Top 3 Investment Philosophies Explained

Did you know that ace investors follow some basic philosophies while investing and selecting stocks? Their choices and selection of stocks are based on several factors such as value, growth, contrarian, risk appetite, as well as on market-caps, namely, small-cap, mid-cap and large-cap. Some of them even follow the principles of world-renowned investors such as Warren Buffett.

Let us now understand these three philosophies and their principles.

Value Investing

The term ‘value investing’ simply means focusing on the value rather than its price. For a better understanding, let us take the example of mobile phones. When you go to a mobile store and select a model, the seller will offer you the Service at its maximum retail price (MRP). However, if you purchase the same Service on a ‘bumper sale day’, you will get the same model at a much discounted price, thereby enabling you to save a lot of money. Purchasing the same model on the right occasion shows your ability to identify the true value of any asset and wait for the perfect time to get hold of it. Thus, there is always a right time to purchase any stock, which can no doubt vary from one stock to another. Therefore, if you follow this method, it can help you gain healthy returns.

The real challenge in this process is finding a Service’s true value because for the same stock, different analysts might derive different intrinsic values. Investors gain by entering into such stocks at a heavy discount, which also provides them a margin of safety. Nevertheless, the ‘bumper sale’ of mobile phones may come many times in a year, but this may not be the case with the stock market.

Value investing involves digging through the entire universe of stocks and finding specific stocks where a ‘sale’ could be taking place. One should keep in mind that the general characteristic of value investing is that it should trade lower than its asset value, which can be measured by its P/B ratio. Further, a lower P/E means the stock is available at a lower multiple to its earnings than earlier.

Also, the discounted cash flow (DCF) is another valuation method used in this philosophy to estimate the value of a stock based on its future cash flows. It is an in-depth and thorough process that takes one closer to accuracy. There could be different reasons for lower valuations. One of the reasons could be that the overall economy is going through tough times, thereby causing the investors to panic and sell stocks massively and forcing the prices to go down. Due to such negative sentiments, the stock might fall beyond its true or intrinsic value, but one needs to perform a thorough analysis before taking a ‘buy’ call on the stock.

Growth Investing

It is a philosophy where investors try to identify a business that has strong growth prospects, which could be in the form of higher profit growth and higher return ratios such as return on assets (ROA), return on capital employed (ROCE), return on equity (ROE), etc.

Simply said, growth investing targets businesses that tend to earn consistent high returns on their invested equity, assets, etc., for at least five years. The companies that qualify under the growth investing category generally have a very low dividend payout ratio or the company may not be paying a dividend at all. These companies reinvest a major portion of their earnings back into the business for future expansion.

The stocks that may fit into the growth investment style are the ones that are presently in the initial stages of the business cycle or those that are innovators of new products or services that might help the business grow faster in the years to come. Such types of companies might also belong to an industry with average performance at present, but with a huge scope of becoming a game-changer in the long-run. The core concept behind this strategy is that the business is likely to prosper and grow faster and, as a result, its revenues and earnings might also grow in future. This would lead to an upswing in its stock price going forward. Growth stocks mostly demand higher valuations, i.e. their market price tends to be really higher than sales, earnings and book value (i.e., high P/E, P/B and P/S). In terms of risk factor, growth stocks are categorised as high-risk investments as most of the companies in this investment category are small or mid-sized.

Contrarian Investing

Contrarian investing involves high risk and requires a futuristic view of the company and its area of operation. In the contrarian investment style, investors try to identify and bet on the stocks which are not normally on the market participants' radar and also liquidate them when other market participants begin investing in them. The main idea in contrarian investing is going against the market view and finding mispricing of stock, which could be either undervalued or overvalued. In this type of investing, investors need to go beyond the herd mentality, i.e. betting against the stock which is being favoured by other market participants. In the short-term, investors may have to bear some losses as it may take some time for the bounce-back in the stock to happen. It requires courage and pain-bearing ability to go against the wind, but stellar returns can make you forget the pain.

Conclusion

Each of the above philosophies has its own advantages in choosing the right stocks that can earn huge returns. We all know that an investor's portfolio must be diversified. Hence, if an investor buys stocks following the above three philosophies, his or her basket will contain a good mix of value, growth as well as some out-of-the-box (contrarian) stocks. This can help the investor to generate handsome returns in the long-run.

Disclaimer: The article is for informational purposes only and not investment advice.