A better understanding of the landscape can bring a fruitful harvest. Deep dive into these FAQs to help you make more informed decisions.
When you invest in equities, you are buying shares in the stock of a company, usually traded on a stock exchange.
Types & themes
Growth stocks are expected to grow and post a much higher rate of earnings than the average market. They typically do not pay dividends as the earnings are used to finance future growth.
Good growth stocks offer attractive returns; the challenge lies in choosing these winners. Increasing sales, growing profit margins and earnings growth are some of the qualities to look for.
Choose growth stocks carefully as the company’s stock price could fall dramatically if growth falls short of expectations.
A value stock is one that is priced at a good bargain even though its fundamentals justify a higher price. Value stocks typically represent mature and stable businesses with modest but steady growth. Investors who buy value stocks at a bargain may need to wait out before the price recovers. Value stocks that are held over the longer term can translate into attractive market-beating returns for the more patient investors.
Not all cheap stocks are value stocks as some may be cheap for good reason.
Momentum stocks are those that are favoured / disfavoured by investors for a variety of reasons. Stocks that have shown consistent rise in earnings may experience an acceleration in its share price with investors betting the positive momentum to support further price rises. Likewise, stocks that face continuous selling pressure due to poor earnings record are experiencing a negative momentum. However, this momentum can reverse at any time and an investor who wants to make money from these stocks may end up buying at the wrong time and losing money.
Focus on the trend and not on timing if you want to invest in momentum stocks.
Cyclical stocks tend to move in tandem with the state of an economy, rising during an expansionary phase and falling upon contraction. When the economy is doing well, both companies and consumers will be more willing to spend on non-essential items; for consumers it may be a new car or house while companies may acquire additional equipment and/or set up new businesses.
Energy, basic materials, technology, financials, industrials, consumer discretionary are examples of cyclical sectors.
Keep an eye on the economic cycle to be able to capitalise from cyclical stocks.
Defensive stocks are the exact opposite of cyclicals in that they are not affected by the economic cycles. Both consumers and companies will continue to spend on essential items even during a recession. As there is a stable demand for products in the defensive sectors, it follows that earnings of these companies will also be more stable. Healthcare, utilities and consumer staples fall into this category.
Defensive stocks in the consumer sector can help buffer portfolios during an economic downturn.
Pricing & valuations
A fall in a stock price does not automatically make it cheap. Valuation measures help to pick out cheap or expensive stocks. One common valuation measure is the price to earnings ratio (P/E).
P/E = Price per share / Earnings per share
A stock is generally considered cheap if the P/E ratio is below its historical trend. For example, if a company’s average growth rate is 10% and its P/E is below that number, the stock is considered good value. If a stock is trading at a low P/E ratio, the chances of its price rising are high if growth is expected to go up. The P/E ratio can be calculated based on past earnings (trailing P/E) and forecast earnings (forward P/E).
To get a wholesome picture, compare a stock’s P/E against others in the same industry.
Analysts do not rely on one valuation measure but a combination to assess a company’s value. Another common measure is the price to book ratio (P/B).
P/B = Price per share / Book value per share
The lower the ratio, the more undervalued the stock. Book value refers to the book value of assets minus the book value of liabilities on a company’s balance sheet.
As the P/B ratio does not consider future earnings prospect or intangible assets, it should not be relied upon as the only valuation measure.
The price to earnings growth ratio (PEG) is an important forward-looking measure of a company’s earnings prospects. Both the P/E and PEG ratios should be assessed to provide a better picture of a stock’s fundamentals.
PE/G = Price to Earnings Ratio / Projected Earnings Growth
The lower the ratio, the more undervalued the stock is relative to its earnings projections whilst a higher ratio suggests the stock is overvalued.
A stock with a high P/E may not be overvalued if its PEG ratio results in a low number (assuming good growth prospects).
The earnings yield (EY) is the reverse of the P/E ratio and is simply another way of looking at returns across stocks against their risk profiles. In addition, EY is a useful measure when comparing returns across asset classes such as bonds.
EY = Earnings per share / Price per share
A sufficiently higher EY is needed to justify the risk of investing in equities rather than bonds.
The dividend yield (DY) reveals the amount of income you obtain from a stock in relation to its price.
DY = Annualised dividends per share / Price per share
The higher the ratio, the more attractive the dividend-paying stock seems. However, dividends are not guaranteed and in times of recession, companies can stop paying dividends.
