sector investors are comprised of institutions, including private equity groups, mutual funds and hedge funds.
Quantitative or “quant” investing, as it is sometimes called, is a strategy that uses vast amount of big data resources in search for patterns that can be used for exploitation and profit by a group of investors. Many times a quant strategy involves looking for arbitrage opportunities within the data. Hedge funds are particularly adept at using quantitative trading strategies to profit from aberrations in the market. A quant strategy does not simply look at a single stock, but takes into account as many stocks as possible, using computer algorithms to analyze the data and extract meaningful clues as to how profit may be extracted. Stock prices are often predicted from complex algorithms that seek to find in-depth patters and/or changes in stocks over specified periods of time, usually a moving average.
Quantitative investing is neither a technique used by or available to retail investors.
Arbitrageurs typically look to exploit various price disparities in the price of a specific security, currency or commodity. They will look at two different markets, analyze where the market is cheaper, buy the security cheaply and immediately resell on the market where the security or other instrument is more expensive. Arbitrage investing is time-consuming as it requires an active view of the markets in which the arbitrageurs play. True arbitrage has very low risk, however, because the prices of the buy and the sell are known well in advance of the transaction.
Also referred to as takeover or merger arbitrage, risk arbitrage is a strategy used by investors who seek to profit from a potential takeover or M&A situation. For instance, such an investor may anticipate a transaction and thus seeks to profit on the expected changes that occur in the price of both the target and the acquirer’s stock. In most instances, risk arbitrageurs will purchase shares in the target to be acquired, assuming there will likely be a rise in the company’s stock. In some cases, the investors will also short the buyer’s stock, assuming the reverse will be true from the acquirer’s perspective. There is risk here as mergers and acquisitions can often be cancelled for regulatory or other reasons. If this occurs, the investor may lose a significant amount of money.
Unusual circumstances may cause a stock to fluctuate in unexpected ways. Special situation investors seek to profit from either the positive or negative impacts of these unique changes. For instance, the loss of a major customer, bad publicity, a merger, fraud, company restructuring or operating in a regulated industry may all be grounds for shorting a company’s stock. These types of investors typically do not make long-term investments in a company’s securities. There is also a lack of focus on the underlying fundamentals of the business. The special situation itself becomes the fundamental wherein the investor seeks to profit when the special situation ends and s/he can buy or sell the stock at a profit.
Investing is a complicated game for both individuals and institutions. These most common strategies for investing are meant to provide a small insight into some of the ways and means both individuals and institutional investor operate in a complex and changing market. There is never a one-size-fits-all approach to investing. What is right for a hedge fund or private equity group is almost always dead wrong for an individual investor. When making business or investing decisions it is always wise to solicit for knowledgeable, professional guidance.
What’s your investing strategy?