What Investing Strategy does Warren Buffet follow?
In my last blog I talked about the difference between Trading and Investing, the two main approaches when it comes to investing in the stock markets. I also briefly touched upon several trading strategies that one could follow. In this post I will be enumerating and explaining the different investment strategies for retail investors.
Value Investing
Value Investing is one of the most commonly known and widely followed strategies in the entire world. If you’ve never heard this term before, does Warren Buffet ring a bell? He is one of the most remarkable people who preaches Value Investing and learnt under the guidance of Benjamin Graham, who is regarded as the world’s first value investor.
The entire strategy is based upon identifying stocks that are cheaper than their intrinsic or real value. ‘Buy low and sell high’ is a phrase you would think of in this context, but Value Investing entails much more. The first step in a value investor’s research is to calculate a stock’s intrinsic value. There are numerous ways of reaching this amount, but there is no way of knowing if your computation is completely accurate or not. It’s all about the closest estimation.
Intrinsic value = [EPS × (8.5 + 2g) × 4.4]/Y
This is the formula Benjamin Graham gave to calculate a security’s intrinsic value. 8.5 is the PE Ratio of a stock with 0% growth and g is the growth rate for the next 7–10 years. 4.4 is the rate on high-grade corporate bonds in the US in 1962 and Y is the Yield on AAA rated corporate bonds in the same year. This formula has been subject to various modifications throughout the years, and according to valueresearchonline.com the following is the formula best suited to Indian markets today.
Intrinsic value = [EPS × (7 + g) × 8.5]/Y
After reaching a fair estimation of intrinsic value, the next step is to calculate the percent difference between the actual value and the computed value. According to Warren Buffet, the margin of safety, or the excess of actual value over intrinsic value, should be at least 25%.
Calculating intrinsic value through these simple formulas, however cannot be compared to the rigorous processes carried out by institutional investors, but it will give you a fair idea of whether a stock is undervalued or not.
Another tool widely used by Value Investors is P/E ratio.
P/E Ratio=Earnings per share/Market value per share
The lower the P/E Ratio, the more suitable the company is for value investors. This ratio alone is not enough to make your investments successful as the number can be easily manipulated by the company. However, if accompanied with qualitative research and analysis of historical data about the company’s financial performance, P/E Ratio can be a valuable tool for your investment decisions. (I will discuss PE Ratio in detail in a later post)
Growth Investing
As the name suggests, Growth Investors look to identify companies with huge growth potential. Unlike Value Investors, Growth Investors do not place much emphasis on analyzing the Intrinsic Value of a stock. Rather than looking for cost-efficient deals, they are in search for ‘the next big thing’. This might sound similar to speculative investing or trading, but Growth Investing is based on solid research and is thus quite different from speculation.
Growth investors spend time researching the company’s health which includes qualitative as well as quantitative aspects. Quantitatively, a company’s revenue and its profits should be on the rise to indicate widespread demand. Qualitatively, the company should maintain a positive public image and the industry should have huge growth potential. For example, a growth investor might look towards Tesla and think about the future of the Electric Vehicle industry.
A downside to Growth Investing is the lack of dividends offered as all companies with massive growth potential will look to re-invest their earnings into the business for expansion or diversification.
Income Investing
Income Investing focusses on building a regular stream of income for investors through stock market or money market (which we will talk about in a later post) instruments. Unlike Value and Growth Investors, their end goal is not to achieve long term capital growth but to invest in securities which give regular returns in the form of dividends, interest payments or bond yields.
Income Investing is considered to be one of the safest strategies as the securities involved are extremely low-risk. It involves the following instruments:
- Stocks - Income Investors look for shares with high dividends which have been constantly increasing over the past few years. If an investor wants to ensure a minimum amount of payment, then they can opt for preferred stocks instead of common ones.
- Government Bonds - It is considered to be one of the most secure investment instruments in financial markets as you’re indirectly lending money to the government, and the chance of the government defaulting on its payments is very little and can only happen in case the economy or the political structure of a country fails. Bonds pay out regular interest payments in return for the money borrowed.
- Corporate Bonds - These are similar in structure to Government Bonds but carry a higher risk of default. However, with an increase in risk comes an increase in potential returns on the amount invested.
- Interest-bearing Accounts - Another option for generating regular income is to open interest-bearing accounts with banks. Banks offer a wide range of instruments such as Fixed Deposits (FD), Regular Deposits (RD), Savings Accounts etc.
Index Investing (Indexing)
Index Investing is a form of passive investing that involves the purchase of a number of securities to generate similar returns to a market index such as the S&P 500 or the Nifty50. You could replicate indexes by individually buying all the weighted securities it comprises of, or you could find an Index Mutual Fund or ETF managed by a financial institution. Most people go for the latter option as they are efficiently managed by a large institution for a minuscule amount of fees.
Apart from being easy to understand and carry out, historical data suggests that indexes such as the S&P 500 have achieved higher returns than actively managed portfolios in the longer run.
Index Investing is all about putting your eggs in multiple baskets so that even if one stock dips the others can cover its loss. A diversified portfolio also helps in minimizing risk over the long as well as the short term.
The Bottom Line
We talked about just four investing strategies in this blog, but you should know that there exist many more. If you feel none of these techniques match your personality or your short/long term needs, then don’t be perturbed; it’s all about carrying out research and identifying which one suits you perfectly.
Thank you for reading the fourth article of Poor Sheep. Stay tuned for more!
